The Irrationality of Flexible Spending Accounts

Ezra Klein has a good post up today on the problems of giving employers, but not individuals, a tax exemption on health insurance. This is clearly central to the problems of healthcare financing in the US, but, given how things are, it’s not the sort of policy that can be changed by itself – doing so without another mechanism to pay for insurance would end up making many more people uninsured.

What has always seemed to me to be bad policy, but not so intimately tied to the rest of our economy, is the existence of Flexible Spending Accounts. The gist of an FSA is that an employee of a firm which offers such a plan can set aside a fixed amount of their salary to pay for health care or dependent care; that portion of their salary is tax exempt, but must be used in the space of a little bit more than a year or it is forfeited.

I can’t see any public policy purpose here. Why is the tax exempt status of my medical or child care spending dependent on my employer offering such a plan? Why do I need to play “Let’s Make a Deal” to guess the closest dollar amount without going under to the amount I will spend on health or child care in order to exempt it from taxes? How does setting aside “use it or lose it” money help in any way to reign in health care costs?

I do participate in these plans. For child care, it’s easy to figure out in advance how much we’ll spend in a year on preschool. For health care, we overestimate how much we’ll spend and, towards the end of the year, use the leftover money to pick up a few pairs of glasses, since optometry is covered as medical. (Call me cynical; I’ll take advantage of a tax break even if I think it’s bad policy.)

But who benefits from FSAs versus a policy which says “The first N dollars of health or child care spending per year is tax exempt”? I can see how the companies which offer these plans to employers benefit. I can see how such things benefit optometrists or other providers where people can spend their money before losing it. I can even see how employers benefit, since they receive the money their employees forfeit due to the “use it or lose it” issue, though I don’t think many employers are actively seeking that revenue.

But the benefit to the public? To individual employees of companies offering the plans? To people who don’t have access to such plans? There are much more straightforward, efficient, and fair ways to provide a tax exemption for medical expenses.