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in 2009 there is no bigger issue

A Baucus Proposal Republicans Should Be Open To

by: John Goodman, Sept 30, 2009

Senator Max Baucus wants to limit the amount people can deposit into tax-free Flexible Spending Accounts to $2,500 a year. His goal: increase federal revenues to fund health reform. Ordinarily this would be a bad idea. However, if Baucus were to agree to allow unspent balances to roll over year-to-year in return for the cap, it’s a deal worth doing.  The reason: It would revolutionize consumer-driven health care.

What’s Wrong with FSAs?  Superficially, Flexible Spending Accounts (FSAs) seem similar to Health Savings Accounts (HSAs).  In fact, many people get them confused.  But the economic incentives these accounts create are profoundly different. The former encourages spending. The latter encourages saving. The FSA is what you would use if you know you are going to have health expenses and you want to pay them with untaxed dollars. The HSA is what you would use if you don’t know what your expenses are going to be and you perceive that self-insurance makes more sense than third-party insurance.

Under current law, only employers can offer FSAs. Once in place, employees can make monthly pre-tax deposits to their own account in order to pay medical expenses not covered by their health insurance plan.  In principle, the amount of the deposit is unlimited.  But because employers have to navigate various anti-discrimination rules, most limit the amount to $4,000 or $5,000 a year.  Ironically, employees must decide how much to deposit into these accounts by the beginning of the year — before they know for sure what their actual health care expenses are going to be.  Then they face a use-it-or-lose-it rule at year end, under which they must forfeit any unspent balances.

There are several reasons why economists tend not to like these accounts as they are currently structured.  First, since they allow people to consume health care with pre-tax dollars, they encourage people to wastefully over consume health care at the expense of other consumption.  Second, the use-it-or-lose-it provision encourages additional waste at year end.  Even if health care goods and services have very little value, people are encouraged to purchase them as opposed to forfeiting their remaining funds.  They may buy designer eyeglasses, for example.  One of our friends and his wife once scheduled his-and-her colonoscopies.

Superficially, it appears that FSAs could be an alternative to over-insurance through third parties.  In practice, they do not function that way. Although the law allows employers to make deposits to these accounts, almost none of them do so. The reason: These accounts encourage wasteful spending rather than prudent self-management of health care dollars on the part of the employees. 

What’s Wrong with HSAs?  The law governing HSAs is way too restrictive, and that is why so many employers have been reluctant to take advantage of them. I once drew the diagram below for Bill Archer. It’s an example of one way to design an HSA plan. It’s not bad if you’re just starting out. But with the passage of time many people have discovered ways to improve on it. In the future, many more improvements will emerge. Unfortunately, Archer’s Ways and Means Committee codified the diagram when it created the Medical Savings Account pilot program in the 1990s. Bill Thomas’s Ways and Means Committee codified it again (with a few exceptions) in the 2003 legislation that created HSAs. Basically, federal law doesn’t allow you to have an HSA unless you have an across-the-board high deductible with the savings account below it.

What’s Wrong with HRAs? About the time that HSAs were getting underway, a favorable Treasury Department ruling permitted employers to create Health Reimbursement Arrangements (HRAs). Unlike HSAs, these accounts are completely flexible. There is no requirement of any deductible anywhere. In principle, they can wrap around any third-party insurance plan — paying expenses the plan does not pay for — as the diagram below illustrates.

The HRAs, then, have all the flexibility that HSAs lack. There is only one problem: employees can never cash out. They can only use HRA unspent balances for health care or health insurance premiums. And this restriction weakens the incentive effects that are needed if individual self-insurance is to become a full fledged alternative to third-party insurance.

Solving All These Problems with FSA-Plus. One simple change could convert FSAs that give people perverse incentives to overspend into a savings account which can function as true self-insurance: allow year-end account balances to roll over and grow tax free. Such a change would make the new account, call it FSA-Plus, better than either an HSA or an HRA. As explained here and here, FSA-Plus Accounts would have all the flexibility of the HRA and all of the cash withdrawal benefits of the HSA. And, whereas HSA and HRA holders number about 6 million each, there are about 35 million FSAs.

I acknowledge that we are still in a second best world. The ideal approach was outlined by Mark Pauly and me about a decade ago in a Health Affairs article. It requires lump sum tax credits and Roth Health Savings Accounts. But in the meantime, FSA-Plus Accounts would be a huge improvement on the current system.