Tax Credits and Medical Savings Accounts

Mark V. Pauly, Ph.D., LDI Senior Fellow, Bendheim Professor; Professor of Health Care Systems, The Wharton School;
John C. Goodman National Center for Policy Analysis

Volume 2, Number 4; June 1995

Many current proposals for health reform include the establishment of medical savings accounts (MSAs) to help individuals pay medical bills. Other proposals include tax credits or tax deductions to help individuals purchase health insurance. This Issue Brief summarizes a proposal to use tax credits, MSAs and catastrophic health insurance to improve efficiency and equity in the health care sector.


The proposal has no personal or employer mandates for health insurance. Instead, it changes the incentive structure for individuals to make the choices between appropriate medical care and excessive use of services.

The Pauly and Goodman proposal features:

a personal income tax credit (of a fixed dollar amount), to reward those who insure voluntarily by obtaining, at minimum, basic catastrophic coverage;
basic catastrophic insurance coverage (with a specified maximum deductible) to cover large medical bills families cannot afford, with higher out-of-pocket payments protected by medical savings accounts; and
medical savings accounts (with after-tax dollars) to pay small medical bills and reward prudent purchasing decisions.

The current system

The U.S. tax system provides a subsidy of nearly $100 billion per year to people who buy private health insurance through their employers.

The present system excludes employer-paid premiums from federal income and payroll taxes. This tax policy:

favors the financing of medical services via insurance, and offers a larger tax break for more costly insurance. Conventional insurance stimulates the use of medical care, because it shields individuals from the true cost of their care.
provides a tax subsidy only to those who work for employers who arrange such coverage.
offers tax breaks to some people but not others earning the same incomes. Also, since the value of the subsidy is directly correlated with a person's marginal tax rate, the subsidy is greater for higher income workers than for lower income workers.

Medical Savings Accounts (MSAs):

Special accounts earmarked to cover out-of pocket medical expenses

Most MSA proposals create a tax-free account from which a person could pay medical bills not covered by insurance. Money deposited in the account would be excluded from taxes, as would any interest earned on the account. The size of the tax subsidy is larger for people paying higher tax rates. Proposals differ on the maximum and minimum amounts of an MSA, on the requirement for health insurance, and on tax treatment of withdrawals and rollovers.

Some proposals permit funds to be withdrawn from the account at any time, as long as income and payroll taxes are paid.
Others impose penalties if funds are withdrawn from the account (similar to the Individual Retirement Account).
Others permit funds to be rolled over into a retirement account, or used to pay for post-retirement health care, or withdrawn without penalty after a certain age.

Problems with tax-free MSAs

Analyses show that tax-subsidized MSAs reduce the incentive to purchase excessive health insurance, but increase the incentive to purchase uncovered medical care, since they subsidize out-of-pocket dollars.

The effects of tax-free MSAs, pointing in opposite directions, reduce their value from a policy perspective and could even lead to an increase in total medical spending. In specific, there are two effects of tax-free MSAs:

a positive "cross-price effect", which encourages consumers to substitute out-of-pocket payments for insurance. This reduces administrative costs, and reduces the overall costs of care, because insurance encourages more costly care.
a negative "own price effect", which provides incentives for higher medical spending because of the tax subsidy. The more people deposit and spend out of an MSA, the lower their taxes.

The view that tax-subsidized accounts encourage medical spending is based on analyses of Flexible Spending Accounts (FSAs), tax- free accounts that employers can offer to cover uninsured medical expenses. In the 1980's tax laws were changed to prohibit open- ended FSAs because they were thought to be too inflationary. They were then replaced by a use-it-or-lose-it provision (leftover funds for the year revert to the employer), which is intended to limit the inflationary effect.

Synthesis of Pauly and Goodman proposal

Tax credits: a specific dollar reduction in taxes contingent on the purchase of at least basic catastrophic coverage

The proposal accomplishes the goals of adequate insurance coverage, appropriate resources to pay for out-of-pocket payments, and fair and efficient financing through a strategy linking tax credits, catastrophic health insurance and medical savings accounts.

The proposal encourages individuals and groups to give up the tax subsidy on employer-paid health insurance, and instead take a refundable tax credit. The fixed dollar credit will likely offset the additional taxes owed. This approach improves upon the old distortive system by:

removing the incentive to purchase more costly insurance packages, because the amount of the tax credit stays the same regardless of coverage chosen.
treating all individuals equally through eligibility for the tax credit, regardless of their employment status.

Basic catastrophic insurance coverage: protection against the risk of large medical bills above a deductible

The proposal encourages people to take costs and benefits into account in making decisions about medical care and coverage. Cost savings can be achieved by the lower insurance premiums charged for policies with relatively high deductibles, and by prudent purchasing decisions. This approach improves upon the old system by:

changing the favorable tax treatment of expensive full coverage policies; government policy would become neutral about the insurance decisions made by individuals.
prompting people to make decisions about how much risk (of medical costs) they are willing to accept and how much they will transfer to insurance.

Medical Savings Accounts: created with after-tax dollars

The proposal encourages efficient financing of medical expenses through MSAs, which would be set up with after-tax dollars.

Accounts would help families finance out-of-pocket expenses and make higher deductible policies more attractive.
Minimum MSA balance would be set at an amount below the maximum deductible, reducing the risk for out-of-pocket expenses to acceptable levels.
Unused funds could be withdrawn and used for other purposes at the end of an insurance year.

How will this work?

A simple version of the proposal would tell people: you are entitled to a $750 tax credit if:

you are not receiving a tax-sheltered employer contribution to your health insurance;
you buy insurance with a maximum deductible of $2000 (or $3000);
you establish a medical savings account with a minimum balance of $1500 [or $2000), leaving a maximum out-of-pocket expense of $500 or $1000.

The specific dollar limits on the catastrophic deductible and out- of-pocket expenses are policy decisions that need to be made.

Will many people choose to establish an MSA?

The experience of Flexible Savings Accounts is not encouraging. Nationwide, only about 9% of all employers offer FSAs, and only a fraction of employees use them. An FSA offers a more constrained tax subsidy than an MSA, but is a guaranteed way to reduce taxes. It is not known whether the use-it-or-lose-it provision is a significant deterrent to establishing an FSA.

Additional policy choices

Beyond the broad outlines of a tax credit, MSA, and minimum catastrophic insurance, other policy decisions must be made to fully implement the proposal. These include:

individual vs. group choice: should individual employees be allowed to exercise the tax credit option, or should the entire group be required to do so? The latter strategy would probably induce the largest number of people to join the new, more efficient tax system. However, permitting individual employees to "defect" might be less cumbersome than requiring a group decision.
tax treatment of rollovers: as an incentive to maintain an MSA, should the interest earned be rolled over or withdrawn without tax penalty at the end of the year? To limit the governmentŐs revenue loss on tax-free interest, there could be a maximum amount that an MSA can earn tax free.
varying the tax credits by income: should the tax credit be scaled to income levels? Since the current tax subsidy rises with income, the credit might increase with income, to encourage maximum participation in these groups. However, this will offer little incentive for lower-income families to participate. Alternately, the credit might decrease with income, especially if we want lower income groups to obtain more generous coverage. But this has a cost to other taxpayers, and may deter work efforts.

This brief is based upon two articles: M.V. Pauly and J.C. Goodman, "Tax Credits for Health Insurance and Medical Savings Accounts," Health Affairs (Spring 1995);14:125-139, and M. Pauly, An Analysis of Medical Savings Accounts: Do Two Wrongs Make a Right? (Washington: American Enterprise Institute, 1994).