From its introduction in the House Ways and Means Committee on Nov. 2 to the final vote expected tomorrow, the Tax Cuts and Jobs Act will arrive on the president’s desk after only 48 days. The bill that emerged from this process is the most important piece of legislation since the Affordable Care Act (ACA). Its impact on healthcare will be felt for years to come. Although there are some positives, the act does not favor the nation’s hospitals and health systems.
An overview of relevant provisions follows. In the days and weeks to come, we will provide you with deeper analysis of these key provisions and their implications.
Repeal of the Individual Mandate
For years, Republicans have been vocal about their desire to dismantle the ACA. Repealing the individual mandate for health insurance is an important step in that direction. The Congressional Budget Office (CBO) estimates that repealing the mandate will decrease the number of insured people by 4 million in 2019 and 13 million in 2027. The CBO also estimates that average premiums will increase about 10 percent more per year than they otherwise would have risen. Evidence suggests newly uninsured people will delay doctor visits, find it difficult to pay medical bills, and experience poorer health long term.
While bad-debt levels likely won’t rise to what they were before the ACA, they will rise. The major provisions of the ACA came into force in 2014, expanding healthcare coverage to an estimated 20 to 24 million people covered by 2016. The increase of millions of uninsured people each year will lead—perhaps gradually—to more bad debt, which hospitals will need to account for in their financial planning.
Elimination of Advance Refundings
Hospitals and health systems, higher education institutions, and others averted a significant setback when a prohibition on tax-exempt Private Activity Bonds was removed from the legislation. Forcing not-for-profits to issue only taxable debt would have increased borrowing costs and limited market-access options. Although one challenge was averted, another remains. The tax bill’s repeal of tax-exempt advance refundings as of December 31, 2017, will significantly limit refinancing options for hospitals.
Advance refundings of outstanding tax-exempt fixed rate bonds have offered hospitals the ability to capture historically low tax-exempt interest rates by refinancing prior bonds, leading to millions of dollars in savings and freeing capital for other projects. Advance refundings have also served as an important tactic for modifying security, covenants, and master trust indentures to today’s standards, particularly helpful in certain acquisitions.
Not-for-profits still have significant opportunities to capture low rates, though the playbook has changed overnight. Most tax-exempt funding alternatives have generous call options so advance refunding limitations do not apply. The prohibition of advance refunding falls to the most popular funding alternative, tax-exempt fixed rate debt. For fixed bonds, the next year is sure to see an exploration of several options to drive down capital cost. We expect to see shorter or more frequent bond call dates on newly issued tax-exempt bonds, a renewed discipline for monitoring tax-exempt current refundings (refundings within 90 days of stated call date), advance refundings using taxable debt, and derivative products such as forward-starting interest rate swaps. We will explore these options in greater detail in future articles.
Lowering the Corporate Tax Rate from 35 percent to 21 percent
Among the changes in the reform bill making headlines is the lowering of the top marginal corporate tax rate from 35 percent to 21 percent. For tax-exempt entities, this has an indirect impact to both existing direct purchase arrangements and incremental financing across almost all products. (Our commentary pertains to debt.) Many borrowers with existing direct lending have previously agreed to marginal tax rate adjustments, thus absorbing the risk of a lower corporate tax rate of the lender. In one analysis, the impact was more than 20 basis points.
As the tax-exempt benefit to the corporate lender is diminished, the cost of capital will rise for the tax-exempt borrower seeking new funding. Banks and insurance companies hold about 25 percent of the municipal market. With corporate rates so low, tax-exempt municipal bonds will be less attractive to these large institutional investors. Research from J.P. Morgan suggests that a 21 percent corporate tax rate will result in a 35 basis point increase in average tax-exempt bond yields in order to tempt the institutional investors to continue to buy hospital debt. It is possible that 2018 will see fewer direct placement bonds. This will hurt smaller hospitals that tend to privately place bonds with banks to avoid managing the credit issues and fees involved with public bond deals. Further, there may be less demand for tax-exempt bonds from the wealthiest individual investors, who will see a 2.6 percent reduction in their tax rate.
Increase in the Medical Expense Deduction
The tax bill is not all bad news for hospitals and healthcare. For 2017 and 2018, individuals will be allowed to deduct unreimbursed medical expenses in excess of 7.5 percent of Adjusted Gross Income (AGI). From 2019 on, expenses exceeding 10 percent of AGI can be deducted. Considering that the deduction was previously on the tax-reform chopping block, this is a huge win for low and middle-income individuals facing high medical costs, especially senior citizens and people with chronic illnesses.
Preservation of Graduate Tuition Waivers and the Deduction for Student Loan Interest Payments
Another relatively modest victory for healthcare in the tax bill pertains to tuition waivers and student loans. Graduate students across the country were up in arms over the House plan to tax tuition waivers as income. Thousands walked out of classes and eight were arrested for demonstrating outside the office of House Speaker Paul Ryan (R-WI).
In a rare piece of good news, the final bill does not tax graduate students’ tuition waivers, and it continues to allow the deduction of qualifying student loan interest payments. With the Association of American Medical Colleges predicting a massive shortage of physicians by 2025, making already-expensive graduate medical study even more costly and pricing out potential students would have been a formidable challenge for American healthcare.
21 Percent Excise Tax on Excessive Compensation Paid by 501(c)(3) Organizations
Buried deep within the text of the Tax Cuts and Jobs Act is a 21 percent excise tax on any compensation over $1 million paid by most tax-exempt organizations annually to their five highest paid employees. This does not include compensation paid to a licensed medical professional for the performance of medical services. Hospitals need top management talent and intellectual capital. The new excise tax will reduce resources for this critical need and is one more thing to add to the financial planning list.
Cuts to Medicare and Medicaid
Potential reduction in Medicare and Medicaid payment is the elephant in the room—a really big elephant. With the CBO predicting a $1.4 trillion deficit caused by tax reform, spending will have to be cut. There is no way around it.
Although Medicare cuts in particular are traditionally the third rail of politics, Speaker Ryan has not been afraid to raise the subject. Recently, Ryan said, “We’re going to have to get back next year at entitlement reform, which is how you tackle the debt and the deficit.” Entitlement reform has been high on Ryan’s agenda for years. With passage of tax reform, and deficit hawks clamoring for reductions in government spending, he may have the momentum and political capital to make it happen.
While it remains to be seen exactly what Ryan and the GOP have in store for Social Security, Medicare, Medicaid, the Children’s Health Insurance Program (CHIP), and ACA subsidies, the Tax Cuts and Jobs Act poses its own dangers to Medicare. The Statutory Pay-as-You-Go Act of 2010 (Paygo) stipulates that legislation that adds to the federal deficit must be paid for with increases in revenue, spending cuts, or other offsets.
The Department of the Treasury believes that the bill will stimulate the economy so much it will not only generate enough revenue to pay for the tax cuts, and create a $300 billion surplus over the next 10 years. However, this analysis contradicts reports released by the CBO and non-partisan Joint Committee on Taxation, neither of which predict a surplus. If the bill doesn’t offset the loss of tax revenue with increases elsewhere, the government will be forced to make $150 billion in mandatory spending cuts each year over the 10 year life of the bill. Of that $150 billion, $25 billion will come from Medicare each year.
Paygo can be waived, but not under budget reconciliation. Instead, it would require a separate bill needing 60 votes to pass, a high bar in this partisan environment.
Looking Ahead
It took 31 years for Congress to pass its first major tax reform bill since the Reagan era. It will not take that long for the next tax reform bill to pass. This bill contains expiration dates for many provisions and a lack of inflation indexing for others (decreasing their real value as time passes), which will eventually force Congress to step in and make changes—we hope taking longer than 48 days.
The tax bill will have a potent effect on healthcare providers. However, it is only one part of a broader set of forces putting pressure on traditional hospital revenue streams, expenses, and business models.
This material has been prepared for informational purposes only and should not be relied upon for or construed as tax advice. Please consult your tax advisor before making any tax-related decisions.