The Self-Employed Push to Repeal the 'Health-Care Tax'

Nine million self-employed workers essentially pay a tax on health-insurance premiums. It's a relatively simple fix, but it amounts to billions in federal revenue

Missing from Washington's health-reform discussion is a simple change that would make insurance more affordable for millions of the nation's smallest business owners by letting them fully deduct the cost of their health insurance premiums.

By a quirk in the tax code, self-employed workers who buy their own health insurance essentially pay an extra tax on their premiums. They're the only taxpayers in the system who pay taxes on premiums, which count as a business expense for corporations and pretax income for employees. Because self-employed workers have no corporate employers to match their payroll tax contributions to Social Security and Medicare, they pay double the rate of wage and salary workers in a levy known as the self-employment tax equal to 15.3% of their net earnings. That's on top of regular state and federal income taxes, and the income they spend on health premiums is not exempt.

The nation's 9 million self-employed—sole proprietors with few or no employees, contract workers, and freelancers—constitute about 8% of the total U.S. labor force, according to the Bureau of Labor Statistics. (The Census Bureau counts 22 million sole-proprietors, but it's not clear how many of those may be payroll workers as well.) "You correct this, think of the widespread health benefit you would give to so many people," says Kristie Arslan, executive director of the lobbying group National Association for the Self-Employed (NASE), which represents the self-employed in Washington.

Legislation to extend the deduction has languished in Congress since 2002, but Arslan wants it included in any health-reform bill passed this year. Bipartisan bills in the Senate and House were introduced in March. Each amends the tax code in just two pages, in contrast to the mammoth health-care bills, but the narrow issue has been untouched so far by lawmakers crafting health reform.

Little Lobbying Power

That may be because the change, while a boon to America's self-employed, would add to the cost of reform while Congress and the White House are trying to lower the price tag. Abolishing the tax on health premiums for self-employed workers would mean $25 billion in lost revenue for the government over 10 years, according to one Joint Committee on Taxation estimate. That's 2.5% of the estimated $1 trillion potential cost of health reform over the next decade. Without the lobbying heft of insurers, pharmaceutical companies, or labor unions, the self-employed (by definition a fragmented group) have not succeeded in getting the tax break into the health-reform bills.

But there is some precedent for peeling back taxes on health insurance for the self-employed. Before 1987, sole proprietors could only deduct a portion of their premiums from their income taxes under narrow circumstances, but legislation that year allowed them to easily write off 25% of premium costs. Congress gradually increased that percentage until the self-employed paid no income tax on health premiums by 2003, but the 15.3% self-employment tax still applies.

To be sure, there are some reforms on tap that will undoubtedly help self-employed business owners. Insurance companies have agreed to drop clauses that let them deny coverage to people with preexisting conditions, a barrier many people buying insurance on the individual market face. Such a change, coupled with subsidies to make individual policies more affordable and an insurance exchange to shop for plans, could help many self-employed workers buy health coverage.

Melissa Barton is one. A 50-year-old small business consultant in Portland, Ore., Barton says she can't buy an individual plan because she has preexisting conditions. She has been self-employed for 15 years, and has had insurance off and on.

But now, even if she could buy individual coverage, Barton estimates that it would cost $400 a month—double what she considers affordable. She favors a public plan that individuals could buy into, along with eliminating the self-employment tax on premiums. Barton thinks that would spur entrepreneurship as people leave jobs they hold onto only for the health coverage. "The prime reason for anyone to decide to go into business right now or not is [health care], and has been for years," she says.

A Roadblock to Entrepreneurship

Plenty of evidence suggests that cutting taxes on health insurance for the self-employed encourages more people to work for themselves. A paper released in May by Treasury Dept. economists found that increasing the amount of premiums that self-employed workers can deduct from income taxes from 60% to 100% had a "large and significant" effect on encouraging people to work for themselves—boosting the likelihood of self-employment by as much as 16.8%, the study suggests. A separate report, sponsored by the Small Business Administration in 2006, found that expanding health-insurance deductions extended the life of the business. "We definitely know that those who claim the deductibility stay in business longer," says Tami Gurley-Calvez, author of the SBA paper. But she says it's hard to determine how big a role health insurance deductibility plays in the decision to start a business.

Entrepreneurs don't need convincing. While the issue has been off Congress' radar, a wide spectrum of small business lobbying groups trying to influence health reform supports repealing the tax on health premiums, including NASE, the National Federation of Independent Business, and Small Business Majority. The change could be made independent of current health-reform legislation efforts. For self-employed business owners, it would go a long way to making health insurance more affordable and the tax code more equitable. Says Barton, "Why is it that a person who is self-employed and pays for that insurance themselves, why isn't that deductible?"

Before it's here, it's on the Bloomberg Terminal.