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Health savings accounts, or HSAs, are a new health insurance option that became available in2004. HSAs couple a tax-preferred savings account(the HSA) with high-deductible health insurance.Enrollees or their employers, or both, make tax-freecontributions to the HSA. Enrollees use the fundsin their HSAs to purchase medical care until they reach their deductibles. At that point, health insur-ance begins paying part or all of enrollees’ medicalexpenses. HSAs reduce government’s influence overconsumers’ medical decisions by reducing theprice distortions created by the federal tax code.However, HSAs as they exist today do not elimi-nate those distortions. Current HSA law restrictsconsumers’ health insurance choices, makes itdifficult for the chronically ill to save for theirfuture medical needs, and discourages cost shar-ing above the health insurance deductible. To address some of those shortcomings,President Bush proposes to reduce the price dis-tortions further, through higher HSA contribu-tion limits and tax credits for individuals whocontribute to their HSAs or who purchase theirown HSA-compatible insurance. Although thosesteps would be helpful, HSAs should be expand-ed further still to give individuals full ownershipof and control over all their health care dollars. Unfortunately, HSAs (and proposals to expandthem) have become politicized. Critics contendthat HSAs benefit only the healthy and thewealthy and that HSAs are ineffective or evenharmful. In most cases, criticisms of HSAs fall flat.In some cases, the critics do have a point. However,the failures they identify stem not from HSAs orproposals to expand them but from the problemsthat HSAs are meant to correct. Expanding HSAswould help to correct those problems faster.
 Health Savings Accounts 
 Do the Critics Have a Point
by Michael F. Cannon 
_____________________________________________________________________________________________________
 Michael F. Cannon is director of health policy studies at the Cato Institute and coauthor of
Healthy Competition:What’s Holding Back Health Care and How to Free It
(2005).
Executive Summary 
No. 569May 30, 2006
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Introduction 
Health savings accounts, or HSAs, are a new type of health insurance option that firstbecame available in 2004. As a concept, howev-er, HSAs have been discussed by policymakersand economists for decades.
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Originally called“medical savings accounts,” HSAs emergedfrom a recognition that federal tax laws distortthe private-sector decisions that people makeabout how to pay for health care and how much health care to consume.Federal tax law treats employer-providedhealth insurance differently than cash wages.Whereas cash wages are subject to federal pay-roll taxes (15.3 percent), federal individualincome taxes (which range from 0 percent to35 percent), and state individual income taxes(which range from 0 percent to 10 percent),the amount that employers pay for employeehealth benefits is not subject to those taxes. (Insome cases, neither are employee contribu-tions.) That encourages workers1. to obtain health insurance through anemployer, because the tax savings lowerthe relative price of employer-sponsoredcoverage;2. to demand comprehensive third-party health coverage, because any medicalcare purchased through their employerplan is effectively tax-free; and 3. to consume more medical care thanthey otherwise would, because compre-hensive third-party coverage insulatespatients from the cost of care at thepoint of service. Those responses contribute to the rising cost of medical care and health insurance.
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Conversely,the tax code penalizes people without employ-er-sponsored health insurance.HSAs were proposed by economists toreduce the distortions of consumer behaviorand to encourage more sensible decisionmak-ing about how much medical care to consumeand how to pay for it. HSAs partially level theplaying field between employer-sponsoredhealth insurance and self-insurance—that is,saving for one’s medical expenses. Thus, HSAdeposits largely enjoy the same tax-preferredstatus as employer-provided health insurance.
How HSAs Work
HSAs combine a high-deductible healthinsurance policy with a tax-free savingsaccount (the HSA).
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Enrollees or their employ-ers, or both, make tax-free contributions to theHSA. Enrollees can withdraw funds from theirHSAs tax-free for out-of-pocket medicalexpenses. Once an enrollee reaches her healthinsurance deductible, the insurance coveragebegins to pay for part or all of her medical care. People with HSA coverage must have a “qual-ified high-deductible health plan,” or HDHP.Essentially, a health plan covering an individualmust have a deductible no lower than $1,050and a limit on out-of-pocket spending no high-er than $5,100. For families, the HDHP musthave a deductible no lower than $2,100 and a limit on out-of-pocket spending no higher than$10,200.
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HDHPs may cover some preventiveservices below the deductible, but they are notrequired to do so.HSA holders or their employers, or both,can make tax-free contributions to the HSA.The maximum contribution that individualscan make in 2006 is the amount of theirhealth insurance deductible or $2,700,whichever is lower. Those with family coveragemay contribute the lesser of their insurancedeductible or $5,450. HSA holders betweenthe ages of 55 and 64 may make additional“catch-up” contributions of $700 in 2006.
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Funds from the HSA may be used to cover any medical expense; withdrawals for this purposeare not taxed. Unused HSA funds remain inthe account, earn tax-free interest, roll overfrom year to year, and follow the account hold-er wherever she goes.In theory, HSAs will make patients moreprudent consumers of medical care, becauseconsumers are more cost conscious whenspending their own money. Patients will asktheir providers more questions about the costsand benefits of different options, such as
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HSAs emerged from a recognition that federal tax lawsdistort the private-sectordecisions that people makeabout how to pay for health careand how muchhealth care toconsume.
 
brand-name versus generic drugs. One survey found that people with HSAs or similar cover-age were 50 percent more likely to askproviders about costs, 33 percent more likely to seek out treatment alternatives, and threetimes more likely to choose a less-expensivetreatment alternative.
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Greater cost conscious-ness on the part of patients should induceproviders to pay greater attention to price andquality as well. Just as HSAs are makingpatients more cost conscious, entrepreneursare responding with services that make accessto care more convenient and affordable.Since HSAs became available in January 2004, the number of Americans enrolled inHSA-compatible health insurance has grownto three million, though the number whohave opened HSAs is smaller and less cer-tain.
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HSA asset growth has outpaced the ini-tial growth of IRA assets. Observers have var-iously projected that there will be six millionHSAs with $5 billion in assets by 2008
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andas many as 25 million HSAs holding $75 bil-lion by 2010. One report projects that HSAswill cover 1 of every 10 individuals by 2010.
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HSAs do not eliminate the price distortionsthat federal tax laws create between health andnonhealth expenditures. Nor do they com-pletely eliminate the price distortions that fed-eral tax laws create between different types of health expenditures (i.e., employer-paid insur-ance premiums, individually purchased insur-ance, self-insurance, and out-of-pocket medicalspending). People without access to employer-sponsored health insurance still face large taxpenalties when purchasing health insurance orcontributing to an HSA.More concretely, HSAs unnecessarily restrictconsumer choice. Current law requires enrolleesto accept a government-designed health insur-ance policy in order to save tax-free for theirmedical needs. Chronically ill patients, for exam-ple, cannot combine an HSA with a health planthat covers prescription drugs below the cata-strophic deductible. Moreover, chronically illpatients are effectively prevented from accumu-lating savings in their HSAs because they cannotcontribute even one penny more than theamount of their deductible, even if they are like-ly to exceed their insurance deductibles yearafter year. President Bush has proposed small stepsthat would address many of those shortcom-ings. He proposes (1) to increase the annuallimit on HSA contributions from the amountof an enrollee’s health plan deductible to thehealth plan’s limit on out-of-pocket costs, (2)to create tax credits that would eliminate theprice distortions between individual andemployer contributions to an HSA, (3) to cre-ate tax credits that would eliminate the pricedistortions between individually purchasedand employer-purchased HDHPs, and (4) toallow people to use their HSA funds to pay thepremiums of HSA-compatible health insur-ance. The higher proposed contribution limits(up to $5,250 for individuals and $10,500 forfamilies) would help more people save fortheir future medical needs. Those proposalswould provide tax parity to millions who areunfairly punished by the tax code.  Although those steps would be helpful,HSAs should be expanded further still. First,HSA contribution limits should be raised sothat nearly all individuals could take 100 per-cent of their health benefits as a tax-free cashdeposit into their HSA. For example, the con-tribution limits could be raised to $8,000 perindividual and $16,000 per family. Second,consumers with such “large HSAs” should bepermitted to use those dollars to purchasehealth insurance tax-free from any source.Large HSA holders could purchase coveragefrom their employer, the individual market, orelsewhere. Third, Congress should eliminatethe HDHP requirement and allow large HSAholders to purchase whatever health plan they wish. Those changes would give individualsfull ownership of and control over all theirhealth care dollars.
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President Bush’s propos-als take measured steps toward that larger goal.
Criticisms That Fall Flat 
The president’s HSA expansion proposalshave put HSAs back on the national agenda.Unfortunately, those proposals have become
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HSAs should beexpanded to giveindividuals full ownership of and control over all their health caredollars.

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