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PERSPECTIVETax Preferences For Nonprofits: From Per Se Exemption To Pay-For-Performance
Defenders of tax preferences for nonprofit hospitals and health plans, including Mark Schlesinger and Brad Gray, contend that nonprofits deserve government support because they provide greater "community benefit" than their for-profit counterparts. This argument is unconvincing. There is some evidence that nonprofits deliver marginally more "community benefit" but no evidence that tax exemption is the cause. Absent proof that tax expenditures, including exemption, "buy" social benefits that are worth the cost to taxpayers, these expenditures are unjustified. The better course would be to pay nonprofits for performance, by tying tax benefits to accomplishments (beyond current achievements) in health promotion, quality, and care for the needy.
IN A LITERAL SENSE, tax exemption for nonprofit hospitals is a historical relic. When Congress exempted charities from the first-ever federal income tax in 1894, nonprofit hospitals cared mainly for the indigent.1 The law of trusts, from which the charitable exemption was derived, treated "promotion of health" by these hospitals as a "charitable purpose" because it was a type of relief for the poor.2 People of means received care elsewhere, often at home. Thus, nonprofit hospitals were covered by the charitable exemption, based on the understanding that their role was to care for the destitute. State tax laws followed this model, as did subsequent federal law. But within a few decades, hospitals were attracting large numbers of people of means. They had become centers of nascent technology that made a therapeutic difference, for which Americans were willing to pay. By the 1920s, they drew most of their revenues from paying patients. The advent of hospital insurance in the 1930s, and its rapid expansion during and after World War II, secured this revenue stream. By the 1950s, nonprofit hospitals were commercial enterprises, dependent on their customers. The advent of Medicare and Medicaid in 1965 completed this transformation. Four years later, industry lobbyists succeeded in getting the Internal Revenue Service (IRS) to eliminate the requirement that nonprofit hospitals provide threshold levels of charity care to qualify for federal tax exemption. They argued, not so presciently, that the need for free care had "largely disappeared," a position that the IRS adopted and successfully defended against court challenges by advocates for the uninsured poor.3 This risky argument invited the uncharitable inference that the need for exemption of nonprofit hospitals had largely disappeared. So the industry recast its case for exemption. It argued to the IRS and to Congress that nonprofit hospitals produce myriad community benefits, aside from free care, and that these benefits alone make nonprofits worth exempting. This argument has largely prevailed at the federal level during the past several decades, although members of Congress from both parties have occasionally complained that nonprofits don’t provide enough free care. At the state and local levels, the argument’s success has been mixed: Some jurisdictions have insisted that nonprofit hospitals provide threshold levels of free or below-cost care to qualify for exemptions from property, sales, and income taxes. Reliance on the "community benefit" argument for exemption is, for nonprofit hospitals, a practical necessity. As even the industry’s strongest proponents concede, the exemption’s cost to federal, state, and local taxpayers almost certainly exceeds the cost of the care that nonprofit hospitals now provide for free to the poor.4 And it is doubtful that the exemption plays a substantial role in pushing nonprofits to give free or below-cost care, since similarly situated for-profits provide nearly equivalent levels of such care without it.5 Moreover, much free care is mandated, for nonprofits and for-profits alike, by federal and state laws that require hospitals to provide emergency treatment without regard for patients’ ability to pay.6 It is thus implausible to claim that federal, state, or local tax exemption "buys" care for the poor at levels that come close to the exemption’s cost. Conditioning a hospital’s exemption on provision of free care of equivalent value could, in theory, ensure that the exemption pulls its weight as a policy tool for providing care to the poor.7 But this would impose a large new burden on most nonprofits (since few now meet this condition), in the face of rising costs and ongoing price pressure from health care payers. Understandably, the industry wants to avoid this, while preserving the exemption. The "community benefit" rationale for exemption offers a way to do so. Is the community-benefit argument persuasive as a basis for tax exemption, either state or federal? Those who say that it is point to studies suggesting that nonprofits provide marginally more of such benefits—including health education and disease prevention programs—than for-profits do. Mark Schlesinger and Brad Gray report that their review of these studies confirms the nonprofit sector’s superior performance.8 They urge nonprofits to seize this opportunity by developing better methods of measuring community benefit and communicating it to policymakers and the public. Coincidentally or otherwise, this is the advice that nonprofit hospital trade associations and consultants have been giving their members and clients since the 1980s.9 This is smart interest-group advocacy, but it’s less than convincing as a basis for public policy. Neither Schlesinger and Gray nor others who press this argument have shown that these benefits approach the exemption’s cost to federal and state taxpayers. More importantly, there is no evidence that the purported difference in community benefit between the nonprofit and for-profit sectors approaches the exemption’s cost. So even if the exemption fully accounts for this difference, it cannot be said (based on evidence) that it "buys" enough community benefit to make it a winning proposition for taxpayers. And it’s doubtful that tax exemption entirely explains this difference. If it did, moreover, there would be no case for selectively exempting nonprofits on community-benefit grounds. If nonprofits have an edge on the community-benefit front only because they are exempt, the rational move would be to exempt both organizational forms. Some, including Schlesinger and Gray, argue that exemption in its current form is justifiable because nonprofits provide better care. They acknowledge that evidence for this is weak in the hospital sector, but they point to studies indicating that for-profit nursing homes are inferior. More research into the causal relationship, if any, between organizational form and measures of quality (including subjective factors such as patient trust and satisfaction) would be helpful: A connection that cuts across all categories of health care hasn’t been shown. Claims that for-profit and nonprofit hospitals differ in quality are unconvincing, but the data on nursing homes are worrisome. Absent strong evidence that the for-profit form per se undermines health care quality, federal and state efforts to improve quality should pursue proven approaches to doing so. Public spending, including tax subsidies, should support development of electronic medical records, evidence-based practice protocols, better ways to assess and compare hospitals’ and health plans’ clinical outcomes, and other quality-enhancing management tools.10 Movement toward pay-for-performance on representative measures of quality could be transformative in this regard. The purchasing power of Medicare and Medicaid positions these public payers to lead the way, by demanding transparency with respect to both clinical outcomes and process-oriented measures of quality. The refashioning of tax expenditures, provider payment schemes, and other public spending to encourage quality directly is likely to achieve more than will tax preferences for the nonprofit form. More speculatively, the superior capacity of for-profits to respond to market forces might enable them to respond with greater agility to increased discrimination on the part of consumers and payers based on quality. An inescapable problem besets arguments for exempting nonprofits per se. They are, at heart, claims that this tax expenditure is worth incurring because it buys personal and public health benefits that exceed its cost. But a tax preference for nonprofits per se is an imprudent way for government to procure these benefits. It rewards status without regard for performance, providing little incentive for hospitals (or health plans) to supply these benefits. Public subsidies fashioned specifically to reward health promotion, quality improvement, provision of care to the poor, and other desired activities would accomplish more. Emerging tools for assessing health care organizations’ performance in these areas are making it possible to precisely tailor tax expenditures and other public subsidies to encourage these activities. Some supporters of tax preferences for nonprofits have misread criticism of per se exemption as disapproval of nonprofit hospitals and health plans. One can criticize the exemption, as I and others have, without either condemning nonprofits per se or claiming that they behave no differently than for-profits do.11 Indeed, a preference for nonprofits, from either the consumer perspective or the vantage point of public policy, is consistent with opposition to tying tax subsidies to ownership form. The argument that nonprofit ownership, in itself, induces better behavior might even weigh against granting them tax benefits per se. Unless a tax expenditure procures a package of public benefits worth more than the tax revenues forgone, it squanders our shared resources.12 This obvious point is an urgent matter in an era of huge budget deficits and soaring national debt. TAX EXEMPTION for nonprofits per se is a historical relic without a plausible, current rationale. But tax preferences for health care organizations that invest in quality-enhancing information technology, supply high levels of safety-net care for the poor, or otherwise promote health and increase the value of the care they provide should be part of efforts to make American medical care more just and efficient. Elimination of federal and state tax exemption for nonprofits would be hugely disruptive, owing to long-standing patterns of institutional reliance. Transformation of the current per se exemption into a pay-for-performance tax benefit, to be phased in over several years, would both attenuate this disruption and turn the exemption into a force for more rational health policy.
Gregg Bloche (gbloche{at}brookings.edu) is a visiting fellow at the Brookings Institution in Washington, D.C.; a professor of law at Georgetown University, also in Washington; and an adjunct professor at the Johns Hopkins Bloomberg School of Public Health in Baltimore, Maryland. The author thanks Daniel Wikler for his suggestions and Gina Russell for her able research assistance. Preparation of this comment was supported in part by a Guggenheim Fellowship.
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