The Value of Tax Breaks for Not-for-Profit Hospitals

"...the aggregate value of the capital tax exemptions for NFP hospitals in 1994 was $4.6 billion from income taxes and $1.7 billion from property taxes."

Tax-exempt status was granted to American hospitals early in this century because hospitals were generally run by religious or philanthropic organizations to serve the poor. They provided a public benefit, were financed by donations, and generated little if any income.

Along with so much else in the health care sector, however, the character of not-for-profit (NFP) hospitals in recent years has changed dramatically. Increasingly, calls have arisen for examination and evaluation of tax breaks for NFP hospitals. For this reason, in The Tax Benefits of Not-For-Profit Hospitals (NBER Working Paper No. 6435) co-authors William Gentry and John Penrod analyze Medicare cost reports, IRS tabulations, corporate databases, and independent research to establish what they call a useful starting point for framing the debate on tax policy towards NFP hospitals.

In contrast to the days when the word hospital was virtually synonymous with charitable institution solely serving the indigent, not-for-profit hospitals today may engage in additional activities, such as teaching, and they indeed generate net income. NFP hospitals still provide social benefit in the form of uncompensated care, specialized services, and facilities like coronary care, radiation therapy, and intensive care units, where NFP teaching hospitals especially tend to have an edge. But at least one study suggests that anywhere from 20 to 80 percent of NFP hospitals do not provide community benefit equal to the government's tax expenditure on them.

Moreover, statistics indicate that the amount of uncompensated care provided by NFP and for-profit (FP) hospitals is quite similar in similar social and physical environments. Further, Gentry and Penrod show that, on average, NFP hospitals tend to treat slightly less difficult cases than FP hospitals. Such findings suggest that for-profit hospitals deserve attention when they claim tax-exemption spells unfair advantage for NFP's in the market place.

There are essentially three kinds of tax breaks for NFP hospitals: exemption from capital taxes on income and property; tax exemption in bond financing (which has the added benefit of freeing up NFP hospitals' endowments to earn tax-free income); and deductibility of charitable contributions. Gentry and Penrod suggest that the value of each of these categories of tax benefits should be considered with respect to the particular circumstance of the NFP. Fifty-nine percent of the nearly 5,000 short-term hospitals in the United States are not-for-profit, but their distribution is very uneven, dominating in the northeast, for example, but facing significant competition from the for-profit sector in such states as California, Florida, and Texas. The value of the tax exemption for a particular hospital depends on the property tax rate, the amount of capital used by the hospital, and the profitability of the hospital.

Beyond these facts, Gentry and Penrod point out that it is often unclear exactly who benefits when the NFP has a tax windfall. Since the law requires not-for-profit hospitals to reinvest any income in excess of expenditure in the hospital itself, any tax breaks create income that also must be reinvested. But who benefits from this reinvestment? It could be that fees will be reduced, or services increased. On the other hand, the NFP stakeholders themselves, that is, administrators, doctors, and other employees, may enjoy the benefit via increased salaries or improved working conditions.

Conversely, say the researchers, one needs to know how tax policy changes would affect prices, outputs, and inputs in the market for hospital services. If tax benefits are shifted forward onto consumers through lower prices, for example, then NFP hospitals may well have fewer resources for enhancing community services. Until such trade-offs can be evaluated fully, say Gentry and Penrod, it is unclear whether tax exemptions for NFP hospitals ultimately maximize benefits for needy patients.

Gentry and Penrod estimate that the aggregate value of the capital tax exemptions for NFP hospitals in 1994 was $4.6 billion from income taxes and $1.7 billion from property taxes. This amounts to 1.7 percent of the total $169 billion paid in property and corporate income tax. In addition, tax-exempt borrowing (via bond issues) may allow NFP hospitals to maintain their endowments, even if they are expanding facilities. Gentry and Penrod assert that almost half of outstanding tax-exempt debt of NFP hospitals could be offset by their endowments, suggesting an arbitrage benefit of $354 million per year. Further, for charitable contributions in 1994, they estimate that the $3.6 billion of donations lowered the donor's tax liabilities by about $1.1 billion.

-- Matt Nesvisky

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