Taxes and the Affordable Care Act

13 Nov

At the time of the writing of this post, the nation is moving from preoccupation about an election to concerns about taxes, spending, and the fiscal cliff.   To many, the debate over the Affordable Care Act (ACA) is a distant memory.  However, the ACA has not yet been fully implemented, regulators and the Administration have substantial latitude over details of the new law, and some provisions may be revisited by Congress.

Some aspects of ACA are tax related and are intertwined with discussions over the fiscal cliff and tax reform proposals.  One of these provisions involves a tax credit for the purchase of health insurance on state exchanges by households who have income less than 400% FPL and do not have access to employer sponsored insurance.

Households claim the tax credit at the beginning of the year when they do not yet know their annual income or whether they are even eligible for the tax credit.  The ACA tax credit is sent directly from the Treasury to the firm providing health insurance to the household.  Taxpayers who underestimate their income (overestimate the amount of the tax credit that they are eligible for) must repay part, or in some cases, the entire overpayment when filing their taxes.

A major objective of the ACA is to prevent individuals who lack health insurance from going into debt when they became ill or injured and incurred major health related expenditures.  However, overpayments in the ACA tax credit will cause some households to incur debt related to their purchase of insurance on state exchanges.

This post outlines the scope of this problem.

Issue One:  How many individuals and households are likely to obtain their health insurance through state exchanges? 

The Congressional Budget Office (CBO) projects that by 2020 twenty million households in the United States will receive premium tax credits with an average credit of $6,740.  There are some reasons to believe that the CBO is understating the eventual role of state exchanges.   Most recipients of insurance from state exchanges will be employees at firms with fewer than 50 employees, which are not subject to the employer mandate.  The number of small firms offering ESI was falling prior to the adoption of the ACA.  ESI coverage at small firms tends to decline even further during recessions when many employees are forced to work part time.

The ACA stipulates that employees at firms that offer ESI are not allowed to take the tax credit for the purchase of health insurance on state exchanges.   Since a firm’s employees lose access to the ACA tax credit if the firm offers ESI coverage and small firms are not mandated to offer coverage many small firms should eschew offering ESI coverage.

Issue Two: How large are the potential repayment obligations for households that receive an overpayment of their ACA tax credit?

There is no limit on repayment obligations for households that end up earning more than 400% FPL during the year.  There are limits on repayment obligations for households that earn less than 400% FPL during the year.

When the ACA was initially enacted the maximum repayment obligation for households with income less than 400% FPL was $400 for individual plans and $600 for family plans.

The repayment obligations were subsequently increased by Congress in order to find funds to increase Medicare reimbursement rates for physicians.  The new repayment obligation limits for individual plans are $300 (FPL < 200 percent), $750 (FPL between 200 percent and 299 percent) and $1,250 (FPL between 300 percent and 399 percent.)  The repayment limits are doubled for family plans.  Pending legislation in the House of Representatives may eliminate or reduce limitations on repayment obligations for individuals with household income less than 400% FPL.

A household with anticipated income slightly below the 400% FPL level who works additional hours and realizes income slightly above the 400% FPL level will lose the entire tax credit.  A household that anticipated income slightly less than 400% FPL but realized income slightly more than 400% FPL could very easily end up owing the Treasury thousands of dollars.  Unanticipated debts of this magnitude could cause some household to declare personal bankruptcy.

Issue Three:  Will a large number of households incorrectly estimate their income and owe funds to the IRS because of the ACA tax credit?

There are many reasons why households might incorrectly estimate their income.  First, many workers get paid by the hour and do not have a set number of hours per week.  Second, many workers are employed seasonally and do not know the number of weeks per year they will be employed.  Third, workers who are laid off will have an increase in household income when they are reemployed.  Fourth, workers will realize changes in earnings when firms cut or expand hours due to fluctuations in the business cycle.  (The fluctuations in hours will include mandatory overtime.)  Fifth, household earnings are affected by the entry or exit of second earners from the workforce.

Academic research by Dynan, Elmendorf, and Sichel found that the volatility of household income has increased by one-third between the 1970s and the early 2000s.

Two countries, Australia and the United Kingdom have implemented paid-in-advance tax credits that are similar to the ACA tax credit that will be implemented in the United Kingdom.   Recipients of the tax credits in these other countries have been forced to repay part of the tax credit they received.

Australia:  An end-of-year reconciliation system was first implemented in Australia for the tax year extending from July 1, 2000 to June 31, 2001.  The reconciliation immediately became a major political issue.  Prior to an election the government announced that the first $1,000 of overpayment obligations would be waived.  After the implementation of the reconciliation requirement one-third of all households were overpaid and had an end of year debt.  (This statistic was obtained in a paper by Whiteford, P. Mendelson, M. and Jane Millar, “Timing it right? Tax Credits and how to respond to income changes,” Joseph Rowntree Foundation, 2003.)

In 2004, Australia introduced a second lump-sum tax credit that was paid at the end of the year.  The end-of-year tax credit became collateral for overpayments on the advanced-year tax credit.  As a result of the new tax credit, the proportion of families that owed money at the end of year fell from around 32% in 2002-2003 to around 8% in 2007-2008.  Australia solved the problem associated with overpayment of advanced-paid tax credits by adding an additional fairly generous end-of-year lump-sum tax credit.

United Kingdom:  The working-class tax credit was first introduced in the United Kingdom in April 2003-2004. Household debts induced by overpayments of the tax credit immediately became an economic problem.   There has been some reduction in overpayments in tax credits due to efforts by the U.K. tax authorities.

  • In 2009/2010 1.453 million households (20% of all recipients) were overpaid the working-class tax credit.  The average overpayment was 847 pounds.

Small overpayments are manageable for most households.  A potentially more important issue involves the number of large overpayments resulting in a large household debt burden.

  • Around 13% of all overpayments involved an overpayment exceeding 200 pounds.

Debts incurred from overpaid tax credits remain a strong political issue in the U.K.   See the protest site link below as evidenced in

Issue Four:  What are the financial impacts of the overpayment of the ACA tax credit on households?

Many households have low levels of liquid assets.    Federal Reserve Board economists estimated that in 2007 median liquid assets defined as the sum of checking and savings accounts was around $4,100.

For households with limited liquid assets, the overpayment of the ACA tax credit can result in a non-trivial bill.  Empirical research has shown that many individuals who declare bankruptcy have relatively few debts.  The combination of low household liquidity and a new health insurance related debt could result in the ACA causing some individuals to file for personal bankruptcy.

Issue Five:  What might the IRS do to minimize impacts of ACA overpayments?

There are some ways to minimize financial disruptions caused by overpayments of the ACA tax credit.  One approach might involve reducing the number of overpayments.  Potential policies include:

  • ACA tax credit payments could be based on a conservative estimate of income.  However, this poses difficulties for many households with limited liquidity.
  • ACA tax credit payments might be adjusted quickly when income rises or falls.  However, income changes can be very sudden and the adjustment process is difficult when household income is volatile.  Also, tax credit payment adjustments would not be effective for households with estimated income slightly less than 400% FPL who realize actual income greater than 400% FPL because such households will lose their entire tax credit.

Second, the IRS and state exchanges could take steps to limit financial impact on households that overpay.  Potential policies include:

  • The IRS could waive penalties and interest on financial obligations incurred from overpaid tax credits.
  • The IRS could allow households to substitute towards a less expensive health insurance plan rather than implementing a collection effort.

Currently, the IRS is primarily, perhaps even exclusively, concerned with minimizing volatility to tax receipts.  However, the economic consequences of an unanticipated tax bill on households may be a more costly financial problem to society than the loss of tax revenue to the Treasury.

Issue Six:  How might the Congress fix issues related to the overpayment of the ACA tax credit

Congress could take actions to minimize financial disruptions caused by the overpayment of the ACA tax credit.

  • First, Congress can eliminate or reduce the limits on repayment obligations.  However, Congress appears to be moving in the opposite direction.  The limits set when the ACA was passed have already been increased as part during subsequent budget negotiations.  Congressional Republicans want all ACA limits increased.
  • Second, Congress could modify the ACA tax credit so that small changes in income do not lead to large overpayments.  This change would likely involve an overhaul of the personal income tax.  It is the subject of a future post.
  • Third, Congress could allow individuals who are married but file separate returns to claim the ACA tax credit.  This arcane issue is the subject of a future post.

Concluding thoughts:  Many economists and many Democratic and Republican politicians have supported the provision of health insurance through state insurance exchanges.  The ACA tax credit for the purchase of health insurance on state exchanges by individuals with household income under 400% of FPL and without access to ESI coverage will cause some household to take on substantial personal debt.  A relatively small amount of unanticipated personal debt can result in personal bankruptcy.  The Administration and Congress should place a high priority on fixing this problem.

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