Tax Loopholes, Wealth Destruction, and Health Reform

AT&T, Caterpillar, Deere, and Verizon garnered headlines last week (and an unwelcome summons to Capitol Hill) for announcing that a provision in the recent health care legislation would result in substantial accounting write downs. AT&T, for example, told the SEC that it expects to take a $1 billion charge in the first quarter because the law eliminates a tax subsidy for providing prescription drug coverage to retirees. According to the Wall Street Journal, Credit Suisse estimates that the total accounting hit for corporate America will total $4.5 billion.

Citing these impacts, a Wall Street Journal editorial denounced the provision as “a wholesale destruction of wealth and capital.” White House Press Secretary Robert Gibbs, in contrast, praised it as “closing a loophole.

Who’s right?

To figure that out, I spent a lovely Saturday afternoon tracking through the intersection of health policy, tax policy, and financial accounting and emerged with a clear verdict: Gibbs is right. The provision does indeed close a tax loophole.

But the WSJ isn’t completely wrong. The first law of loopholes is that every loophole benefits someone. If you close a loophole, someone will be hurt. That’s what’s happening here. The extra subsidy for retiree prescription drug coverage provided an extra financial boost for AT&T, Caterpillar, et al. Eliminating the loophole will thus reduce the value of the companies and the wealth of their shareholders, just as the WSJ alleges. But it’s hard to get too teary-eyed since that value and wealth were created by the loophole in the first place.

And now to the details:

Health policy. In 2003, the Medicare Modernization Act added a prescription drug benefit to Medicare. Some employers already provided prescription drug coverage to their retirees, and Congress worried that they would stop these programs and move all those people onto the government nickel. Congress thus created a subsidy to encourage employers to maintain those benefits. The government pays 28% of the cost of qualifying prescription drug coverage for employer-provided prescription drug coverage for retirees who are at least 65. Nothing in the new health legislation would change that.

Tax policy. Congress had to make two decisions in creating this subsidy.

  • First, would the subsidy be treated as taxable income to recipients? Quite reasonably, Congress answered no.
  • Second, would for-profit employers still be able to deduct from their taxable income any spending on retiree prescription drug coverage that was covered by the subsidy? For reasons I don’t understand, Congress answered yes. As a result, the AT&Ts of the world could spend $100 on coverage, receive a $28 subsidy, and still deduct $100 in expenses from its income for tax purposes (rather than, say, $72).

In my view, the first decision—subsidies aren’t taxable—makes sense because it treats all employers equally. For-profit firms, non-profit organizations, and state and local governments would all receive the same 28% incentive to maintain retiree coverage. If that subsidy were taxable then either (a) we would have to extend income taxation to non-profits and state and local governments or (b) the subsidy would be smaller for for-profit employers. Neither of those makes sense.

The second decision—for-profit firms can deduct even those expenses that are covered by the subsidy—appears peculiar for the same reason. That provision—which I characterize as a loophole—means that the subsidy is actually more valuable to for-profit firms than to other types of employers. They get the subsidy (without paying taxes on it) and they get the tax benefit of writing off those expenses. As the Joint Committee on Taxation recently noted, that treatment is highly unusual. In my view, it’s right that the recent health legislation closed that loophole.

Financial Accounting. This change doesn’t actually go into effect until 2013. So why all the hullabaloo now? Two words: accrual accounting. Corporations must report the cost of future retiree health benefits as liabilities on their balance sheets. The associated tax subsidies show up as corresponding assets. The value of those tax assets got slashed by the new health legislation. Firms have to report that hit in the quarter in which the law was signed. That’s why we’ve seen this rash of announcements warning shareholders of a surprise hit to first quarter profits. The charges are non-cash at this point—no money is going out the door of these firms just yet—but will turn into real cash (i.e., higher tax payments) in the future.

Note: Another important question is how eliminating the loophole will affect the number of retirees who get drug coverage from their previous employer. Presumably the number will go down, but I haven’t seen any estimates of how much.

Disclosure: I have no investments in AT&T, Caterpillar, Deere, or Verizon.

18 thoughts on “Tax Loopholes, Wealth Destruction, and Health Reform”

  1. Thanks for clearing this up. I was concerned when I first read about this since my retiree father has prescription drug coverage through his former employer.

    For him, the new law will not change anything directly as he worked for a non-profit.

    Increasing taxes, even when the government is just saying you can’t deduct the money that it gives you, will always cause anti-government backlash.

  2. Seems the basic story is that the government was laundering some of its medicare drug spending through the tax code.

    This change will start to bring it back into Medicare proper.

  3. This was a $100M soundbite, which generated a collosal bang for its “buck.” As clarified here, it was merely Caterpillar’s marginal tax rate x 28% of its expenditures to provide prescription coverage to retired employees. Hardly a blip on its screen. Interesting.

  4. Thank you for your well-formed piece. Upon hearing the large costs that these corporations were reporting, I knew there was much more to it than they were unwilling to divulge.

  5. A good summary, but I’m afraid it may miss the bigger picture. Mr. Marron wrote: “In 2003, the Medicare Modernization Act added a prescription drug benefit to Medicare. Some employers already provided prescription drug coverage to their retirees, and Congress worried that they would stop these programs and move all those people onto the government nickel”.

    OK, so the government pays 28 percent and the company pays the remaining 72 percent and gets a federal tax deduction for the latter. Assuming a total drug cost of $100 and a tax rate of 35 percent, the net cost to a company would be $100-28=$72 -(.35x$72) =$46.80.

    Isn’t the larger implication now that Congress has changed its policy, that the original worry will become reality? That is, this net cost of $46.80 will NOW be moved on to the government nickel? Or were those original fears unfounded?

    1. Vivian,
      As I understand it, and I could be wrong, your calculations pertain to the situation after HCR passed. As I understand it, before HCR passed, a company was able to get a federal tax deduction for the full cost of the benefit (both the $72 that the company paid and the $28 that the government paid). The money the company would receive would be the $28 subsidy and $35 tax benefit (.35 X $100), so the company would be paying $37 for $100 of benefit.

      The amount of money that the company is responsible for to provide $100 of benefit will increase from $37 to $46.80, about a 26% increase. The amount of money the government provides will decrease from $63 to $53.20.

      As I understand it, the purpose of the original law was to have employers provide a prescription drug benefit to their retirees, rather than have them switch to the government program. As Mr. Marron said, the real question is whether companies will continue to provide prescription drug benefits to their retirees, or will retirees be moved the the government plan.

      1. Don,

        Thank you for the comment—and the correction. I had focused too much on the general and didn’t pay close enough attention to the specific.

        Nevertheless, the general point remains. It has been suggested by Mr. Marron that the government set up the tax situation not necessarily to provide a benefit to companies, but because Congress thought by giving the tax benefit it would end up keeping retirees off “the government nickel”. The decision was supposedly a pragmatic and self-serving one.

        So, the issue now remains: will the change brought about by the HCR prove to be the “tipping point” which results in more people going on “the government nickel”? And, if so, is this the proverbial “shot in the foot”?

      2. The irony in this question is that, before Bush rammed the 2003 Medicare part D down the throat of Congress, most of the companies receiving these subsidies (and deducting them to boot) were already paying for 100% of the benefits for thier retirees. The 28% subsidy was theoretically intended to stop them from dumping all of their employees off the private system and onto government rolls after Medicare Plan D passed, but in reality, this was corporate lobbyists bellying up to the bar for some serious pork. As many have pointed out, many of these companies are unionized, and have contracts with employees that cannot be changed so easily (to dump employees off the private plan). So for them, this was always a huge corporate welfare giveaway, allegedly driven by fear that this GOP hatched health benefit would induce big companies to stop providing benefits . . . whereas I will bet dollars to doughnuts that the fear was largely unfounded, and reality was that this fear was a strawman used to a pretext to justify yet another slice of corporate welfare for some of America’s biggest and most politically infuential priovate businesses. And now, wathcing a deduction they get for spending the taxpayers money which never should have been allowed in the first place being taken away from them, they are squealing like stuck pigs. Shameful and dishonest. All of the lying about health insurance reform needs to stop.

  6. But why call it a “loophole”? “Loophole” carries the connotation that it is something that was accidentally left out of the original legislation, yet in this case, it was intentionally put in by Congress.

    Call it an unnecessary tax subsidy if you want, but I think there is disagreement on the “unnecessary” part of this phrase. The tax subsidy was expressly added by Congress so that companies would keep their retirees in their own drug prescription plans, so as to keep them from dumping their retirees on the newly created Medicare Part D plan. As I understand it, the tax subsidy is cheaper (in the sense that it costs the government less) than paying the Medicare Part D would be.

    1. Hi Rex — I absolutely agree that the line between “loophole” and “unnecessary subsidy” and, for that matter, “possibly necessary subsidy” is hazy. In this case, it feels like a “loophole” to me because (a) it’s an unusual and obscure provision (as the JCT piece linked above notes, it’s very unusual to allow tax deductions for expenditures covered by tax-exempt interest) and (b) it gives a better deal to taxable employers than non-taxable employers (suggesting that it isn’t simply Congress’s view that the overall subsidy needs to be larger; if that were the case, they would offer it to all employers).

      My second rationale could be overturned, of course, if it turns out that it makes sense to offer a larger subsidy to for-profit firms (if, for example, they are more likely to drop coverage). But I haven’t seen any evidence one way or the other.

      Oh, and according to today’s WSJ editorial, a similar provision may have been included in the recent health bill. Which adds weight to your point that it may not have been unintentional.

  7. Rex,

    Call it what you want, lophole or tax subsidy. Either way, these corporations are still better off than when they willingly offered these plans.

    When these corporations offered their prescription drug coverage for retirees there was no subsidy. No matter how you look at it, they are still paying 35% less than the bargain that they freely entered into before Medicare PArt D was enacted.

    Comparing a well amnaged free market drug plan with Medicare Part D is folly. The basic problem with Medicare Part-D can not be ignored: there is no cost control.

    I would bet most of the corporations have introduced drug tiers, paying for smaller proportions for expensive drugs with active patents and larger proportions for similarly effective drugs that have generic equivalents. They probably have higher copays and lower coverage for name brand drugs.

    Interestingly, these corporations can even bargain with the pharmaceutical companies for a lower price for a drug, something prohibited by Medicare Part D.

    Medicare Part D distorted the market by paying whatever the asking price was for the drug. For Pharma, it encourages innovation of the most expensive drugs, and little incentive to provide lower cost drugs.

      1. Thanks Donald,

        I will give it a look. Thank You.

        I have heard that the cost of Medicare Part D has been lower than projected by the CBO when enacted. I wonder if anyone has looked at where the differences between the projections and reality are the greatest.

        I remain concerned that the rate of increase for drug expenditures is higher than the rate of increase for other portions of the practice of medicine, and certainly higher than the rate of increase for other goods and services. This would seem to indicate that we could do better, unless one can argue that the increased expenditures in drugs offset the expenditures on other parts of healthcare. My gut says this is not likely. But, I have been wrong before…

  8. The fact that the rate of increase for drugs is faster than the rate of increase for other medical services and other goods and services is not necessarily bad. If the value received from new drugs is increasing faster than the cost of the drugs that is good.

  9. What the companies don’t tell you is the dollars they are mentioning (e.g. $1 billion for AT&T) is a 30 year total of the tax loophole not being applied. They aren’t annual numbers as you’d assume.

    $33 million per year, when you consider how big AT&T is, isn’t as shocking of a figure. And its not like the government is asking for anything back from previous years where the company benefited from the loophole…

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