CBO and tax-exempt hospitals

This month the Congressional Budget Office issued two reports on the tax-exempt hospital industry. Both are worth reading, as much for what they say about the mind-set on Capital Hill these days as for what they tell us about tax-exempt hospitals.

1. Nonprofit Hospitals and the Provision of Community Benefits. How much tax benefit do nonprofit hospitals receive as a result of their exemption from federal, state, and local taxation? Answer (as of 2002): $12.6 billion, about half of which comes from the federal income-tax exemption. And what is the value of the community benefits provided by the tax-exempts? Therein lies a tale, because it all depends on how you define (and measure) community benefits. This report breaks out "uncompensated care" (also a thorny definitional problem), the unreimbursed cost of providing Medicaid-covered services, and such generally unprofitable specialized services as burn intensive care, emergency room care, high-level trauma care, and labor and delivery services. This reports limits itself to five states, including one (Texas) with a very explicit community-benefits requirement for nonprofit hospitals. The tax-exempt hospitals' performance in these three areas of service are also compared to their for-profit and government-owned counterparts. How do they compare?

• When regression techniques were used to adjust for the hospitals’ size and location and for the characteristics of the local populations, nonprofit hospitals were estimated to have an average uncompensated care share that was 0.6 percentage points higher than that for otherwise similar for-profit hospitals. That estimated difference corresponds to nonprofit hospitals in the five selected states providing between $100 million and $700 million more in uncompensated care than would have been provided if they had been for-profits.
• When regression techniques were used to control for hospital characteristics, nonprofit hospitals were found to have adjusted Medicaid shares that were 1.3 percentage points lower than those of otherwise similar for-profit hospitals.
• CBO found that nonprofit hospitals were more likely than for-profit hospitals to provide each of the four specialized services examined. After adjustment for hospital characteristics, nonprofit hospitals were found to be significantly more likely than for-profit hospitals to provide two of the four specialized patient services (emergency room care and labor and delivery services).

2. Nonprofit Hospitals and Tax Arbitrage. This one's a little more technical. It deals with the ability of tax-exempt hospitals to borrow at below-market rates by issuing tax-exempt bonds and then deploy the borrowed funds for higher-yielding investments. So-called "arbitrage bonds," however, are not exempt from federal taxes, which removed the main incentive to engage in such practices. That said, there are plenty of other opportunities for nonprofit hospitals to engage in a sort of tax arbitrage, and this report analyzes some of them. One occurs when a tax-exempt entity decides to invest some of its accumulated surplus and gifts in high-yield taxable securities and to finance structures and equipment with low-cost exempt bonds. In economic terms, it's the same as if bond proceeds were being invested in securities, and there's a "replacement proceeds rule" (26 CFR § 1.148-1(c)) that attempts to identify such events and subject them to taxation. But for a variety of reasons the rule is difficult to apply and undoubtedly misses a lot of such tax-arbitrage activity. The CBO report considers the possibility of broadening the definition of tax arbitrage, which they conclude would probably result in increased tax revenues for the federal government, at least in the short run. But over time, it seems likely hospitals would adjust to the new (increased) cost of capital by reducing their level of arbitrage bond issues, resulting in a decrease in tax savings for the federal government, even under the broader definition. A second likely effect would be

two different costs of capital for nonprofit hospitals. Nonprofits with larger portfolios of investment assets would be more likely to be subject to the rule and thus effectively face higher interest costs associated with financing using taxable debt. Hospitals with smaller amounts of such assets would be more likely to continue to receive the benefit of tax-exempt financing. Both would still face lower costs of capital than for-profit hospitals. But the different borrowing costs of the two groups of nonprofit hospitals could engender inefficiencies by creating a new differential in capital costs.