Federal Tax Treatment of Health Insurance Expenditures by the Self-Employed: Current Law and Issues for Congress

Federal Tax Treatment of Health Insurance
Expenditures by the Self-Employed:
Current Law and Issues for Congress
Updated February 22, 2008
Gary Guenther
Analyst in Public Finance
Government and Finance Division



Federal Tax Treatment of Health Insurance
Expenditures by the Self-Employed:
Current Law and Issues for Congress
Summary
Current federal tax law allows self-employed individuals to deduct from their
gross income the entire amount of their spending on health insurance for themselves
and their spouses and dependents.
This report explains how these expenditures are treated under the federal tax
code, reviews the legislative history of the deduction, assesses its effectiveness as a
policy tool for expanding access to health care for the self-employed, describes
proposals in the 110th Congress to modify the deduction, and discusses policy issues
it raises. It will be updated to reflect significant legislative action.
Under section 162(l) of the Internal Revenue Code (IRC), self-employed
individuals may deduct the entire amount of their payments for health insurance for
themselves and immediate family members. A self-employed individual is defined
as a sole proprietor, a working partner in a partnership, or an employee of a
subchapter S corporation who owns over 2% of the firm’s stock. Use of the
deduction is governed by several rules. First, it may not exceed an eligible taxpayer’s
net earned income from the trade or business in which the health plan was
established, less the deductions for 50% of the self-employment tax and contributions
to certain pension plans. Second, the deduction may not be claimed for any period
when a self-employed individual is eligible to participate in a health plan offered by
an employer or by a spouse’s employer. Third, the expenditures eligible for the
deduction may not also be added to the medical expenses eligible for the itemized
deduction under IRC section 213. Finally, self-employed individuals must include
their expenditures eligible for the deduction in the income base for the self-
employment tax.
The tax deduction for health insurance expenditures by the self-employed has
advantages and disadvantages. On the one hand, it is relatively easy for the IRS to
administer and for self-employed taxpayers to claim and establishes greater parity
between the tax treatment of health insurance for the self-employed and the taxation
of employer contributions to employee health plans. On the other hand, the
deduction provides the greatest tax benefit for the same insurance policy to those who
arguably need it the least: self-employed individuals with the highest incomes.
At least two bills in the 110th Congress (H.R. 3660 and S. 2239) would eliminate
one of the remaining obstacles to the equal tax treatment of health insurance
purchased by the self-employed and the taxation of health insurance obtained by
employed individuals from their employers. The obstacle lies in a significant
difference between the payroll taxes paid by wage earners and those paid by the self-
employed: health insurance expenditures by the self-employed are included in the
income base for the taxes, whereas employer contributions to employee health plans
are not. H.R. 3660 and S. 2239 would allow the self-employed to treat these
expenditures as a deductible business expense, exempting them from the self-
employment tax.



Contents
Current Law and Coverage..........................................1
Legislative History of the Health Insurance Deduction for the Self-Employed...4
Effectiveness of the Deduction.......................................5
Legislation in the 110th Congress to Modify the Deduction.................8
Policy Issues Related to the Deduction.................................8
List of Tables
Table 1. Deduction for Health Insurance Expenditures by the Self-Employed
on Federal Income Tax Returns...................................4



Federal Tax Treatment of Health Insurance
Expenditures by the Self-Employed:
Current Law and Issues for Congress
Current federal tax law makes it possible for self-employed individuals to
deduct the entire amount they spend on health insurance for themselves and their
spouses and dependents. This treatment is similar to the exclusion for employer
contributions to the health plans of wage earners, with one noteworthy exception:
employer contributions are exempt from payroll taxes (e.g., Medicare and Social
Security taxes), but health insurance expenditures by the self-employed are not
deemed a deductible business expense and thus are subject to the self-employmentth
payroll tax. Companion bills in the House and Senate in the 110 Congress would
allow self-employed taxpayers to exclude those expenditures from the income base
for the tax.
This report examines the current tax treatment of these expenditures, the
legislative history of the deduction, its effectiveness as a policy tool for improvingth
access to health care for the self-employed, proposals in the 110 Congress to alter
the deduction, and the main policy issues it raises.
Current Law and Coverage
Under section 162(l) of the Internal Revenue Code (IRC), self-employed
individuals are allowed to deduct the entire amount of their spending for health
insurance for themselves and their immediate family members. A self-employed
individual is defined as a sole proprietor, a working partner in a partnership, or an
employee of a subchapter S corporation who owns over 2% of the firm’s stock.1 The
deduction is claimed above-the-line, which means it may be claimed even if a self-
employed individual does not itemize deductions on his or her income tax return.
Some self-employed individuals hire employees to assist with their trade or
business. Any self-employed individual who offers health benefits to employees may
deduct the cost of those benefits as an ordinary and necessary business expense. But


1 Subchapter S corporations pay no corporate income tax. Instead, their items of income and
loss, deductions, and credits are passed on to shareholders, who must report them on their
own income tax returns. To qualify for subchapter S status, a firm may have no more than
100 shareholders, all of whom must be citizens or residents of the United States; may issue
only one class of stock; and must be a domestic corporation organized under the laws of any
state or U.S. territory.

he or she may not include the cost of these benefits in any deduction claimed under
IRC section 162(l).
Use of the deduction is subject to several limitations. First, the deduction may
not exceed a self-employed taxpayer’s net earned income from the trade or business
in which the health plan was purchased, less the deductions for 50% of the self-
employment tax and contributions to certain pension plans (e.g., Keogh plans or
simplified employee pension plans for the self-employed).2 If a self-employed
taxpayer earns income from more than one business or trade, he or she may not sum
the profits and losses from those businesses to determine the net income ceiling for
the deduction. Second, the deduction may not be claimed for any month when a self-
employed individual is eligible to participate in a health plan offered by an employer
or a spouse’s employer. Third, the expenditures eligible for the deduction may not
also be included in the medical expenses eligible for the itemized deduction under
IRC section 213 — though health insurance expenditures that cannot be deducted
under IRC section 162(l) may be included in these medical expenses.3 Finally, health
insurance spending by self-employed individuals is not deemed a business expense,
which means that those expenditures are part of the income base for the self-
employment tax of 15.3%.
In addition, self-employed individuals may add their payments for long-term
care insurance to the health insurance expenditures eligible for the deduction. But
the deductible amount of long-term care insurance premiums is limited by the age of
the individual at the close of the tax year, and the limits are indexed for inflation. In
2008, the deductible amounts range from $310 for those age 40 and under to $3,850
for those age 71 and over.
Besides purchasing a health insurance policy in the non-group market and
claiming the deduction, a self-employed individual has two options for obtaining
health insurance coverage that offer more tax advantages than the deduction.
They may open a health savings account (HSA), which serves as a tax-exempt
vehicle for paying medical and dental expenses not covered by insurance or not
otherwise reimbursable.4 An individual can open an HSA and make contributions
to it only if he or she is covered by a qualified high-deductible health insurance plan
and no other plan, including Medicare (with a few exceptions). In 2008, qualified
plans must carry a deductible of at least $1,100 for individual coverage (with an out-
of-pocket limit of $5600), and $2,200 for family coverage (with an out-of-pocket


2 All self-employed individuals must pay the self-employment (SECA) tax, whose purpose
is to provide Social Security and Medicare benefits to such individuals. The tax, whose
current rate is 15.3%, is assessed on self-employment income, which is defined as the net
earnings from self-employment. In reality, it consists of two separate taxes: a 12.4% Social
Security tax and a 2.9% Medicare tax. Employees pay the same taxes, but they split the tax
evenly with their employers.
3 Taxpayers claiming the itemized deduction for medical expenses may deduct all such
expenses that exceed 7.5% of adjusted gross income.
4 For more details on HSAs, see CRS Report RL33257, Health Savings Accounts: Overview
of Rules for 2008, by Bob Lyke.

limit of $11,200). Total contributions to an HSA in 2008 are limited to the lesser of
the deductible or $2,900 for individual plans, and the lesser of the deductible or
$5,800 for family plans. Employer contributions are exempt from income and
employment taxes, and account owners may claim a deduction for contributions they
make. Self-employed individuals may not contribute to an HSA on a pre-tax basis
(unlike employees who contribute to such an account through an employer’s cafeteria
plan), and they must include their contributions in the income base used to determine
the self-employment tax. Withdrawals to pay for medical expenses are not subject
to taxation. Unused balances may be carried over without limit to the following year
with no tax penalty.
Self-employed individuals may also open Archer medical savings accounts
(MSAs) — though the total number of such accounts nationwide is currently capped
at 750,000. They are similar in design to HSAs but more restrictive in the rules for
contributions. Holders of MSAs are allowed to own HSAs and transfer their MSA
balances to the new accounts. It is not known how many self-employed individuals
are covered by MSAs and HSAs.
An estimated 14.1 million non-elderly individuals were self-employed in 2006,
the most recent year for which data on U.S. health insurance coverage by
employment status are available. Of this total population, 9.7 million had private
health insurance, 0.9 million received public health insurance (mainly Medicaid), and
3.8 million were uninsured.5 About 72% of the self-employed with private health
insurance (or 7.0 million) in 2006 were covered through plans offered by a current
or former employer or a spouse’s employer. The remaining 2.7 million (or 19% of
the self-employed population) with private health insurance purchased it on their
own.
According to the Internal Revenue Service (IRS), self-employed taxpayers filed
3.9 million claims for the deduction for a total amount of $19.6 billion in 2005 (see
Table 1).6 Individuals with adjusted gross incomes from $50,000 to under $500,000
accounted for 58% of those claims.
The revenue cost of the deduction was an estimated $4.3 billion in FY2007.7
This cost represents the tax revenue that would have been collected if there were no
deduction, and self-employed taxpayers instead had added their health insurance
expenditures to the expenses eligible for the itemized deduction for medical
ex penditures.


5 Paul Fronstin, Sources of Health Insurance and Characteristics of the Uninsured: Analysis
of the March 2007 Current Population Survey, Issue Brief No. 310, Employee Benefit
Research Institute (Washington: October 2007), fig. 11, p. 14.
6 Internal Revenue Service, Statistics of Income Bulletin: Fall 2007 (Washington: 2007),
table 1, p. 37.
7 Office of Management and Budget, Analytical Perspectives: Fiscal Year 2009
(Washington: GPO, 2008), p. 295.

Table 1. Deduction for Health Insurance Expenditures by the
Self-Employed on Federal Income
Tax Returns
Percent of the
Tax ReturnsTotalAverage Self-Employed NotEligible for
Yearwith theDeduction Amount Amount Per ReturnMedicare
($ millions)($ billions)($)with IndividuallyPurchased Health
Insurance

1990 2.754 1.627 591 29a


1995 3.011 2.601 864 22
1999 3.492 6.755 1,934 20
2000 3.565 7.569 2,123 19
2001 3.560 8.177 2,297 19
2002 3.571 10.494 2,939 20
2003 3.802 16.454 4,328 19
2004 3.884 18.457 4,733 19
2005 3.901 19.646 5,037 18
Sources: Employee Benefit Research Institute, Sources of Health Insurance and Characteristics of
the Uninsured (Washington: various years); Internal Revenue Service, Statistics of Income Bulletin:
Fall 2007 (Washington: 2007), table 1, p. 37.
a. 1991
Legislative History of the Health Insurance
Deduction for the Self-Employed
The tax deduction for health insurance purchased by self-employed individuals
entered the federal tax code as a temporary provision of the Tax Reform Act of 1986
(TRA86, P.L. 99-514). Initially, it was limited to 25% of qualified expenditures and
was scheduled to expire at the end of 1989. Although the act specified that Congress
was to assess the deduction’s effectiveness before it expired, no such study was
completed.
Congress made several significant changes in the rules governing the
deduction’s use before it considered legislation to extend the deduction beyond 1989.
The Technical and Miscellaneous Revenue Act of 1988 (TAMRA, P.L. 100-647)
added the limitation that the deduction cannot exceed a self-employed taxpayer’s
earned income from the trade or business in which the health insurance policy was
established. TAMRA also added the requirement that the deduction be included in



a self-employed taxpayer’s income base for the computation of the self-employment
tax.
A string of laws enacted in the early 1990s extended the deduction for brief
periods. The Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) extended
the deduction through September 30, 1990 and made it available to certain
subchapter S corporation shareholders; the Omnibus Budget Reconciliation Act of
1990 (P.L. 101-508) extended the deduction through December 31, 1991; the Tax
Extension Act of 1991 (P.L. 102-227) extended it through June 30, 1992; and the
Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66) extended the deduction
through December 31, 1993.
For reasons that evidently had nothing to do with the effects of the deduction,
Congress allowed it to expire at the end of 1993 and did not extend it in 1994. But
a bill adopted in April 1995 (P.L. 104-7) permanently extended the deduction,
retroactive to January 1, 1994. It also increased the deductible share of health
insurance expenditures by the self-employed to 30%, starting in 1995 and continuing
thereafter.
The 104th Congress turned its attention to the deduction again in 1996, when it
passed the Health Insurance Portability and Accountability Act of 1996 (HIPAA, P.L.
104-91). Among other things, the act established a timetable for raising the
deductible share of health insurance expenditures from 30% in 1996 to 80% in 2006
and thereafter. HIPAA also permitted self-employed taxpayers to include in the
spending eligible for the deduction any payments they make for qualified long-term
care insurance as of January 1, 1997; imposed annual limits on the amount of long-
term care insurance premiums that could be deducted; and indexed these limits for
inflation.
The Omnibus Consolidated and Emergency Supplemental Appropriations Act,
1999 (P.L. 105-277) accelerated the timetable for removing one of the differences
between the tax treatment of employer-provided health insurance and the taxation of
health insurance purchased by the self-employed by raising the deductible share of
health insurance spending by the latter to 100%, beginning in 2003 and thereafter.
Effectiveness of the Deduction
One way to evaluate the effectiveness of the deduction is to determine whether
it has achieved its intended purpose. Congress was seeking to achieve at least two
policy objectives in enacting the deduction as part of TRA86. One was to provide
the self-employed with a tax benefit for health insurance comparable to the exclusion
for employee health benefits. The other objective was to foster a substantial8
expansion of health insurance coverage among self-employed individuals. To what
extent have these objectives been achieved?


8 U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act
of 1986, JCS-10-87 (Washington: GPO, 1987), p. 815.

The deduction reduces the after-tax cost of health insurance for a self-employed
individual by a factor equal to his or her marginal income tax rate. For example, a
self-employed individual in the 35% tax bracket realizes a 35% reduction in the after-
tax cost of a health plan by claiming the deduction.
All other things being equal, a reduction in the after-tax cost of this insurance
can be expected to lead to an increase in the coverage rate among the self-employed.
The extent of the gain would hinge on how sensitive their demand for health
insurance is to changes in its cost. There is some evidence that the demand for health
insurance among single self-employed individuals is responsive to declines in this
price.9 Yet unlike a tax credit for the purchase of health insurance, which would be
of equal value to everyone who claims it, the deduction is of lesser value to those
with lower incomes and of greater value to those with higher incomes, for the same
health insurance plan. This is because the tax benefit from a deduction depends on
a taxpayer’s marginal tax rate: for a taxpayer in the 35% bracket, a $100 deduction
reduces his or her tax liability by $35; but for a taxpayer in the 10% bracket, the same
deduction yields a reduction in tax liability of $10. To the extent that health
insurance coverage among the self-employed varies with household income, the
deduction reinforces this linkage.
Does the deduction create a level playing field between wage earners and the
self-employed in the tax benefits they receive for the purchase of health insurance?
Yes and no. On the one hand, the deduction has the same direct effect on the after-
tax cost of health insurance as the exclusion for employer contributions to employee
health plans: both lower that cost by a factor equal to an individual’s marginal tax
rate. On the other hand, the expenses eligible for the deduction are subject to the
self-employment tax, whereas employer contributions to employee health plans are
exempt from payroll taxes. This difference means that the after-tax cost of a health
plan is 15.3% higher for a covered self-employed individual than for a covered wage
earner. On a truly level playing field, self-employed individuals would be able to
exclude their payments for health insurance from the income base used to determine
the self-employment tax.
It should also be noted that the federal tax code does not provide a level playing
for every taxpayer who purchases health insurance. There is no preferential treatment
for health insurance bought by the unemployed or individuals whose employers do
not offer health benefits — other than the itemized deduction for medical
expenditures.
Is there any evidence that the deduction has caused an expansion in health
insurance coverage among the self-employed? Such an effect seemed to materialize
in the first few years after the deduction was enacted. In 1985, the year before the


9 A 1994 study by the economists Jonathan Gruber and James Poterba of the impact of the
deduction on the demand for health insurance by the self-employed found that a 1% increase
in the after-tax cost of this insurance lowered the likelihood that a single self-employed
person will be insured by 1.8 percentage points. See Jonathan Gruber and James Poterba,
“Tax Incentives and the Decision to Purchase Health Insurance: Evidence from the Self-
Employed,” Quarterly Journal of Economics, vol. 109, no. 3, August 1994, p. 727.

deduction was enacted, 69% of the self-employed were covered through private
health plans (both plans they purchased individually and plans offered by former
employers); but in 1987, the first full year in which the deduction could be claimed,
the share climbed to 76%. It is possible that much of that rise in coverage was due
to the advent of the deduction. Still, coverage has trended downward ever since: it
was 69% in 2006, the most recent year for which data are available.10 In addition, the
share of the self-employed population with individually purchased private health
insurance was significantly lower in 2006 (19%) than in 1991 (29%). These declines
raise the possibility that whatever initial boost the deduction may have imparted to
the demand for health insurance by the self-employed has been more than offset by
certain other factors. A powerful countervailing force has been increases in the cost
of health care, which is the main driver of trends in the cost of health insurance. In
recent decades, the cost of health care has risen much faster than overall inflation.11
This is not to suggest that the deduction no longer influences a self-employed
individual’s decision to purchase health insurance. Given that the deduction reduces
the after-tax cost of health insurance, health insurance coverage among the self-
employed since the late 1980s probably would have been notably lower if the
deduction had not been available.
At the same time, there is some evidence that the use of health care by the self-
employed is not as tethered to health insurance coverage as one might expect. A
2001 study by Craig Perry and Harvey Rosen of the role of health insurance in the
use of medical services by the self-employed found that the “self-employed had the
same utilization rates for medical services in 1996 as wage-earners, despite the fact
that they (the self-employed) were substantially less likely to be insured.”12 More
specifically, Perry and Rosen found no statistically significant differences between
employees and the self-employed in hospital admissions, hospital stays, dental
checkups, and optometrist visits, while the self-employed had higher utilization rates
for alternative care and chiropractor visits. The authors concluded that the self-
employed were able to “finance access to health care from sources other than
insurance,” such as their own assets or loans. Their findings call into question one
of the justifications made for the deduction during the debate over adopting it:


10 The source for these figures is the Annual Social and Economic Supplement (ASES) to
the Current Population Survey (CPS) conducted monthly by the Census Bureau for the
Bureau of Labor Statistics. Although the CPS covers about 50,000 households, the ASES
is a survey of about 78,000 households that is done in March of each year. Respondents to
the ASES are asked to answer a variety of questions about the health insurance coverage in
the previous year of every member of a household. See the bureau’s website at
[ h t t p : / / www.c e n s u s . go v/ hl t h i n s / ove r vi e w] .
11 For U.S. urban consumers, this cost rose at an average annual rate of 5.4% between
January 1987 and January 2006; by contrast, the overall rate of inflation for the same set of
consumers in that period was 3.1%. The price index used to measure the rate of inflation
for health care is the Consumer Price Index for medical care services used by all urban
consumers (1982-84=100). Overall inflation is measured by the Consumer Price Index for
all items used by these consumers.
12 See Craig William Perry and Harvey S. Rosen, Insurance and the Utilization of Medical
Services Among the Self-Employed, working paper 8490 (National Bureau of Economic
Research: Cambridge, MA, September 2001), p. 26.

namely, that it was needed to raise health insurance coverage among the self-
employed, thereby giving them the same access to health care as wage earners
covered by employer health plans.
Legislation in the 110th Congress
to Modify the Deduction
Many bills to create new tax subsidies for health insurance have been introduced
in the 110th Congress. Some of them would benefit the self-employed. A case in
point is the proposals (e.g., H.R. 914 and S. 1875) to establish a refundable tax credit
for individuals who purchase health insurance on their own. Depending on its
design, such a credit could lead to more extensive health insurance coverage among
self-employed individuals, as well as the population at large. A key consideration is
the effective rate of the credit. If it is large enough to lower the after-tax cost of
health insurance more than the deduction does, then a self-employed individual
would be better off claiming the credit. A simple example illustrates this point.
Suppose a self-employed individual in the 15% tax bracket buys a health insurance
policy for $3,000. Would he or she be better off with a 50% refundable tax credit for
that purchase or a deduction of $3,000? With the credit, the after-tax cost of the
policy would be $1,500, but with the deduction, the after-tax cost of the policy would
rise to $2,550. And the individual would receive the credit even if he or she has no
federal income tax liability.
At least two bills in the current Congress would modify the deduction to get rid
of a remaining difference between the tax treatment of health insurance purchased
by the self-employed and the tax treatment of employer contributions to employee
health insurance. The difference lies in the disparate reach of the Medicare and
Social Security taxes paid by wage earners on the one hand and by the self-employed
on the other hand: health insurance expenditures by the self-employed are subject
to the taxes, whereas employer contributions to employee health plans are not.
Proposals by Senator Bingaman (S. 2239) and Representatives Herger, Kind,
Schwartz, and a few others (H.R. 3660) would exempt these expenditures from the
self-employment tax by allowing the self-employed to treat them as a deductible
business expense. It is not known what the revenue cost of the proposed exemption
would be. Nonetheless, this cost could be an important consideration in future
congressional deliberations over whether to adopt such an exemption.
Policy Issues Related to the Deduction
The tax deduction for health insurance expenditures by the self-employed has
several advantages. It is relatively simple for the IRS to administer and for self-
employed individuals to claim. In addition, the deduction contributes to an expansion
in health insurance coverage among the self-employed and their immediate families
by lowering the after-tax cost of health insurance. Many economists regard a lack of
health insurance as a market failure because of the negative externalities associated
with being uninsured: the uninsured are more likely than the insured to spread
communicable diseases, and the cost of uncompensated care received by the



uninsured is passed on to taxpayers through higher taxes and to insured patients
through higher prices for medical care.13 The deduction also establishes a substantial
degree of parity between the tax treatment of health insurance purchased by the self-
employed and the taxation of health benefits obtained by employees from their
employers.
Yet the deduction also has some disadvantages, some of which have
implications for the debate in the current Congress over the use of tax subsidies to
shrink the size of the domestic uninsured population.
First, the deduction leads to insurance outcomes that many regard as unfair or
unseemly. This is because its value to self-employed individuals who claim it
depends on their marginal tax rates. Under the tax system’s progressive rate
structure, a deduction of $1 is of greater value to someone with a relatively high
income (as much as $0.35) than to someone with a relatively low income (as little as
nothing). Although disposable income plays a major role in decisions about whether
to buy health insurance or how much coverage to buy, the deduction delivers the
smallest marginal benefit to those who arguably are in greatest need of public
assistance in order to be insured. One policy option for avoiding such a result is to
enact a refundable tax credit for the purchase of health insurance that phases out over
some range of relatively high incomes. Such a credit would deliver the largest
marginal benefit to those most in need of assistance and the smallest (or no) marginal
benefit to those least in need of assistance.
Second, the deduction cannot compensate for or replicate the significant
advantages of receiving health insurance through an employer. Those advantages
stem from certain critical differences between the group and non-group (or
individual) health insurance markets. On the whole, wage earners who receive health
benefits through their employers participate in the group market, while self-employed
individuals who purchase health insurance from private insurers participate in the
non-group market. Group health plans generally cater to the health care needs of
relatively large groups of people who are drawn together for purposes other than
obtaining insurance, such as employment. The plans are managed by sponsors (e.g.,
an employer) who negotiate directly with insurers on behalf of the insured members.
By contrast, individual health plans generally are tailored to the health care needs of
the individuals seeking coverage. Insurers set premiums and benefits in the group
market mainly on the basis of key characteristics of the particular groups seeking
coverage, especially their recent claims history, demographic composition, and
geographic location; premiums tend to reflect an insurer’s assessment of the expected
cost of claims for medical services by the average member of a group (or risk pool).
By contrast, insurers set premiums and benefits in the individual market mainly
through a practice known as medical underwriting. Each applicant usually undergoes
a thorough medical examination to assess his or her risk for developing a variety of
serious health problems. Once the assessment is completed, an insurer then decides
whether or not to offer a policy, what coverage to provide if it offers a policy, and the
cost of that coverage, within the requirements imposed by state law.


13 Jonathan Gruber, Public Finance and Public Policy (New York: Worth Publishers, 2005),
p. 401.

The differences between the two markets translate into more stable pricing and
lower premiums in the group market than in the non-group market.14 Premiums tend
to be lower for comparable coverage in the group market for several reasons. Group
insurance offers economies of scale in administrative functions such as billing,
marketing, and claims processing that cannot be duplicated in individual insurance.
In addition, relatively large employers can use their employment size to negotiate
deals with insurers that provide more generous benefits with lower cost-sharing
requirements than individuals could obtain on their own.
There is no simple or easy way to modify the deduction so that self-employed
individuals could enjoy the advantages of employer-sponsored health plans to the
same extent as wage earners. Such an outcome would require an overhaul of the U.S.
health insurance market that would allow any adult not eligible for public health
insurance (e.g., Medicare or Medicaid), regardless of his or her employment and
health status, to join any group health plan on the same terms as those available
through similar plans offered by large employers.
Third, like the exclusion for employer contributions to employee health plans,
the deduction has the potential to foster inefficient uses of medical care. Such an
outcome is the result of a market failure peculiar to insurance markets known as
moral hazard. In the case of health insurance, moral hazard refers to the impact of
insurance on the demand for medical services. Health insurance gives covered
individuals a powerful incentive to consume too much health care because the
insurance allows them to pay only a fraction of its cost through deductibles or co-
payments. As a result, they could use medical services until their marginal benefit
equals their out-of-pocket cost, and for someone with comprehensive first-dollar
coverage, that cost can be nothing. Widespread use of health care whose marginal
benefit is less than its true marginal cost entails a social welfare loss.
Neither the exclusion nor the deduction are capped. Without an upper limit on
coverage, wage earners and the self-employed are more likely to purchase generous
health insurance coverage than they would if they were required to pay in after-tax
dollars for coverage beyond the cost of a typical individual or family policy in the
regions where they reside. Indeed, conventional economic theory predicts that
offering substantial subsidies for health insurance coverage will result in the purchase
of more insurance than individuals would choose without the subsidies.15 This extra
coverage is more likely to activate the substantial costs of moral hazard than
coverage that requires individuals to pay for most of the cost of routine medical
procedures and fully insures only large medical expenses.16 Capping the deduction
at an amount tied to average premiums in the non-group market for individual or
family plans is one way to curtail whatever welfare loss arises from overly generous
health insurance coverage. For example, the President’s Advisory Panel on Federal
Tax Reform recommended in its final report that the exclusion for employer-


14 CRS Report RL32237, Health Insurance: A Primer, by Bernadette Fernandez.
15 Kathleen McGarry, “Public Policy and the U.S. Health Insurance Market: Direct and
Indirect Provision of Insurance,” National Tax Journal, December 2002, p. 795.
16 Gruber, Public Finance and Public Policy, p. 409.

provided health insurance be limited to $11,500 for families and $5,000 for
individuals in 2006; these amounts were the projected average health insurance
premiums that year.17
And fourth, the deduction does nothing to remedy a lack of horizontal equity in
the tax treatment of spending on health insurance. Under current tax law, the
unemployed and those whose employers do not provide health benefits receive no
above-the-line deduction for their expenditures on health insurance. Several
proposals in the 110th Congress (e.g., H.R. 227) would eliminate this inequity.


17 President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth:
Proposals to Fix America’s Tax System (Washington: November 2005), p. 81.