A Primer on Tax Subsidies for Health Care

1. A Primer on Tax Subsidies for Health Care Larry LevittVice President of Special Projects Kaiser Family Foundation April 2009 This is Larry Levitt, a vice president at the Kaiser Family Foundation. As policymakers look to reform the nation's health system -- and potentially trim the rate of growth in government entitlement spending at the same time -- one issue that will likely come up is how the federal tax system subsidizes the cost of health insurance, an often misunderstood aspect of health care financing. Though not strictly an entitlement, tax subsidies for health insurance rival the federal cost of the Medicare and Medicaid programs. And like these health care entitlements, the federal expense for health insurance tax subsidies is driven in large part by the yearly rise in health care costs. This whirlwind tour through the tax system will explain how tax subsidies for health insurance work, and discuss the arguments for and against them.This is Larry Levitt, a vice president at the Kaiser Family Foundation. As policymakers look to reform the nation's health system -- and potentially trim the rate of growth in government entitlement spending at the same time -- one issue that will likely come up is how the federal tax system subsidizes the cost of health insurance, an often misunderstood aspect of health care financing. Though not strictly an entitlement, tax subsidies for health insurance rival the federal cost of the Medicare and Medicaid programs. And like these health care entitlements, the federal expense for health insurance tax subsidies is driven in large part by the yearly rise in health care costs. This whirlwind tour through the tax system will explain how tax subsidies for health insurance work, and discuss the arguments for and against them.

2. Types of Tax Subsidies for Health Care Under Current Law Health insurance subsidies Employer contributions for insurance are exempt from taxes for employees Section 125 plans subsidize worker contributions Self-employed can deduct premiums Subsidies for out-of-pocket health care expenses Health Savings Accounts (HSAs) Health Reimbursement Arrangements (HRAs) Flexible Spending Accounts (FSAs) Deduction for expenses >7.5% of income Broadly speaking, there are two types of tax subsidies for health care: [click] Subsidies that provide assistance with the purchase of health insurance, mainly employer-provided coverage. [click] And subsidies that provide a tax break for people's out-of-pocket expenses, including tax-free savings mechanisms like Health Savings Accounts. I'm going to start with this second group. And then spend more time on the first group, since insurance subsidies are perhaps most relevant to the developing health reform debate. And they're also probably the most confusing part of the tax system.Broadly speaking, there are two types of tax subsidies for health care: [click] Subsidies that provide assistance with the purchase of health insurance, mainly employer-provided coverage. [click] And subsidies that provide a tax break for people's out-of-pocket expenses, including tax-free savings mechanisms like Health Savings Accounts. I'm going to start with this second group. And then spend more time on the first group, since insurance subsidies are perhaps most relevant to the developing health reform debate. And they're also probably the most confusing part of the tax system.

3. Tax-free employer/individual contributions to account for out-of-pocket costs Must be enrolled in high deductible insurance plan; Minimum deductible of $1,150 single/$2,300 family; Preventive services exempt from deductible Limit on out-of-pocket costs Accounts are portable and roll over from one year to next Enrollment has grown – 6.1 million currently enrolled but only 4% of covered workers Tax Subsidies for Out-of-Pocket Health Spending: Health Savings Accounts [click] HSAs Of the various ways the tax system subsidizes out of pocket health care costs, Health Savings Accounts, or HSAs, are the most prominent, and perhaps the most controversial as well. Let me run through specifically how they work.An HSA is an account that an individual can set up to cover out of pocket health expenses with tax exempt funds. Employers and individuals can both make tax-free contributions to an HSA account, which are then used to cover out of pocket health costs. To set up an account, you have to be enrolled in a high deductible insurance plan. For 2009, the insurance policy has to have a minimum deductible of $1,150 for a single person, or $2,300 for a family. Only preventive services can be exempt from the deductible. The policy also has to have a limit on out of pocket costs -- $5,800 for a single, and $11,600 for a family. The accounts are owned by individuals, meaning they are portable and can be taken from job to job, or when changing insurance policies. And, balances roll over from one year to the next. HSAs have grown tremendously. 6.1 million people are now covered by insurance plans that are so-called HSA qualified, up from 1 million in 2005. Still, this represents a relatively small percentage of the overall insurance market -- just 4% of workers with coverage of any kind are enrolled in these plans. And, not everyone who has an HSA-qualified plan actually has a savings account or money in that account. For workers with a high deductible plan that qualifies for an HSA, about 1/4 don't get any contributions from their employers, while about 1/4 get contributions of $2,500 or more. [click] HSAs Of the various ways the tax system subsidizes out of pocket health care costs, Health Savings Accounts, or HSAs, are the most prominent, and perhaps the most controversial as well. Let me run through specifically how they work.

4. Tax Subsidies for Out-of-Pocket Health Spending: HRAs, FSAs, Deduction Health Reimbursement Arrangements Used with any type of plan Tax-free contributions by employers only Flexible Spending Accounts Tax-free employer/individual contributions Money is deducted from paycheck, lowering taxable income Use it or lose it Deduction for medical expenses Direct expenses and insurance premiums Only expenses above 7.5% income can be deducted Must itemize deductions [click] HRAs HRAs -- or health reimbursement arrangements -- sound similar to HSAs, but are really quite different. Unlike HSAs, HRAs do not have to be paired with a high deductible plan, though they often are. HRAs allow for tax-free contributions to cover out of pocket health costs. But unlike HSAs, only employers can make contributions, not individuals. [click] FSAs So, you've got HRAs, HSAs, and then…FSAs, or flexible spending account. These -- which have been around for quite a while -- are used by workers to set aside tax free money in advance to cover out of pocket health expenses. Like an HRA, an employer has to set up an FSA for it to be used by workers. There's no real cost to the employer for doing this beyond the administrative hassle. And, 73% of larger employers -- those with 200 or more workers -- that offer health benefits also set up FSAs. But only 20% of smaller businesses do so. Employees designate how much they want to contribute to an FSA at the beginning of the year. The money is automatically deducted from their paychecks, lowering the amount of their wages that are taxed -- that is, what shows up on their W2's at tax time. Employers can also contribute to FSAs, but employee contributions are more typical. Unlike HSAs and HRAs, FSA are referred to as use it or lose it. So, amounts don't carry over from year to year. [click] Deduction Separate from all the savings accounts and arrangements, health care expenses can also in certain cases be deducted on an income tax return. This applies to both direct expenses for health care services and insurance premiums. There are several limitations, though: The health care expenses must exceed 7.5% of adjusted gross income. Only the amount above 7.5% of income can be deducted. And, you must itemize deductions on your tax return in order to qualify. Given these limitations, the deduction is not seen as a broad-based subsidy for health care expenses. But even so, in the 2006 tax year, 10.2 million tax returns claimed this subsidy. [click] HRAs HRAs -- or health reimbursement arrangements -- sound similar to HSAs, but are really quite different. Unlike HSAs, HRAs do not have to be paired with a high deductible plan, though they often are. HRAs allow for tax-free contributions to cover out of pocket health costs. But unlike HSAs, only employers can make contributions, not individuals. [click] FSAs So, you've got HRAs, HSAs, and then…FSAs, or flexible spending account. These -- which have been around for quite a while -- are used by workers to set aside tax free money in advance to cover out of pocket health expenses. Like an HRA, an employer has to set up an FSA for it to be used by workers. There's no real cost to the employer for doing this beyond the administrative hassle. And, 73% of larger employers -- those with 200 or more workers -- that offer health benefits also set up FSAs. But only 20% of smaller businesses do so. Employees designate how much they want to contribute to an FSA at the beginning of the year. The money is automatically deducted from their paychecks, lowering the amount of their wages that are taxed -- that is, what shows up on their W2's at tax time. Employers can also contribute to FSAs, but employee contributions are more typical. Unlike HSAs and HRAs, FSA are referred to as use it or lose it. So, amounts don't carry over from year to year. [click] Deduction Separate from all the savings accounts and arrangements, health care expenses can also in certain cases be deducted on an income tax return. This applies to both direct expenses for health care services and insurance premiums. There are several limitations, though: The health care expenses must exceed 7.5% of adjusted gross income. Only the amount above 7.5% of income can be deducted. And, you must itemize deductions on your tax return in order to qualify. Given these limitations, the deduction is not seen as a broad-based subsidy for health care expenses. But even so, in the 2006 tax year, 10.2 million tax returns claimed this subsidy.

5. Tax Subsidies for Health Insurance: Employers Employers can deduct cost of health benefits for workers (but not a special subsidy for health insurance) Employer contributions for insurance are exempt from taxes for employees Benefits provided as tax free compensation No income or payroll tax paid by workers on value of benefit Worker contributions can be made pre-tax (125 plan) Taxable income is reduced by amount of contributions Self-employed can deduct premiums Individuals buying insurance on their own do not generally get subsidies Employer deduction: [click] Many think of the subsidy for employer-provided health insurance coverage as coming from employers being able to deduct the cost of health benefits. It is certainly true that they can deduct these costs, just like they can deduct pretty much any other business expense. Except, of course, for the so-called three-martini lunches made infamous by President Carter in the 1970s. But the employer deduction provides no special subsidy for health insurance. Exclusion: [click] In fact, the real subsidy for health insurance in the tax system is the fact that employer contributions for health insurance are not taxable, unlike wages. They are exempt from both income taxes and the payroll taxes that fund Social Security and Medicare. This in effect means that the government is covering a portion of the cost of health insurance, since the benefits are provided tax free. Which in turn leads to higher levels of employer-provided benefits than would otherwise be the case. I'll work through a couple examples in a minute, which will help explain this more clearly.Employer deduction: [click] Many think of the subsidy for employer-provided health insurance coverage as coming from employers being able to deduct the cost of health benefits. It is certainly true that they can deduct these costs, just like they can deduct pretty much any other business expense. Except, of course, for the so-called three-martini lunches made infamous by President Carter in the 1970s. But the employer deduction provides no special subsidy for health insurance. Exclusion: [click] In fact, the real subsidy for health insurance in the tax system is the fact that employer contributions for health insurance are not taxable, unlike wages. They are exempt from both income taxes and the payroll taxes that fund Social Security and Medicare. This in effect means that the government is covering a portion of the cost of health insurance, since the benefits are provided tax free. Which in turn leads to higher levels of employer-provided benefits than would otherwise be the case. I'll work through a couple examples in a minute, which will help explain this more clearly.

6. Example 1: Modest Income Family (15% Income Tax Bracket) Let me work through a couple examples of how this works for employer-sponsored coverage. We'll start with a modest income family with one worker and one stay at home parent. I'll show how taxes get calculated with the tax exemption in current law, and then also without it, to see the difference. Under both scenarios, this family has $50,000 in wages. And before accounting for health insurance, they have taxable income -- after other exemptions and deductions -- of $30,000. Now, let's say their employer provides a health insurance policy that costs $12,000, with the firm paying $10,000 towards it and the family paying $2,000. Those are pretty typical amounts. Under current law, the family's taxable income becomes $28,000 rather than $30,000. The $10,000 contributed by the employer is not taxable. And the family can exclude its $2,000 payment from income through a section 125 plan. If the tax exemption were removed, though, this would change quite a bit. The family could no longer exclude its $2,000 premium payment from taxes, and the $10,000 paid by the employer would count as taxable income. So, taxable income rises to $40,000. This is $12,000 higher than under current law, which is simply the amount of the health insurance premium. Looking at the income taxes actually owed by the family, they would go from $3,398 under current law, to $5,198 if the tax exemption were removed. That's a difference of $1,800, which represents the income tax subsidy provided to this family under the current system. [click] Another way to look at the $1,800 subsidy is that it's 15% of the total insurance premium. That's because the family is in the 15% income tax bracket. You can also see here the effect of the tax exemption on payroll taxes paid by employers and workers. For Social Security, the employer and the employee each pay 6.2% of wages up to a maximum wage of $102,000 for 2008. For Medicare, they each pay 1.45% of wages, with no cap. Note that the combined payroll tax subsidy for this modest income family is even greater than the income tax subsidy.Let me work through a couple examples of how this works for employer-sponsored coverage. We'll start with a modest income family with one worker and one stay at home parent. I'll show how taxes get calculated with the tax exemption in current law, and then also without it, to see the difference. Under both scenarios, this family has $50,000 in wages. And before accounting for health insurance, they have taxable income -- after other exemptions and deductions -- of $30,000. Now, let's say their employer provides a health insurance policy that costs $12,000, with the firm paying $10,000 towards it and the family paying $2,000. Those are pretty typical amounts. Under current law, the family's taxable income becomes $28,000 rather than $30,000. The $10,000 contributed by the employer is not taxable. And the family can exclude its $2,000 payment from income through a section 125 plan. If the tax exemption were removed, though, this would change quite a bit. The family could no longer exclude its $2,000 premium payment from taxes, and the $10,000 paid by the employer would count as taxable income. So, taxable income rises to $40,000. This is $12,000 higher than under current law, which is simply the amount of the health insurance premium. Looking at the income taxes actually owed by the family, they would go from $3,398 under current law, to $5,198 if the tax exemption were removed. That's a difference of $1,800, which represents the income tax subsidy provided to this family under the current system. [click] Another way to look at the $1,800 subsidy is that it's 15% of the total insurance premium. That's because the family is in the 15% income tax bracket. You can also see here the effect of the tax exemption on payroll taxes paid by employers and workers. For Social Security, the employer and the employee each pay 6.2% of wages up to a maximum wage of $102,000 for 2008. For Medicare, they each pay 1.45% of wages, with no cap. Note that the combined payroll tax subsidy for this modest income family is even greater than the income tax subsidy.

7. Example 2: Higher Income Family (28% Income Tax Bracket) Now, here's another example, showing a higher income family making $200,000, again with one stay at home parent. I won't go through the whole thing, but just note the bottom line: The income tax exemption is worth a lot more for this family -- $3,360 rather than $1,800. This is because the family's tax bracket is higher -- 28% rather than 15%. Interestingly, the exemption from payroll taxes is worth substantially less for this higher income family than in the previous example. This worker is well above the point where wages get capped for Social Security payroll taxes -- $102,000 -- so the exemption here doesn't make any difference in terms of the taxes owed. The only payroll tax subsidy is for Medicare, which isn't subject to any cap on wages.Now, here's another example, showing a higher income family making $200,000, again with one stay at home parent. I won't go through the whole thing, but just note the bottom line: The income tax exemption is worth a lot more for this family -- $3,360 rather than $1,800. This is because the family's tax bracket is higher -- 28% rather than 15%. Interestingly, the exemption from payroll taxes is worth substantially less for this higher income family than in the previous example. This worker is well above the point where wages get capped for Social Security payroll taxes -- $102,000 -- so the exemption here doesn't make any difference in terms of the taxes owed. The only payroll tax subsidy is for Medicare, which isn't subject to any cap on wages.

8. What Does the Exemption Cost? A tax provision that acts like an entitlement – costs go up annually without an act of Congress But, subsidies are “hidden” from workers and the federal budget As a result, costs can only be estimated Estimated federal cost = $224.7 billion in 2008 for active workers ($134.3 billion for income taxes, $90.5 billion for payroll taxes) Thinking about the overall cost of the tax exemption for the federal government, there are a few things to keep in mind: First, even though it's part of tax system, it really functions like an entitlement. Costs -- or in this case what are called tax expenditures -- pretty much go up every year, and without any appropriation or act of Congress. Also, because of the nature of the exemption, the subsidies are in a sense hidden. There's no piece of paper that identifies a subsidy that a worker receives. There's not even a line on your tax return that identifies it like other tax subsidies. In fact, they're not just hidden from families, but in a sense from policymakers as well. There's a fair amount of uncertainty about how much the exemption actually costs the federal government. Employers don't report their health insurance premiums to the government, so costs have to be estimated using statistical models of the health insurance system. Based on analysis from Jonathan Gruber at MIT, we estimate the federal cost for the tax exemption at about $225 billion in 2008. This is just for active workers. It doesn't include anything for retirees, who also get tax-free benefits from former employers. It also doesn't include state tax subsidies for those states that have income taxes and also provide an exemption for health insurance.Thinking about the overall cost of the tax exemption for the federal government, there are a few things to keep in mind: First, even though it's part of tax system, it really functions like an entitlement. Costs -- or in this case what are called tax expenditures -- pretty much go up every year, and without any appropriation or act of Congress. Also, because of the nature of the exemption, the subsidies are in a sense hidden. There's no piece of paper that identifies a subsidy that a worker receives. There's not even a line on your tax return that identifies it like other tax subsidies. In fact, they're not just hidden from families, but in a sense from policymakers as well. There's a fair amount of uncertainty about how much the exemption actually costs the federal government. Employers don't report their health insurance premiums to the government, so costs have to be estimated using statistical models of the health insurance system. Based on analysis from Jonathan Gruber at MIT, we estimate the federal cost for the tax exemption at about $225 billion in 2008. This is just for active workers. It doesn't include anything for retirees, who also get tax-free benefits from former employers. It also doesn't include state tax subsidies for those states that have income taxes and also provide an exemption for health insurance.

9. Based on the examples I worked through earlier, it's not too surprising that the benefits of the tax exemption go disproportionately to higher income workers. This is because they're more likely to have access to employer coverage, and also because they're in higher tax brackets. [click] In fact, if you look at a breakdown of the average tax exemption per worker by income, it ranges from just $319 for those with incomes under $20,000, to over $2,800 for those earning more than $150,000 per year.Based on the examples I worked through earlier, it's not too surprising that the benefits of the tax exemption go disproportionately to higher income workers. This is because they're more likely to have access to employer coverage, and also because they're in higher tax brackets. [click] In fact, if you look at a breakdown of the average tax exemption per worker by income, it ranges from just $319 for those with incomes under $20,000, to over $2,800 for those earning more than $150,000 per year.

10. Arguments Made For and Against the Tax Exemption For: Encourages employer coverage and pooling Reflects negotiated tradeoffs between benefits and wages Against: Provides regressive benefits; no subsidy for those without employer coverage Encourages “over insurance” (more generous coverage) Provides little opportunity to control federal cost Dating back many years, there have been proposals to alter the way the tax system subsidizes health care, and those ideas may play a role in the emerging health reform debate. Underlying debate over those proposals are a number of arguments made in favor of, and against, the tax exemption for employer coverage. Those in favor of the tax exemption argue that it… …encourages employer coverage, which many believe is a good thing. And because employer coverage groups together people with diverse characteristics -- younger and older, sicker and healthier -- the tax exemption encourages the pooling of risk. In contrast, the non-group insurance market -- which is largely unsubsidized by the tax system -- tends to exclude people who are sicker due to medical underwriting. Also, because the exemption is uncapped, it acts as a cushion for employers with sicker than average workers, and therefore higher costs. And, since the tax exemption has been around for so long, it reflects tradeoffs -- for example in union negotiations -- made between increases in wages and benefits. Changing the exemption would disrupt these tradeoffs. Critics generally point out, as discussed earlier, that… …the benefits of the tax exemption are regressive, with subsidies going disproportionately to higher income workers. Also, they argue that there's not a level playing field. People who buy coverage on their own generally don't get the benefit of any tax subsidy. Some also say that the exemption, because it is uncapped, encourages over-insurance. It's kind of like putting insurance on sale, so employers end up offering more generous insurance than they would otherwise. And again, because the tax exemption is uncapped and not really subject to any restrictions, the only way the federal government can lower the cost of it is by taking steps to lower the underlying cost of private insurance overall.Dating back many years, there have been proposals to alter the way the tax system subsidizes health care, and those ideas may play a role in the emerging health reform debate. Underlying debate over those proposals are a number of arguments made in favor of, and against, the tax exemption for employer coverage. Those in favor of the tax exemption argue that it… …encourages employer coverage, which many believe is a good thing. And because employer coverage groups together people with diverse characteristics -- younger and older, sicker and healthier -- the tax exemption encourages the pooling of risk. In contrast, the non-group insurance market -- which is largely unsubsidized by the tax system -- tends to exclude people who are sicker due to medical underwriting. Also, because the exemption is uncapped, it acts as a cushion for employers with sicker than average workers, and therefore higher costs. And, since the tax exemption has been around for so long, it reflects tradeoffs -- for example in union negotiations -- made between increases in wages and benefits. Changing the exemption would disrupt these tradeoffs. Critics generally point out, as discussed earlier, that… …the benefits of the tax exemption are regressive, with subsidies going disproportionately to higher income workers. Also, they argue that there's not a level playing field. People who buy coverage on their own generally don't get the benefit of any tax subsidy. Some also say that the exemption, because it is uncapped, encourages over-insurance. It's kind of like putting insurance on sale, so employers end up offering more generous insurance than they would otherwise. And again, because the tax exemption is uncapped and not really subject to any restrictions, the only way the federal government can lower the cost of it is by taking steps to lower the underlying cost of private insurance overall.

11. I'll close with an illustration of just how much money is potentially at stake here. This is not a specific proposal, or a precise forecast. [click] But, take a look at what would happen over the next 10 years under the status quo, assuming the tax exemption grows at the increase in projected insurance premiums, which is about 5.4% per year. Total tax expenditures -- that is, the cost to the federal government -- would amount to about $3.2 trillion. [click] If instead spending grew at expected inflation -- or about 2.4% per year -- total expenditures would instead be $2.8 trillion. [click] That would mean federal savings of $441 billion. Even these days, that's a lot of money. Of course, any proposal to eliminate or cap the current tax exemption would likely be controversial, with opponents arguing that it serves an important purpose in sustaining employer-based health insurance. But you can see why people will be paying close attention to the current tax system as a potential health reform debate unfolds.I'll close with an illustration of just how much money is potentially at stake here. This is not a specific proposal, or a precise forecast. [click] But, take a look at what would happen over the next 10 years under the status quo, assuming the tax exemption grows at the increase in projected insurance premiums, which is about 5.4% per year. Total tax expenditures -- that is, the cost to the federal government -- would amount to about $3.2 trillion. [click] If instead spending grew at expected inflation -- or about 2.4% per year -- total expenditures would instead be $2.8 trillion. [click] That would mean federal savings of $441 billion. Even these days, that's a lot of money. Of course, any proposal to eliminate or cap the current tax exemption would likely be controversial, with opponents arguing that it serves an important purpose in sustaining employer-based health insurance. But you can see why people will be paying close attention to the current tax system as a potential health reform debate unfolds.

12. Kaiser Family Foundation issue brief on tax subsidies for health insurancehttp://www.kff.org/insurance/7779.cfm America’s Health Insurance Plans census of HSA-eligible planshttp://www.ahip.org/content/pressrelease.aspx?docid=23159 Kaiser/HRET Employer Health Benefits Surveyhttp://ehbs.kff.org/ Congressional Budget Office analysis of health care budget optionshttp://www.cbo.gov/doc.cfm?index=9925 Kaiser resources on national health reformhttp://www.kff.org/uninsured/healthreform.cfm Kaiser survey of enrollees in consumer-directed health planshttp://www.kff.org/kaiserpolls/pomr112906pkg.cfm