02 January 2008

Health Care and Federal Tax Complexity

The federal tax law that applies to health insurance benefits and medical expenses is unnecessarily complex, and fixing the problems could be done fairly easily.

The Status Quo

1. Self-Employed v. Employer Health Insurance.

Health insurance provide by an employer is not included in the income of an employee for purposes of either income taxation or FICA, but is deductible by the employer as a compensation expense.

Self-employed people (i.e. sole proprietors, partners and S corporation owners even if they receive primarily wages), in contrast, receive an above the line income tax deduction (which is a close equivalent to an exclusion of income for income tax purposes) for health insurance, but not for self-employment tax purposes (the self-employed person's substitute for FICA).

2. Personal v. Employer Health Insurance.

Health insurance not provided by an employer for someone who is not self-employed is deductible for income tax purposes, but not does not reduce that person's income for FICA tax purposes, just like an self-employed person. But, unlike self-employed people, this deduction is an itemized deduction. Thus, it is only available for people who itemize their tax returns (in practice, typically almost all homeowners and high income renters in states with income taxes). And, the deduction does not cover the first 7.5% of adjusted gross income spent on medical expenses including health insurance.

An employer that adopts a certain kind of Section 125 flexible benefit program for employees, something that requires no employer contribution other than administrative expenses, however, can give personally purchased health insurance of an employee the same treatment as employer provided health insurance (i.e. an above the line deduction that is also pre-FICA).

Generally speaking, Section 125 plans are not available to self-employed people.

3. Out of Pocket Health Care Expenditures.

Normally, out of pocket health expenditures other than health insurance reduce your taxable income only if you itemize and tax a medical expense deduction, and then reduce only your income taxes (not FICA or self-employment taxes) and applies only to amounts in excess of 7.5% of adjusted gross income.

In cases where exceptions to this general rule do not apply, this creates a tax incentive to purchase health insurance with low or not deductibles, because health insurance expenditures are favored to a greater extent in the tax code than other medical expenditures for employees with employer provided health care or a Section 125 plan and self-employed people.

But, there are exceptions. The principal ones are "Medical Savings Accounts" also known as Archer MSAs, which have since fallen out of favor (and may be phased out) as a second called "Health Savings Accounts" were adopted. A third exception is for Section 125 flexible spending accounts, and a fourth is a health reimbursement account.

The Archer MSAs are available only to self-employed people and small businesses (under 51 employees) in connection with a high deductible health insurance plan under Internal Revenue Code Section 220. Contributions by self-employed people are deductible up to 65% of the deductible (75% for families). Contributions by employers for employees are treated as health insurance expenditures and excluded from income, while contributions from employees receive treatment similar to that of self-employed people. Interest is tax free. Withdrawals before age 65 or a disability for non-medical expense purposes are subject to penalties similar to those for an early individual retirement account distribution (taxable and subject to a 15% penalty). Withdrawals for non-medical purposes for the disabled or elderly are taxable but not subject to a penalty. A similar option is available in connection with certain Medicare benefits under Internal Revenue Code Section 138.

Health savings accounts under Internal Revenue Code Section 223 can be set up by an employer with employer contributions or as part of a Section 125 flexible benefits plan (aka a cafeteria plan) with payroll deductions. Like Archer MSAs they are available only to high deductible health insurance plan enrollees, but unlike Archer MSAs they are not limited to small employers and self-employed people. Employer and employee payroll deduction contributions are excluded from income and FICA taxation. Self-employed and non-employer based contributions are above the line income tax deductible, but are not excluded from FICA taxation or self-employment taxes. Contributions are limited to $2,850 for an individual and $5,650 for a family, with an additional $800 of contributions allowed for people aged 55-64. Withdrawals for medical expenses are tax free. Over the counter drugs are permissible expenditures (unlike the medical expense itemized deduction). Withdrawals for non-medical expenses are taxable income and subject to a 10% penalty (the penalty does not apply to those age 65 or older or who are disabled).

A flexible spending account is a use it or lose it fund, up to $5,000 a year, set up by an employer that can be used for medical expenses including over the counter drugs that are not tax deductible for itemizers. The full amount is available at the beginning of the year, on a reimbursement basis. Contributions are typically deducted from each pay check in an amount set by the employee although the employer can contribute as well. Payments out of the account are tax free for both income tax and FICA purposes. These accounts are usually offered in connection with health insurance plans, but they need not be high deductible plans.

A health reimbursement account (created under Internal Revenue Code Section 105) is an agreement by an employer to pay specified kinds of health care costs. The reimbursements actually paid are treated like health insurance expenditures for tax purposes (i.e. excluded from income tax and FICA income) and do not involve an employee contribution. Self-employed people are not eligible. These plans either operate as self-funded health insurance plans or are offered in connection with another health insurance policy of any type.

While medical savings accounts and health savings accounts earn tax free interest, the tax savings from this component of the plans is typically nominal compared to the other tax benefits, because the amount of income is typically small, and the time period before the funds are used are typically only a few years.

The Solutions

Eliminating the 7.5% of adjusted gross income limitation on the medical expense deduction would end the income tax disparity between people who pay personal health insurance and those with self-employed health insurance under current law for itemizers.

Eliminating the 7.5% of adjusted gross income limitation on the medical expense deduction would also eliminate the vast majority of the income tax disparity between people who make out of pocket medical expenditures and those who are reimbursed out of an employer plan or tax privileged savings account of some sort.

Allowing the medical expense deduction to include over the counter drugs would further reduce the gap between medical savings accounts and reimbursement plans on one hand and the medical expense deduction on the other.

An additional tax credit for employees with medical expenses (including health insurance) equal to 7.5% of their itemized medical expenses up to FICA amounts actually paid would virtually eliminate the tax disadvantages for non-employer provided health care to the employee (although the employer would not get a FICA refund and would still be worse off for not providing health insurance and a savings plan). It would also eliminate positive or negative biases in favor of a particular deductible level, leaving the market to resolve that issue.

A shift of the medical expense deduction to be an above the line deduction for non-itemizers (also eligible for the tax credit) which would end disparate treatment of itemizers and non-itemizers.

The tax free interest benefit of medical savings accounts could be partially preserved by allowing withdrawals from individual retirement accounts to be made for unreimbursed medical expenses eligible for the medical expense deduction.

Fixing The Complexity From The Fix

These would also create record keeping complexity for non-itemizers. The over the counter drug deduction would also create additional complexity for itemizers.

A good solution to this problem would be to have two changes that would ease the consequences of poor record keeping.

First, health insurance companies could send a 1099-like form to covered individuals once a year showing health insurance premiums paid by that individual (if any), and the deductibles and co-payments spent by the person under the plan each year, something the companies already keeps track of even though the insured pays for them, allowing the taxpayer with health insurance who doesn't itemize to get most of the tax benefit with far less record keeping.

Second, there could be a standard deduction equal to the average per capita spending on over the counter drugs (perhaps one $50 standard deduction amount per exemption claimed on the return and an additional deduction in the same amount in addition for each person claimed as an exemption on the return who is over age 65), which could be claimed for people who don't want to keep track of over the counter drug spending. Those who document their over the counter drug expenses could claim a larger amount.

Transition Issues

While health care related plans under Internal Revenue Code Sections 105, 125, 220 and 223 could be repealed as they would be largely obsolete with the tax code changes I suggest, there is no compelling reason to do so right away.

Allowing people to jump through hoops to get a tax benefit that they can get even if they don't comply with the rules doesn't hurt anybody and keeping those sections on the books simplifies the transition with no tax revenue impact. Phase out rules would be more complicated to explain. Keeping these provision on the books would also eliminate the need to analyze what tiny niches of people might be hurt by their repeal.

Nuts and Bolts

A repeal Internal Revenue Code Section 162(l)(4) would eliminate the disparity between employer provided health insurance and self-employed health insurance which has no solid policy basis.

The 7.5% of adjusted gross income limitation if found at Internal Revenue Code Section 213(a) and could be eliminated by striking the last thirteen words of that provision.

The over the counter drug exclusion is found at Internal Revenue Code Section 213(b) which could be repealed, and replaced with the over the counter drug standard deduction.

The FICA tax credit would probably fit best in the tax code as an amendment to Internal Revenue Code Section 35, which provides health insurance tax credits to certain qualified individuals impacts by NAFTA and people receiving pension benefit guarantee payments, as a new Internal Revenue Code Section 35A.

Internal Revenue Code Section 62(a) (definition of adjusted gross income) could be amended to create an above the line deduction instead of an itemized one.

Internal Revenue Code Section 72(t) would be amended to allow penalty free withdrawals from retirement accounts for medical expenditures.

An addition section on information returns from health insurance companies would also have to be added to the information return part of the Code.


A bill only several pages long could dramatically simplify the federal tax treatment of health care, at a fairly modest tax cost (I'll save a specific revenue impact estimate for another post). This is not too surprising because it is possible for any business to structure its affairs in a way that achieves this end with the tools described above. Indeed, the key point of taking the step to simplify like this is that it simply reduces dead weight transaction costs and makes benefits available to the less sophisticated without letting anyone get more than they could have before with sufficient effort.

The simplification generally, would also make it easier for the uninsured and small businesses to secure health care, something that elaborate tax rules discourages both groups from even investigating, and something that the inability of employees in these situations to negotiate for benefits prevents them from achieving all together.

The reform would also probably be progressive in a tax sense because it would benefit primarily people who don't have employer provided health insurance with lots of bells and whistles who tend to have lower incomes.

No this isn't a radical overhaul of anything. The tax code probably isn't the place to do that. It is simply a way to simply the tax code that gives us something similar to the status quo but better to work from until a better solution can be secured.

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