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Policymakers Shouldn’t Repeal Limit on Tax-Advantaged Health Accounts

The House Ways and Means Committee is scheduled to consider legislation (H.R. 1270) this week to repeal health reform’s limit on the use of flexible spending accounts (FSAs) and other tax-advantaged health accounts to purchase over-the-counter medicines.  The limit, which has been in effect for more than four years, is both sound tax policy and health policy and should be retained. 

Health reform raised revenue by conforming the definition of medical expenses that individuals can cover with FSAs and other tax-advantaged accounts with the income tax code’s long-standing definition for the itemized deduction for medical expenses.  As a result, starting in 2011, individuals could no longer use these accounts to receive reimbursements for the cost of over-the-counter medications and other over-the-counter items without a prescription or a letter of medical necessity from a physician.  

Among the reasons this limit makes sense:

  • Few workers benefit from the tax break these accounts provide.  In 2010, 39 percent of all workers had access to FSAs through their employers and only 37 percent of those with access participated, according to the Congressional Research Service.
  • High-income people benefit disproportionately from the tax break.  That’s because they’re in higher tax brackets, tend to consume more health care, and can afford to deposit larger amounts in their accounts.  Middle- and lower-income people benefit much less, if at all, because they pay little or no income tax and therefore can receive little income-tax savings from tax-advantaged accounts. 
  • Administration and compliance is costly.  Employers must manage the accounts themselves or hire a vendor to do so — typically at a cost of about $60 annually per participant.  Accountholders must spend hours complying with onerous recordkeeping requirements to ensure that they are using their accounts only for approved items.
  • Tax-advantaged accounts encourage the overconsumption of health care.  The accounts make people less price-sensitive and reduce the effectiveness of cost-sharing requirements in controlling health care use.  Moreover, prior to health reform’s restriction on over-the-counter items, funds in tax-advantaged accounts could be used to purchase nearly any health care item or service, regardless of whether it was medically necessary, cost effective, or of meaningful health value. 

Congress’ Joint Committee on Taxation (JCT) has offered several reasons for using the same definition of “medical care” for both tax-favored accounts and itemized deductions.  First, different definitions of “medical care” for different provisions caused similarly situated individuals to receive unequal tax treatment.  Second, purchases of over-the-counter medicines and other items (such as pain relievers, cold remedies, and sunscreen) constitute routine personal expenses, which generally aren’t considered deserving of a tax subsidy.  Third, “providing a subsidy for over-the-counter medicines may also result in less compliance, as it may be more difficult to distinguish products that are medical from those that are not, such as toiletries and products that promote general health.” 

Purchases of over-the-counter medicines also are a very minor expenditure for most people.  According to one survey, about 9.8 million households used an FSA to purchase over-the-counter medications in 2010, spending an average of $136 — which would have conveyed a tax benefit of only $14 to $48, depending on the household’s tax bracket. 

The limit on the use of FSAs and other tax-advantaged accounts remains a sound way to help pay for helping to extend health coverage to 25 million more Americans while lowering the deficit.  Lawmakers should reject the proposal to repeal it.