A hidden tax in Obamacare
The healthcare law's $2,500 annual cap on flexible spending accounts will amount to a tax on older and sicker Americans.

Patient by Shutterstock.com

The central provisions of the Affordable Care Act require younger and healthier Americans to buy insurance policies that will, in essence, subsidize the health care of older and sicker Americans. But one of Obamacare's hidden taxes — a new limit on contributions to health flexible spending accounts, or FSAs — will hit older and chronically ill individuals hardest.

Starting this year, the health care law imposes a $2,500 annual cap on an individual's contribution to an FSA that is part of an employer's "cafeteria" benefits plan. Such contributions, diverted directly from one's paycheck, are not subject to federal income and payroll taxes. The money in an FSA can then be used to pay for qualified medical expenses such as deductibles, co-insurance and co-payments, as well as services not covered by insurance.

Before Obamacare, there were no FSA contribution limits for workers under federal tax law. Employers set their own annual limits, and many chose amounts well above $2,500. The federal government, as one example, allowed FSA contributions of up to $5,000 a year.

This implicit "tax" on wage income that now won't be diverted pretax into FSAs is expected to raise $1.5 billion this year, and a total of $13 billion between 2013 and 2019, according to the Joint Committee on Taxation.

So when President Obama offered his many variations on the assertion that if you have insurance from your job, nothing will change — that's not actually true. The FSA limit is just one of the ways the law extracts billions from already insured workers to pay for an expansion of Medicaid and subsidies for policies to be sold on health insurance exchanges.

The trick, of course, was to raise this tax revenue without aggravating more political backlash against the law when it passed in 2010. That meant making many such changes, and then rolling them out over multiple years to obscure the overall impact of higher taxes. Among them: an additional 0.9% payroll tax on individual salaries above $200,000, new taxes of 3.8% on investment income in similar higher-income households, and a 2.3% excise tax on the sale price of medical devices, all of which kicked in this year. The individual mandate to purchase federally approved health insurance arrives next year.

But this revenue enhancement strategy hit particularly vulnerable targets with this FSA cap.

In a 2012 study published in Forum for Health Economics & Policy James Cardon, Mark Showalter and Joel Moore examined patterns of FSA usage by income and health status from 1998 to 2008. They found that of the estimated 13.9 million households nationwide with an FSA, 35% will be affected by the new FSA cap, with an average tax increase of $101 in 2013. By 2020, an estimated 41% of FSA households will hit the FSA cap because medical costs will rise faster than the inflation-indexed limit on contributions.

Further, this tax burden will be highly skewed. The study found that among FSA-eligible households from 2004 to 2008, those who rank among the top 10% of contributors would have paid 66% of the additional tax if the cap were in place. And which households are most likely to set aside thousands a year for out-of-pocket health expenses? The sick. In fact, nearly two-thirds of these households included individuals with three or more chronic health conditions.

FSAs tend to be used for large and predictable health care expenditures such as prescription drugs to keep a chronic condition in check. Employees carefully estimate how much they should set aside because they forfeit the funds they don't use by the end of a health plan year. In other words, few individuals needlessly pad their FSAs.

Consider households that put more than $2,500 in an FSA three or more times in a five-year period. They tended to be older (average age 48) than those that never or rarely surpassed that amount. Also, 65% of such households were "unhealthy" (with three or more chronic conditions), while 35% of households that never used an FSA were "unhealthy."

Of course, the third of taxpayers who itemize their deductions might still be able to deduct a portion of their medical expenses without FSAs. About 10.4 million filers did so in 2010. But those deductions do not reduce payroll taxes, and they only apply to very large out-of-pocket costs — expenses exceeding 10% of a taxpayer's adjusted gross income. That's up from 7.5%, thanks to the health care law.

FSA caps reflect the bias throughout Obamacare for more comprehensive (and therefore costly) insurance coverage. Yet it was the flexibility of FSAs, which could fill certain gaps in coverage, that allowed employees to choose the more affordable plans that otherwise might appeal only to those with low health risks. This was good for employers too because they could get both "healthy" and "unhealthy" enrollees into one insurance pool, increasing the cost-sharing and risk-sharing across more people.

In March, the Senate approved an amendment to its budget to repeal the $2,500 FSA cap, but because a final joint House-Senate budget resolution for the next fiscal year remains extremely unlikely, we're probably stuck with this cap for now. Still, substantial support exists on Capitol Hill to remove this tax burden, which poses a danger to the health of chronically ill Americans. Congress should give it an expiration date before it produces more unintended harm.

Tom Miller is a resident fellow at the American Enterprise Institute.

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