Annette Nellen

Pot of Gold in the Employer-Provided Healthcare Exclusion

How this pot also benefits tax reform.

June 12, 2008
by Annette Nellen, CPA/Esq.

As most CPAs will agree, money is a key issue when it comes to providing adequate health insurance for more individuals. Healthcare reform debates though, have not always included tax reform, despite the dollars in our tax code tied to healthcare and the frequent use of the tax law as a way to address social and economic problems.

In its 2005 report, President Bush’s Advisory Panel on Federal Tax Reform noted the connection between healthcare and tax reform. More recently, the Senate Finance Committee not only noted the connection, but is holding a hearing on both topics to help set the stage for the work of the 111th Congress (Senator Chuck Grassley of Iowa’s testimony (PDF) of May 2008 and June 2008 Health Reform Summit).

Below, we’ll look closer at the healthcare problem, the effects of the tax exclusion for employer-provided health insurance, examples of reform proposals, and the advantages and challenges of connecting healthcare and tax reforms.

Healthcare Problems

Key problems driving the need for healthcare reform include the following:

  1. Approximately 46 million Americans have no health insurance. (U.S. Census Bureau (PDF), 2006).
  2. Rising healthcare costs are projected to represent 25 percent of GDP in 2025, up from 16 percent in 2007 and five percent in 1965. Per capita healthcare spending has been growing on average at almost five percent annually over the past 40 years, more than double the rate of per capita GDP. Since 1985, healthcare spending has tripled reaching about $1.9 trillion in 2005 (CBO testimony (PDF), January 2008).
  3. Increased costs per patient due to new technologies and an aging population (CBO testimony (PDF)).

Our Tax System — Awkward Healthcare Facilitator

For federal income tax purposes, employers may deduct the cost of health insurance provided to employees. Employees may exclude the value of this benefit from their income. The “cost” of the exclusion in 2007 was about $134 billion (OMB, Analytical Perspectives FY2009 (PDF)). The cost is an estimate of revenues not collected due to the exclusion. Repeal would not yield this amount, however, due to behavioral changes that would occur. This exclusion is the largest tax expenditure in the federal tax system. The exclusion also means that Social Security and Medicare taxes are not paid on this employee benefit; this “cost” is not measured by the government.

Our tax law includes other favorable provisions for healthcare, including health savings accounts and an itemized deduction for medical care. The cost of these expenditures is far less than the exclusion, but ideally, any reform efforts would look at the entire package of tax provisions dealing with healthcare.

The exclusion has led to large numbers of insured individuals. In 2003, the breakdown of coverage sources was as follows (President’s Advisory Panel, Final Report (PDF)):

  • Employer-provided coverage    64 percent of individuals age 65 or                                           under
  • Government health plan          17 percent
  • Purchased on own                 7 percent

The exclusion creates inefficiencies in healthcare spending. Because employees do not directly pay for the insurance, they might select more insurance than they need. Also, when patients are not focused on costs, they may also seek more healthcare than needed which can drive up insurance and healthcare costs for everyone (Final Report (PDF)).


Tax reform proposals that make any change to the exclusion for employer-provided healthcare will affect healthcare, but do not address the entire set of healthcare issues. For example, the President’s Advisory Panel (PDF) proposed to keep the existing exclusion but to cap it at $11,500 (MFJ), with indexing. A deduction equal to the exclusion would be added as an option. While this approach is more equitable than the present system, many employees would still be disassociated from healthcare costs which can lead to inefficiencies. It would not cause all individuals to be insured.

President Bush’s FY2009 budget proposed to require employees to include employer-provided health insurance benefits in income. Individuals purchasing insurance through their employer or elsewhere would deduct the cost, limited to a standard deduction of $15,000 for family coverage. (Treasury Explanation (PDF)) S. 1111 (110th Congress), a tax reform proposal, also calls for a standard deduction for healthcare. This approach is likely to encourage more uninsured to obtain coverage, but would not result in universal coverage or address healthcare spending problems.

In contrast, S. 334 (110th Congress), the Healthy Americans Act, calls for mandatory coverage and uses the tax law to help support the mandate. Per Senator Wyden, S. 334 “cuts the link between health insurance and employment altogether.” The bill requires employers to increase wages by the amount of the employee’s insurance coverage. Workers would then be required to purchase private coverage. Other reforms are included, such as incentives for wellness programs, to help reduce healthcare spending, (Cong Rec S757, January 2007) While S. 334 includes a major tax change, it makes it in isolation of other needed tax reforms. This is relevant to tax reform discussions because it affects reform options. For example, elimination of the largest tax expenditure leaves fewer options for revenue neutral reform that would broaden the base and lower rates.

Finally, major tax reform proposals that replace the income tax with a consumption tax should consider the impact on healthcare. The flat tax, such as S. 1040 (110th Congress) and the national sales tax, H.R. 25 (110th Congress), eliminate the deduction for employer-provided health insurance (since these proposals are not based on income). This could lead employers to stop providing coverage. Such proposals should be coordinated with healthcare reform proposals.

Looking Ahead

Given the significance of the healthcare provisions in our income tax, their indirect effects on costs, and the ability of taxes to change behavior, healthcare reform and tax reform ideally should be addressed together.

Benefits of coordinated reform include the following:

  • Enabling all federal dollars devoted to healthcare to be considered in designing healthcare reform.
  • Making our healthcare and tax systems more equitable and efficient.
  • Lower healthcare spending.
  • Providing better support to Social Security and Medicare by reducing or eliminating the exclusion for health-related compensation.
  • Perhaps opening the door to worker classification reform by eliminating the link between employment and healthcare.

Change is never easy and dealing with two complicated systems — healthcare and taxes, which affect all Americans, will certainly be challenging. Given rising healthcare costs, the large number of uninsured individuals, the desire for tax reform and the reality that the two systems are connected, coordination in reform activities is warranted.

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Annette Nellen, CPA/Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.