A Primer on Tax Subsidies for Health Care Larry Levitt Kaiser Family Foundation December 5, 2008

Types of Tax Subsidies for Health Care Health insurance subsidiesHealth 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 expensesSubsidies for out-of-pocket health care expenses –HSAs –HRAs –FSAs –Deduction for expenses >7.5% of income Chart 1

Tax Subsidies for Out-of-Pocket Health Spending Health Savings AccountsHealth Savings Accounts –Minimum deductible of $1,150 single/$2,300 family; tax-free employer/individual contributions to cover out-of-pocket costs; portable and can be rolled over Health Reimbursement ArrangementsHealth Reimbursement Arrangements –Used with any type of plan; tax-free contributions by employers only; can generally be rolled over Flexible Spending AccountsFlexible Spending Accounts –Tax-free employer/individual contributions; use it or lose it Deduction for medical expenses >7.5% of incomeDeduction for medical expenses >7.5% of income Chart 2

Tax Subsidies for Health Insurance Employers can deduct cost of health benefits (just like any other business expense)Employers can deduct cost of health benefits (just like any other business expense) Employer contributions for insurance are exempt from taxes for employeesEmployer contributions for insurance are exempt from taxes for employees –1943: War Labor Board rules health benefits exempt from wage freeze –1954: Revenue Act codifies exclusion of benefits Worker contributions can be pre-tax (125 plan)Worker contributions can be pre-tax (125 plan) Self-employed can deduct premiumsSelf-employed can deduct premiums Otherwise, generally no subsidies for individuals buying on their ownOtherwise, generally no subsidies for individuals buying on their own Chart 3

Example 1: Modest Income Family With and Without the Tax Exemption With Tax Exemption Without Tax Exemption Difference Wages$50,000$50,000 Taxable income, before insurance $30,000$30,000 Employer premium contribution $10,000$10,000 Worker premium contribution $2,000$2,000 Wages, with insurance $48,000$60,000 Taxable income, with insurance $28,000$40,000$12,000 Income taxes $3,398$5,198$1,800 Worker payroll taxes $3,672$4,590$918 Employer payroll taxes $3,672$4,590$918 Source: Kaiser Family Foundation calculations. 15% of the premium Chart 4

Example 2: Higher Income Family With and Without the Tax Exemption With Tax Exemption Without Tax Exemption Difference Wages$200,000$200,000 Taxable income, before insurance $150,000$150,000 Employer premium contribution $10,000$10,000 Worker premium contribution $2,000$2,000 Wages, with insurance $198,000$210,000 Taxable income, with insurance $148,000$160,000$12,000 Income taxes $30,184$33,544$3,360 Worker payroll taxes $9,195$9,369$174 Employer payroll taxes $9,195$9,369$174 Source: Kaiser Family Foundation calculations. 28% of the premium Chart 5

Cost of the Exemption Acts like an entitlementActs like an entitlement But, subsidies are “hidden” from workers and the budgetBut, subsidies are “hidden” from workers and the 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)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) Chart 6 Source: Analysis by Jonathan Gruber for the Kaiser Family Foundation; figures for 2008 for active workers only.

Average Tax Exemption Per Worker (2008) Source: Analysis by Jonathan Gruber for the Kaiser Family Foundation; figures for 2008 for active workers only. Chart 7

Arguments Made For and Against the Tax Exemption For:For: –Encourages employer coverage and pooling –Reflects negotiated tradeoffs for benefits Against:Against: –Benefits are regressive; no subsidy for those without employer coverage –Encourages “over insurance” –Minimal ability to control federal cost Chart 8

Illustration: What If the Tax Exemption Grew at Inflation? Source: Kaiser Family Foundation analysis based on CMS projections for insurance premiums and CPI. Assumes no change in the number of people with employer coverage over time or as a result of lower subsidies. $580 B $3,430 B $2,850 B Chart 9