Tax Treatment of Health Insurance Expenditures by the Self-Employed: Current Law and Selected Economic Effects
CRS Report for Congress
Received through the CRS Web
Tax Treatment of Health Insurance
Expenditures by the Self-Employed:
Current Law and Selected Economic Effects
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division
Summary
The federal tax code has offered a deduction for the health insurance expenditures
of the self-employed since 1987. In 2001, self-employed individuals may deduct from
their gross income 60% of the cost of health insurance for themselves and their
immediate families, and the share is scheduled to rise to 70% in 2002 and 100% in 2003
and thereafter.
The deduction encourages the self-employed to purchase non-group health
insurance by lowering its after-tax cost. While there is evidence that it has boosted
health insurance coverage among the self-employed since it went into effect, the
deduction in its present form raises some economic policy issues. Specifically, some are
concerned that it is more valuable to high-income than low-income households,
encourages the consumption of inefficient amounts of health care, and could worsen the
problem of adverse selection in health insurance markets.
Tax Treatment of Health Insurance Expenditures by the Self-
Employed
Under Section 162(1) of the Internal Revenue Code, self-employed persons are
permitted to deduct from their gross income a portion of the cost of health insurance they
purchase for themselves and their immediate families. The self-employed are defined as
sole proprietors, working partners in a partnership, and employees of Subchapter S
corporations who own more than 2% of their stock.1 The deduction is taken above-the-
line, which means that it is available regardless of whether a self-employed person itemizes.
1 Subchapter S corporations are not subject to the corporate income tax but enjoy the non-tax
benefits of regular corporations, especially limited liability under state laws. To qualify as an S
corporation, a firm can have no more than 75 shareholders, the shareholders must be resident
citizens of the United States, and the firm can issue only one class of stock.
Congressional Research Service The Library of Congress
It lowers a self-employed individual's after-tax cost of health insurance by a factor equal
to her or his marginal tax rate. In 2001, 60% of health insurance premiums are deductible,
and the deductible share is scheduled to rise to 70% in 2002 and 100% in 2003 and
thereafter. Between now and 2003, the portion of premiums that cannot be deducted may
be combined with other medical expenses, and the amount above 7.5% of adjusted gross
income may be claimed as an itemized deduction.
Certain rules govern the use of the deduction. First, self-employed individuals are not
allowed to deduct their health insurance expenditures in computing their self-employment
taxes. Second, the deduction cannot exceed a self-employed individual’s earned income
from the trade or business for which the insurance plan was established, less the deductions
for 50% of the self-employment tax and contributions to certain pension plans. Third, the
deduction cannot be claimed for any month in which a self-employed individual is covered
by a subsidized health insurance policy provided by a current or former employer or a
spouse's employer.
Under a provision of the Health Insurance Portability and Accountability Act of 1996
(HIPAA, P.L.104-191), self-employed individuals (like all other taxpayers) may include
long-term care insurance premiums in their health insurance expenditures eligible for the
deduction. However, there are indexed annual limits on the amount of premiums that can
be deducted, and the limits depend on the age of the insured individual: in 2000, these
limits ranged from $210 for those 40 years and under to $2,660 for those over 70.
The self-employed (along with employees of firms with 50 or fewer employees) also
have the option of opening medical savings accounts (MSAs) instead of buying
conventional health insurance. This option stems from a pilot program established by
HIPAA and begun in 1997 that is scheduled to last through 2002 and is limited to a total
of 750,000 participants. A MSA resembles an individual retirement account in that it is
a tax-exempt trust or custodial account established to pay unreimbursed medical expenses
as part of a high-deductible health care plan. Individual contributions to MSAs are
deductible from gross income up to an annual limit equal to 65% of the deductible (set at
$1,550 to $2,350 in 2000) for insurance policies covering one person and 75% of the
deductible (set at $3,100 to $4,650 in 2000) for policies covering two or more persons.
About 12.5 million workers were self-employed in 1998, up from 12.0 million in2
1995, according to the latest estimates by the Employee Benefit Research Institute. Of
the 1998 self-employed population, 9.0 million had private health insurance, 0.6 million
had public insurance – mainly Medicaid – and 3.1 million were uninsured. About 73% of
the self-employed with private health insurance (or 6.6 million) were covered through a
current or former employer or a spouse's employer. The remaining 2.4 million self-
employed with private health insurance purchased it themselves. According to the U.S.
Internal Revenue Service, 3.2 million claims for the deduction were filed in 1998, and the
total amount claimed was $4.5 billion. The congressional Joint Committee on Taxation
(JCT) estimates that the deduction cost the U.S. treasury $1.2 billion in forgone tax
revenue in fiscal year 2000.
2 Paul Fronstin, Sources of Health Insurance and Characteristics of the Uninsured: Analysis of
the March 1999 Current Population Survey, Issue Brief No. 192 (Washington: Employee Benefit
Research Institute, January 2000), Table 4, p. 10.
Tax Treatment of Employment-Based Health Insurance
In analyzing the economic effects of the tax deduction for health insurance
expenditures by the self-employed, a useful frame of reference is the tax treatment of
employment-based health insurance. The majority of Americans under age 65 are covered
by group health insurance policies provided by employers or labor unions. In 1998, an
estimated 154.8 million Americans (or 65% of the non-elderly population) were covered
by such policies. In general, employment-based group health insurance carries
substantially lower premiums than comparable individual or non-group health insurance
largely because large employers can pool the health risks among their workers and
efficiently process the information required to calculate and collect premiums and submit
claims.
Under current law, workers who obtain health insurance through their employers as
a fringe benefit pay no federal or state income and federal payroll taxes on their employers'
contributions for the insurance. For employers, the contributions are considered a
deductible business expense, like wages and salaries. There is no limit on the amount of
employer contributions per employee that can be excluded from taxation. If an employer's
contribution is less than the full premium, then covered employees typically pay for the
difference out of their after-tax incomes.
The exclusion for employment-based health insurance represents a significant and
costly subsidy for the purchase of this insurance. In effect, it reduces the after-tax cost of
health insurance to employees by a factor equal to their combined marginal income and
employment tax rates. This means for an employee covered by employment-based health
insurance that the tax exclusion reduces the price of that insurance in after-tax dollars3
relative to the prices of other goods and services he or she may consume. As a result, it
gives employees a robust incentive to prefer compensation in the form of health insurance
rather than wages and salaries. Wages are subject to income and payroll taxes, unlike
fringe benefits such as employment-based health insurance. Moreover, because the tax
exclusion is not capped, employees have an added incentive to prefer comprehensive
health insurance with little or no cost sharing. With over 60 million workers taking
advantage of the tax exclusion, it has a sizable impact on the federal budget.4 The JCT
estimates that the exclusion lowered federal income tax revenue by $61.3 billion in FY
3 In an analysis of the potential effects of various fundamental tax reform proposals on employer-
provided health insurance, economists Jonathan Gruber and James Poterba estimated that the after-
tax price of $1.00 of this insurance in 1994 was $0.62 in wages because of the tax exclusion for
employment-based health insurance. See: Jonathan Gruber and James Poterba, "Fundamental Tax
Reform and Employer-Provided Health Insurance," in Economic Effects of Fundamental Tax
Reform, Henry J. Aaron and William G. Gale, eds. (Washington: Brookings Institution Press,
4 See Thomas M. Selden and John F. Moeller, “Estimates of the Tax Subsidy for Employment-
Related Health Insurance,” National Tax Journal, vol. 53, no. 4, December 2000, p. 880.
Legislative History of the Health Insurance Deduction for the Self-
Employed
The tax deduction for health insurance expenditures by the self-employed was first
enacted as a temporary provision of the Tax Reform Act of 1986 (TRA, P.L. 99-514). It
was equal to 25% of health insurance premiums and scheduled to expire at the end of
1989. Although the TRA specified that Congress was to assess the effectiveness of the
deduction before it expired, no such study was completed. Nonetheless, with strong
bipartisan support, the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239)
extended the deduction through September 30, 1990. The deduction was further extended
by the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508) through December 31,
1991, the Tax Extension Act of 1991 (P.L. 102-227) through June 30, 1992, and the
Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66) through December 31, 1993.
No measure renewing the deduction was enacted in 1994.
Under legislation enacted in April 1995 (P.L. 104-7), the deduction was reinstated
retroactively for 1994, made permanent, and increased to 30% of eligible premiumsth
starting in 1995. The 104 Congress further modified the deduction by passing the Health
Insurance Portability and Accountability Act of 1996 (P.L.104-191), which included a
gradual rise in the deduction from 30% in 1996 to 80% in 2006.
With the urging of small business owners, the 105th Congress twice liberalized the
deduction. The Taxpayer Relief Act of 1997 (P.L. 105-34) accelerated the scheduled
increase in the deduction and made health insurance expenditures by the self-employed
fully deductible in 2007. And the Omnibus Consolidated and Emergency Supplemental
Appropriations Act for FY 1999 (P.L. 105-277) made health insurance expenditures by
the self-employed fully deductible beginning in 2003.
Selected Economic Effects of the Tax Deduction for the Self-
Employed
Economists tend to evaluate subsidies like the tax deduction for health insurance
expenditures by the self-employed largely on the basis of their effects on economic equity
and efficiency. In general, depending on their design, tax subsidies can transfer resources
from taxpayers as a whole to the intended beneficiaries, altering the distribution of income.
Tax subsidies can also increase the expected benefits from engaging in the targeted
activities, altering the allocation of economic resources.
Equity Effects. The fairness of the health insurance tax deduction for the self-
employed can be assessed from two different but complementary perspectives. One is the
federal tax treatment of health insurance as a whole, and the other is the deduction’s
impact on different income groups among the self-employed.
Before the enactment of the deduction in 1986, the federal tax code subsidized the
purchase of health insurance through the exclusion for employer contributions for
employment-based health insurance and the deductibility of medical expenses (including
health insurance premiums) beyond a certain level of taxable income for individuals who
itemized (including the self-employed). On the eve of the enactment, the tax subsidy per
dollar of health insurance expenditure was much greater for individuals with employer-
provided health insurance than for self-employed individuals who purchased their own
health insurance, and the gap was greatest for individuals in the highest tax brackets. Thus
it can be argued that the deduction for the self-employed has made the tax treatment of
health insurance more equitable by reducing the disparity between the tax subsidy for
employment-based health insurance and that for health insurance bought by the self-
employed.
The equity effects of the tax deduction take on a different appearance when the frame
of analysis shifts to its impact across income groups. As the tax subsidy for health
insurance expenditures by the self-employed is a deduction, its value depends on a self-
employed individual’s marginal tax rate. The higher the rate, the larger the subsidy per
dollar of health insurance. Since high-income households are more likely to be covered
by health insurance than low-income ones, the deduction is likely to amplify this difference
in coverages rates. A 1994 study by economists Jonathan Gruber and James Poterba
supports this view. They found that between 1985-86 and 1988-89 health insurance
coverage rose much more among self-employed households with over $50,000 (1985
dollars) in income than among self-employed households with less than $20,000 (1985
dollars) in income.5
Efficiency Effects. In essence, the tax deduction for health insurance expenditures
by the self-employed affects economic efficiency in two ways. One is through its impact
on the decision by self-employed individuals to purchase health insurance. The second
avenue is through the deduction’s impact on the amount of health care consumed by
individuals who become insured in response to the price effects of the deduction. It is
unclear from available evidence what the net efficiency effect of the deduction has been.
Nevertheless, its magnitude is likely to be small; the self-employed with private health
insurance accounted for only about 5% of privately insured nonelderly Americans in 1998.
On the one hand, consumers generally are better off when they have the opportunity
to protect themselves against the risk of catastrophic financial losses caused by unexpected
events like severe illness or injury. This principle implies that the presence of a market for
health insurance enhances economic efficiency.
Yet this market and the related market for health care are subject to certain problems
that may elevate the price of heath insurance to the point where too few consumers have
it. Prices might reach such levels partly because a share of health insurance premiums is
used to pay for some of the cost of providing uncompensated health care to the uninsured.
Putting additional upward pressure on premiums is the presence of adverse selection in the
private health insurance market. Adverse selection arises when individuals with relatively
high risks of developing costly health problems who know more about their health status
than insurers subscribe to insurance plans composed mostly of lower-risk individuals.
Once high-risk individuals become insured, insurers have no choice but to raise premiums
on all plan subscribers in the next period to cover higher-than-expected claims. As
premiums rise, more and more lower-risk individuals leave the plans for less costly ones
5 Jonathan Gruber and James Poterba, "Tax Incentives and the Decision to Purchase Health
Insurance: Evidence From the Self-Employed," The Quarterly Journal of Economics, vol. 109, no.
or drop out of insurance risk pools altogether and self-insure. Over time, adverse
selection, if unchecked by policy measures such as mandatory community rating could
result in too few individuals covered by health insurance. In addition, because health
insurance lowers the price of health care paid by individuals, it can encourage the
consumption of inefficient amounts of health care, further driving up health insurance
premiums. These market failures imply that the level of health insurance coverage may be
less than socially optimal in the absence of government intervention.
For these reasons, it can be argued that the deduction for the self-employed improves
economic efficiency to the extent that it increases health insurance coverage among the
self-employed. Indeed, it appears that the deduction has increased the health insurance
coverage rate among the self-employed by reducing the after-tax cost of this insurance.
Gruber and Poterba have estimated that because of the decline in the after-tax price of
health insurance induced by the deduction for 25% of health insurance expenditures that
took effect in 1987, the coverage rate for the self-employed went up by 6.8% between6
On the other hand, health insurance may reduce economic efficiency through its
encouragement of the consumption of inefficient amounts of health care. Health insurance
substantially lowers the out-of-pocket cost of covered health services to insured
individuals, and this price reduction increases utilization of health care. The magnitude of
the increase depends on the price sensitivity of the demand for health care. Such an
outcome is likely to entail efficiency losses because it violates another prerequisite of
economic efficiency – namely, that the marginal benefits of consuming a good or service
should equal its marginal costs. In other words, health insurance leads insured individuals
to consume additional health care whose actual marginal benefits may be less than its
actual marginal costs.
The deduction for the self-employed also does not remedy the problem of adverse
selection in the health insurance market — although it may offset some of the price effects
of this problem. One significant advantage of employment-based health insurance is that
it reduces the scope for adverse selection by fostering the growth of group health
insurance policies priced on the basis of the average risk of a large pool of workers,
typically with varying health problems and risk preferences. Under such a risk-pooling
arrangement, it is likely that the insurer's assessment of the average risk for the group
would come close to the group's actual average risk. By contrast, the deduction for the
self-employed encourages the purchase of individual or non-group policies priced on the
basis of what information an insurer can obtain about the health status and history of the
persons to be covered by them. The scope for adverse selection is greatest when the
purchase of health insurance is voluntary and health insurance is priced on the basis of
narrow rather than wide risk pools.
6 Ibid., p. 720.