Overview of Refundable Tax Credit

Modify the Tax Code to Create New Credits to Offset Cost of Health Insurance Premiums

What is it?

Tax code incentives aim to expand health insurance coverage by reducing the absolute cost that individuals face when buying insurance. Typical policy proposals include the provision of tax deductions or tax credits to individuals purchasing health insurance. However, proposals vary on how broadly these reforms should be applied, and many stipulate that the incentives be provided only to individuals with incomes below a certain threshold.

When a tax credit is provided, individuals subtract the amount of the tax credit from their total tax liability. Although the value of the credit is not usually provided directly to these individuals, the reduction in their tax liability effectively increases the amount of their income that is available for purchasing other goods such as health insurance. If the credit is refundable, the value of the tax credit is provided directly to the individuals. A key feature of a refundable credit is that individuals receive the full value of the credit even if it exceeds the amount of taxes owed.

A tax deduction also effectively increases the amount of income available for purchasing health insurance by reducing the amount paid in taxes, but it operates differently than a tax credit. The corresponding amount of the deduction is subtracted from individuals' total taxable income before determining their tax liability. The reduction in total taxable income results in a reduction in total taxes owed; however, the deduction cannot exceed the tax liability.

Proposals for tax incentives are almost always tied to the elimination of the deductibility of employer-sponsored insurance. Tax incentives are also considered regressive by some analysts because the tax-exemption is worth more to those with higher incomes since they would have to pay higher marginal tax rates on their premiums if they were included in taxable income. Another important consideration when evaluating tax incentive policy options is how incentives will affect those who do not pay taxes. Because a majority of the uninsured do not pay taxes, a tax incentive will be most effective at expanding coverage if it is available to those who do not pay taxes (i.e., a refundable credit rather than a deduction).

When comparing incentives, it is helpful to understand that a credit and deduction of equal nominal value are not financially equivalent, that is, a $1,000 tax deduction does not have the same monetary value as a $1,000 tax credit. This is because one is applied before tax liability is determined and the other is applied after tax liability is determined. While this tax credit would be equivalent to 1,000 after-tax dollars, the deduction would be equivalent to $1,000 times the marginal tax rate, which varies by income level but will always be less than the nominal amount of the deduction.

A final question is whether these incentives will apply to all types of insurance. For example, the tax incentives could be limited to non-group insurance, particularly if the deductibility of employer-sponsored insurance is not eliminated.

How would it work?

Current tax incentive proposals are usually tied to eliminating the deductibility of employer-sponsored insurance. Proposals can vary by the type and magnitude of the incentive provided. Tax credits may be refundable or nonrefundable.

1. Tax Deductions. The most commonly proposed tax deduction policy consists of replacing the existing tax exemption for employer-sponsored insurance (ESI) with a tax deduction of $7,500 for individuals and $15,000 for families. This tax deduction would be available for people with private health insurance, regardless of whether it is sponsored by their employer or is from the non-group insurance market.
2. Tax Credits. A number of reform proposals center on issuing tax credits to individuals and families who purchase health insurance. We describe several alternative arrangements that involve the use of tax credits.

One proposal consists of a refundable credit of up to $1,000 for individuals with incomes less than $15,000 and $3,000 for families with incomes less than $25,000. These credits will be phased out at incomes of $30,000 for individuals, $40,000 for single parents, and $60,000 for joint filers. Those who participate in ESI or public insurance are not eligible. Another proposal would provide a refundable credit of $2,500 to individuals and $5,000 to families.

Tax incentive policy options have been proposed in academic journals as well as by policymakers. One plan proposed a refundable tax credit equal to the difference between the cost of modest health insurance coverage and 10 percent of income. The credit could be used to buy employer-sponsored or non-group health insurance from a Federal Employees Health Benefits Program (FEHBP)-like pool at a premium price similar to the FEHBP Blue Cross and Blue Shield standard option. Another plan would provide a nonrefundable credit of up to $1,000 for individuals and $2,000 for families. Individuals with incomes up to $45,000 and families with incomes up to $75,000 would be eligible for the maximum credit value. The credit would phase out with higher incomes (up to $60,000 for individuals and $100,000 for families).

Has it been tried before?

In the early 1990s, academics were proposing the use of tax credits to address the problem of uninsurance. Proposals were made during the administration of George H. W. Bush, and presidential candidates in the 2000 election (including Senators Bill Bradley and Al Gore and then-Governor George W. Bush) all proposed the use of credits and/or vouchers (Pauley, Hoff, 2002). As president, George W. Bush has twice proposed tax incentives as an alternative to democratic proposals to move toward universal health coverage. However, then as now, tax incentive proposals face stiff opposition in Congress—especially since they are often tied to proposals to eliminate the tax deductibility of employer-sponsored health insurance.