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PERSPECTIVE

Subsidizing Health Care Providers Through The Tax Code: Status Or Conduct?

Abstract

 
The merits of tax exemption for nonprofit health care providers have been hotly debated for decades. Mark Schlesinger and Brad Gray provide a useful, dispassionate meta-analysis of past research; they conclude that there are real differences in the performance of nonprofit and for-profit hospitals and nursing homes, although they vary along several key dimensions. Unfortunately, their findings offer no insight on whether these differences are large enough to justify a sizable subsidy and whether it makes more sense to use an undifferentiated subsidy tied to status (current practice), or a graduated subsidy tied to quantifiable and objective measures of performance.

Throughout the economy, almost all employers are for-profit, tax-paying entities as well. Even in health care, a sizable percentage of institutions operate for profit and pay taxes. Roughly 70 percent of nursing homes, health maintenance organizations (HMOs), and dialysis centers; 50 percent of home health agencies and psychiatric hospitals; 25 percent of substance abuse centers and hospice programs; and 16 percent of hospitals are organized and operated on a for-profit basis.¹

These simple facts make the decades-long debate over the merits of nonprofit health care somewhat puzzling. We trust in, and confer considerable discretion on, for-profit health care providers. Why should it matter whether a hospital or nursing home is nonprofit? Even if it matters, does it make any sense to subsidize some health care providers by exempting them from federal, state, and local taxes, based solely on institutional status?

Mark Schlesinger and Brad Gray attempt to answer these questions with a meta-analysis of 162 studies comparing the real-world performance of nonprofit and for-profit hospitals and nursing homes.² The strength of the paper is its systematic evaluation of the empirical literature on the significance of entity status on a host of measures of economic performance, quality of care, and accessibility. Schlesinger and Gray’s results indicate that there are real differences in the performance of nonprofit and for-profit hospitals and nursing homes, although they vary in magnitude, direction, and degree of overlap of the underlying distribution. These differences are affected by the type of service, nature of the measure, time frame, and context—including the competitiveness of the relevant market. Their measured findings are far removed from the claims one routinely hears from partisans on both sides of the debate over tax exemption for nonprofit hospitals.

Schlesinger and Gray’s analysis makes it clear that entity status matters. However, the more difficult policy questions are whether it matters enough to justify a sizable subsidy and whether it makes more sense to use an undifferentiated subsidy tied to status (current practice) or a graduated subsidy tied to quantifiable, objective measures of performance.

It is important at the outset to distinguish nonprofit status from tax exemption. It is easy to qualify as a nonprofit. An organization simply has to incorporate under the relevant state statute, after which it may engage in any line of business and may charge customers as much or as little as it wants. However, it must retain its net earnings and use them to promote the purposes for which the nonprofit was created. It may not distribute net earnings to those who control it, whether officers, directors/ trustees, or key employees (a nonprofit by definition does not have shareholders). The law calls this a prohibition on "inurement."

Nonprofit status is necessary but not sufficient for tax exemption. To receive a federal tax exemption, a nonprofit entity has to be organized and operated exclusively to promote one of the specific purposes set forth in section 501(c)(3) of the Internal Revenue Code—including charitable, religious, educational, and scientific ends. "Charitable" is used in its legal sense to include relief of the poor, the distressed, or the underprivileged. A version of this provision has been part of the Internal Revenue Code since its inception in 1913.

Only in health care and education are a sizable percentage of revenue-generating firms organized as nonprofit, tax-exempt entities. The reasons for these patterns are complex. From a philosophical perspective, output in these markets is difficult to monitor. Nonprofits were thought to be less likely to "cheat" on quality, price-gouge, or limit their services to those able and willing to pay. From a pragmatic perspective, hospitals and universities are expensive to build—and for much of our nation’s history, the best source of capital for such entities was voluntary, community-based endowment. There is also a significant "lock-in" effect; once these nonprofit, tax-exempt entities were created, they faced daunting obstacles to conversion to a for-profit form.

Once a hospital is deemed tax-exempt, it typically qualifies for a variety of preferences, including exemption from federal income tax and state and local property taxes, the ability to receive tax-deductible contributions, and the ability to issue tax-exempt bonds. To understand these preferences, let us consider the evolving reasons for subsidizing nonprofit hospitals through the tax code.

Early hospitals were essentially poorhouses, for which charitable support was both obvious and intuitive. The rapid growth of hospitals during and after World War II and the dramatic expansion of federal income taxation created pressure to clarify the standards for exemption. The first Internal Revenue Service (IRS) guidance (1956) required a tax-exempt hospital to "be operated to the extent of its financial ability for those not able to pay for the services rendered."³ The hospital could not "refuse to accept patients in need of hospital care who cannot pay for such services," nor was it dispensing charity if it operated "with the expectation of full payment" and incurred bad debt from those who did not pay for those services.

This guidance made redistribution the touchstone for exemption. However, the value of the resulting subsidy varies according to the particular situation of an individual institution. All else being equal, a hospital that provides little charity care and is located in a "desirable" location (in terms of property values) will receive a much greater financial benefit when its income and property go untaxed than a hospital that provides lots of charity care and is located in an "undesirable" location. Thus, in important respects, current subsidies are "upside down" in the sense that they are worth the most to institutions that redistribute the least.

Although there is undoubtedly a role for redistribution in a nation with forty-five million uninsured residents, other rationales are needed to justify tax exemption now that nonprofit hospitals serve mostly paying patients. Following the enactment of Medicare and Medicaid, which assured hospitals of payment for treating certain indigent patient groups, the IRS withdrew its explicit requirement of uncompensated care and substituted a "community benefit" standard. New guidance (1969) stated that a hospital was entitled to a tax exemption if it provided "care for all those persons in the community able to pay the cost thereof either directly or through third party reimbursement," because it was "promoting the health of a class of persons that is broad enough to benefit the community."⁴ Individual states apply different criteria to determine whether a hospital is tax-exempt, although most are variations of the federal standard. Several states have imposed more specific standards or reporting requirements, or both.

What are the possible justifications for a broad community-benefit standard, compared to the redistributionist standard it replaced? One possibility is efficiency. A nonprofit hospital may engage in more activities with positive externalities that merit funding, such as promoting overall community or public health. In addition, as noted previously, if the public is unsure of what it wants to purchase, provider self-regulation might outperform the profit motive. An alternative justification is that a community benefit standard encourages flexible, decentralized (that is, community-based), nongovernmental responses to problems—a justification that appeals to both communitarians and libertarians.

At the same time, the prohibition on inurement frees nonprofits from the disciplining effects of shareholders and the capital markets, and it encourages them to plough their earnings into expanding operations by building more and fancier facilities, whether needed or not. In like fashion, organizations that need not achieve a competitive return on investment are prone to capture by parochial interests, including physicians and labor unions.

Deciding whether and how to subsidize requires one to balance these considerations against one another and to quantify the extent to which nonprofit hospitals are providing "enough" community benefit. Unfortunately, Schlesinger and Gray’s analysis offers no traction on these critical issues, or much in the way of justification for the community-benefit standard. Schlesinger and Gray forthrightly concede that most nonprofit, tax-exempt hospitals do not "earn" their exemption on redistributionist grounds by providing charity care. They assert that nonprofit hospitals offer community benefit in other ways, but they confess that in many instances, these "cannot be readily counted." Worse still, in an earlier paper, Schlesinger and Gray also conceded that operational definitions of community benefit are "inconsistent, narrow, fragmented, and only loosely related to the ways in which communities actually affect the health of their residents."⁵ There is also much overlap in the degree of positive externalities provided by for-profits and nonprofits; both promote health by rendering services to the community. These findings make it hard to justify an upside-down subsidy tied to whether or not a hospital has a constraint on inurement.⁶

We believe that public policy should move from the current "all-or-nothing" subsidy tied to entity status to an approach that ties the amount of the subsidy to the satisfaction of specific quantifiable and objective measures of performance. Schlesinger and Gray argue that this strategy is problematic because it will force hospitals to satisfy an inflexible standard—a "one size fits all" regulatory strait-jacket—and do so at the expense of the health care needs of individual communities.

Yet it is residents of these individual communities who have complained to their state attorneys general about nonprofit hospitals’ aggressive efforts to collect exorbitant bills—triggering investigations of hospital billing and collection practices in numerous states.⁷ It is these same residents who have become named plaintiffs in more than fifty class-action lawsuits, alleging that nonprofit hospital systems in their communities are not charitable entities.⁸ It is these same residents who have signaled doubts about the performance of their hospitals by not making tax-deductible contributions to them. Finally, it is individual communities, not remote federal "revenooers," that have taken the lead in challenging hospital tax exemptions, including Champaign, Illinois (2004), Cleveland, Ohio (2004); Lebanon, New Hampshire (1997); the majority of hospitals in Pennsylvania (1985–1998); Chattanooga and Nashville, Tennessee (1988); Burlington, Vermont (1987); and Salt Lake City, Utah (1985).⁹ Schlesinger and Gray might have satisfied themselves that nonprofit hospitals are serving their communities, but in numerous communities, those most affected do not agree.

We agree with Schlesinger and Gray that taxing authorities should make individualized exemption decisions, using criteria relevant to the specific goals they wish to achieve—whatever those might happen to be. However, we are quite skeptical of their suggestion that policymakers in each market should attempt to specify the optimal balance of nonprofit and for-profit entities. It will be difficult enough to designate concrete targets on which to base subsidies and to monitor compliance with those standards. It will be nigh on impossible to develop a command-and-control infrastructure that can make the subtle regulatory judgments that Schlesinger and Gray propose. Decades of experience with certificate-of-need proceedings demonstrate that processes of this sort are prone to interest-group manipulation and often will be used to anticompetitive ends.

When negotiating arms control agreements with the Soviet Union, President Ronald Reagan characterized his approach as "trust, but verify." If we want to make sure that nonprofit, tax-exempt hospitals "do the right thing," we have to both trust and verify. The past has been heavy on trust and light on verification. It is time to reverse that skew.

Editor's Notes

 
David Hyman (dhyman{at}law.uiuc.edu) is a professor of law and medicine at the University of Illinois in Champaign. Bill Sage is a professor of law at Columbia University in New York City.

NOTES

Top NOTES

 

1. M. Schlesinger and B. Gray, "How Nonprofits Matter in American Medicine, and What to Do about It," Health Affairs 25 (2006): W287–W303 (published online 20 June 2006; 10.1377/hlthaff .25.w287), Exhibit 1.[Abstract/Free Full Text]
2. Ibid.
3. Revenue Ruling 56-185, 1956-1 Cumulative Bulletin 202, at http://www.taxlinks.com/rulings/1956/revrul56-185.htm (accessed 18 May 2006).
4. Rev. Rul. 69-545, 1969-2 C.B. 117, at http://www.irs.gov/pub/irs-tege/rr69-545.pdf (accessed 14 June 2006).
5. M. Schlesinger and B. Gray, "A Broader Vision for Managed Care, Part 1: Measuring the Benefit to Communities," Health Affairs 17, no. 3 (1998): 152–168, quote on p. 155.[Abstract]
6. D.A. Hyman, "The Conundrum of Charitability: Reassessing Tax Exemption for Hospitals," American Journal of Law and Medicine 16, no. 3 (1990): 327–380; and J.D. Colombo, "The Failure of Community Benefit," Health Matrix 15, no. 1 (2005): 29–65.[Medline]
7. Various sources in support of this point are available from David Hyman; send e-mail to dhyman{at}law.uiuc.edu.
8. See B. Cohen, "The Controversy over Hospital Charges to the Uninsured: No Villains, No Heroes," Villanova Law Review 51, no. 1 (2006): 95; Clifford Law Offices, "Not-for-Profit Hospital Class Action Litigation," http://www.cliffordlaw.com/not-for-profit-hospital-class-action-litigation (accessed 18 May 2006); J. Appleby, "Barrage of Lawsuits Huge Wake-Up Call for Non-Profit Hospitals," USA Today, 19 July 2004; and L.W. Clark et al., "What May Arrive in Tomorrow’s Mail? An Analysis of Class Action Lawsuits concerning Hospital Billing of Uninsured Patients," BNA’s Health Law Report, 29 July 2004.
9. Hyman, "The Conundrum of Charitability," 340–348; Colombo, "The Failure of Community Benefit," 37–40; and A.A. Noble et al., "Charitable Hospital Accountability: A Review and Analysis of Legal and Policy Initiatives," Journal of Law, Medicine, and Ethics 26, no. 2 (1998): 116.[Free Full Text]

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