Should Nonprofit Hospitals Receive Property Tax Exemptions When They Provide Paltry Charitable Care?
by Patrick R. Carlson
Abstract
In the past nonprofit hospitals provided generous levels of charitable care. Today, many “nonprofit” hospitals act more like for profit enterprises and provide paltry levels of charitable care. These “nonprofit” hospitals essentially charge fees for services, provide very little free or significantly reduced-cost care, and have attempted to claim that billing patients and then subsequently cancelling debt is tantamount to charity care. In spite of this behavioral disconnect, many of these “nonprofit” hospitals enjoy property tax exemptions, which result in substantial savings and a competitive advantage which is often not passed on to patients. This dichotomy between a stated philanthropic mission and seemingly profit motivated behavior makes one question the continued efficacy of permitting these institutions to retain valuable property tax exemptions.
Several economic theories exist to support granting property tax exemptions to nonprofit hospitals, ranging from the subsidy theory to the relief of government burden theory. This paper discusses these theories and provides criticism and analysis. Given the enormous increase in the cost of medical care, it is important to understand the economic roots and possible solutions. An analysis under these theories leads to a conclusion that restricting property tax exemptions for insufficiently charitable hospitals will improve the health care system by providing an incentive to provide greater levels of charitable care.
The current approach of many states is to tie the property tax exemption to the federal tax exemption. This paper discusses an alternative approach for tying the exemption to the level of charity care provided. Under this approach, a nonprofit hospital would be assessed the ordinary amount of real property tax, but could then obtain a rebate linked to the level of charitable care that it provided during the year.
Table of Contents
I. Introduction
II. An Overview of Property Tax Exemptions
A. Historical Justification
B. Economic Justification
C. Legal Justification
III. The Need for Change
A. The Failure of the Current System
B. Three Models for Reform
1. Revoke the Property Tax Exemption Completely
2. Use a Proportional Tax Approach
3. Use a Tax Rebate Approach
IV. Conclusion
I.Introduction
The cost of health care in America has been a source of concern for citizens, politicians, policy makers, and others.[1] Health care spending in America during 2005 represented sixteen percent of the gross domestic product.[2] Disturbingly, health care spending is projected to increase by the year 2016 to nearly twenty percent of gross domestic product.[3]
Based on the 2008 presidential election, it is in the interests of communities and government for health care to be available for everyone including low income persons. Health care cost and availability are central issues to many people in this county. It is therefore important to consider what tax policies could be implemented to improve the provision of health care to low income individuals.
One aspect of the problem of health care cost for low income or indigent individuals is that nonprofit hospitals have valuable property tax exemptions and yet often behave like for-profit institutions, virtually ignoring their ostensible charitable purpose. In spite of the receipt of valuable property tax benefits, many nonprofit hospitals continue to increase the cost of care to their patients.[4] Since these nonprofit hospitals operate in the same marketplace as for-profit institutions, they often charge prices and behave like for-profit institutions.[5] This behavior runs counter to the economic and legal underpinnings that support property tax exemptions for nonprofit organizations.
Many hospitals are tax exempt organizations. They pay no federal or state income taxes on their receipts. Many of those hospitals are also exempt from state and local real property taxes. This exemption is often merely a “rubber stamp” of the federal income tax exemption. Merely accepting a federal income tax exemption as a basis for a real property tax exemption ignores the difference in the purpose of real property taxes and what effect an exemption has on individual communities and states and their budgets.
It is commonly accepted that most local government’s primary source of revenue is a combination of sales and real property taxes. The primary purpose of such sales and real property taxes then must be to fund local government activities, such as fire protection, police protection, roads, schools, and other similar functions. These services, which are supported by real property taxes, directly benefit the property that is subject to the tax. The income tax, on the other hand, provides government services of a much broader scope, like national defense, old-age pension programs, basic research funding, monetary and fiscal stimulus, and similar national scope activities.
The impact of an income tax exemption has a less direct impact on other taxpayers. However, the impact of a real property tax exemption for a nonprofit organization is felt by other taxpayers in a more significant manner. Non-exempt real property taxpayers must not only then pay their share of the cost for local services, but they must also pay for the amount used by the tax exempt organization. This is more significant for the smaller tax base of local property taxes than it is for the broader national income taxes.
The question we should ask is: why should nonprofit hospitals, which generally charge market prices for their services and often own valuable parcels of real property, be allowed to avoid paying property taxes, when these nonprofit hospitals compete directly with and behave like for-profit hospitals and health care providers?
II.An Overview of Property Tax Exemptions
There are historical, economic, and legal justifications often given to support property and income tax exemptions for nonprofit hospitals. After exploring and analyzing these various justifications potential routes for reform can be discussed.
Many state and local governments impose real property taxes on property situated within their borders. Many real property tax laws contain exemptions for property devoted to charitable purposes. These exemptions often exempt the entire value of the property, rather than just exempting the portion of the property devoted to charitable purposes.
Real property taxes are one of the primary ways in which fire, police, other emergency response, education, and other local government functions are funded. Nonprofit organizations use many of these services. Yet those nonprofit organizations that own real property, such as nonprofit hospitals, pay none of the related costs because of their real property tax exemption.
A.Historical Justification
Many nonprofit hospitals began with a mission to care for the indigent.[6] Care for the indigent often entailed providing care free of charge, with no expectation of payment at any time by the provider. Over time many of these hospitals began to shift to charging for their services, where possible.[7] Throughout the twentieth century and into the twenty-first century, nonprofit hospitals increasingly began to look like for-profit institutions as they began to serve primarily paying patients.[8]
The historical basis for a tax exemption is basically no longer in existence. Today, nonprofit hospitals often compete against for-profit hospitals and other medical care providers. In 2007 for example, many nonprofit hospital institutions provided as little as one percent of their revenues as free or reduced cost care for the indigent.[9] In 2007, seven percent of nonprofit hospitals did not maintain a publicly available emergency room.[10]
Although important as a historical backdrop, it cannot be seriously argued that providing one percent of total revenues as charity care justifies a total property tax exemption.
B.Economic Justification
When an organization does not have to pay a tax that others have to pay, an indirect subsidy has been granted.
Subsidies may appropriately be granted when the provision of public goods is involved. A public good is a good characterized by positive externalities. Economists say positive externalities occur when some portion of benefits of consumption or provision of a good accrue to parties not directly involved in the transaction. In such a transaction, benefits accrue to those directly involved, for example the buyer and seller, but also accrue to others who are not parties. Goods characterized by positive externalities are underprovided in pure market environments because some third party people experience benefits of the transaction, but experience no cost. The main parties to the transaction do not take into account the third party benefits when determining the scope of nature of their transaction.
For example, suppose a homeowner hires a gardener to plant flowers, shrubs, and trees on her property. These additions beautify the property for passersby and neighbors. To the extent that these plants increase the value of the homeowner’s property, no externality has accrued. However, the benefits of passing by an attractive garden or the benefit of a more attractive surrounding to neighbors is not realized by either the gardener or the homeowner. These benefits accruing to passersby and these benefits to neighbors are positive externalities. The homeowner generally will not consider the value accruing to his neighbors or any passersby when he determines how many plants to plant. The gardener only works to please the homeowner and generally will not consider working harder to benefit any of the neighbors or passersby.
In contrast, economists use the term private good to be a good whose benefits accrue only to those parties directly involved in the transaction. No benefits are experienced by third parties. The majority of consumption is in private goods. For example, when a person buys a new couch or purchases an airline ticket, only that person enjoys the new couch or takes that flight.
There is a significant debate regarding whether health care is a public good or a private good.[11] Much of the health care performed in America is likely a private good. However, most people want the power to be healthy and have access to care for themselves and for the members of their community, regardless of their economic constraints.
Under the subsidy theory, health care is viewed as a public good, which will be underprovided in the absence of some support, for example, by providing a real property tax exemptions.[12] Under the relief of government burden theory, the provision of health care, particularly for the indigent, is considered a public duty.[13] Providing a subsidy in the form of a real property tax exemption in this case assists because the government is obligated (if not legally, at least in a moral sense) to provide health care to its disadvantaged citizens.
C.Legal Justification
Many states link property tax exemptions to federal income tax exemptions provided by the Internal Revenue Code.[14] It is therefore important to examine the federal income tax provisions to determine when a nonprofit hospital will be tax exempt for federal purposes. Examining the treatment of nonprofit hospitals by the Internal Revenue Service can assist in explaining real property tax exemptions provided by states.
The 1601 Statute of Charitable Usesin England, the first statutory enactment defining charity in the common law world, did not explicitly establish public health promoting trusts as charitable; however trust law developed such a proposition over time. The Restatement (Second) of Trusts, an authoritative analysis and summary of trust law, in § 372 says that a “trust for the promotion of health is charitable.” The common law attributes of what constitutes charity are important because the United States Supreme Court, in Bob Jones University v. U.S., 461 U.S. 574, 586 (1983), said that the income tax exemption for charitable institutions incorporates the common law standards of charity. So the common law definitions of charity, including the common law charitable trust promoting public health, are relevant for federal income tax exemption.
The Internal Revenue Code and the accompanying treasury regulations do not specifically mention hospitals or the provision of health care as a charitable aim.[15] However, other sources of federal income tax law provide guidance. The Internal Revenue Service has provided guidance regarding income tax exemptions for nonprofit hospitals under two important revenue rulings.
Revenue Ruling 56-185 was the first standard employed by the Internal Revenue Service for the analysis of income tax exemptions for hospitals. It recognized the original historical justification for a tax exemption for charitable hospitals.[16] It emphasized, among other things, that a nonprofit hospital should operate to the extent of its ability to care for those who are unable to pay and that it should not deny care to those who could not pay.[17] This approach was altered substantially by the Internal Revenue Service in 1969 following the enactment of Medicare and Medicaid.
Since 1969, Revenue Ruling 69-545 has been the standard for income tax exemption for a nonprofit hospital. It was released following the changes resulting from Medicare and Medicaid to the health care landscape. It introduced the “community benefit” standard to income tax exemption. Since 1969, this “community benefit” standard has governed the granting of income tax exemptions to nonprofit hospitals.
The “community benefit” approach departs from a focus on care for indigent patients or patients who are unable to pay for care into a broader approach. Now, the Internal Revenue Service examines all the facts and circumstances and several enumerated factors to determine if a hospital is “charitable” for purposes of the income tax exemption.[18] These factors include whether the governing body of the hospital is composed of independent members of the community; whether medical staff privileges in the hospital are available to qualified physicians in the area; whether the hospital operates a full-time emergency room open to all regardless of ability to pay; whether the hospital otherwise admits as patients those able to pay for care; and whether the hospital’s excess funds are generally applied to expansion and replacement of existing facilities and equipment, amortization of indebtedness, improvement in patient care, and medical training, education, and research.[19]
Several of these factors are relevant for the property tax exemption as well. The composition of the hospital’s staff, administration, and doctors and its ties to the community, the availability of an emergency room which accepts patients regardless of ability to pay, and the extent to which funds are used to benefit low income persons. However, the granting of a real property tax exemption affects local communities more drastically than granting an income tax exemption affects the national treasury.
The effect is greater on local communities and their budgets than on the national budget because the federal tax base is broader because it is so much larger. Also, the services provided by local governments generally benefit those within the community’s borders. When some groups receive these local government provided services without paying property tax (which is a primary method of funding such operations), the rest of the community must pay more. Because of the size of the federal tax base and because its programs tend to provide benefits of national scope, these burden issues are not present to the same extent.
III.The Need for Change
The current justifications for real property tax exemptions for nonprofit hospitals are generally unsound. As discussed previously, the historical justifications described previously do not exist any longer for many nonprofit hospitals. Many nonprofit hospitals provide little truly charitable care, charge for the majority of services rendered, and instead directly compete with for-profit hospitals for patients. The economic subsidy and relief of government burden justify some assistance in the form of a tax exemption or other subsidy, but not the generous level that is currently provided. The federal income tax exemption is at best a rough proxy for the reasons supporting a real property tax exemption. Now is the time for state and local governments to depart from the rubber-stamp granting of real property tax exemptions.
A.The Failure of the Current System
It is estimated that nonprofit hospitals saved $1.7 billion in real property taxes in 1995.[20] According to the CBO, the total savings of nonprofit hospitals from all types of tax exemptions, of which real property tax exemptions are a sizable part, in 2002 was a staggering $12.6 billion.[21]
This savings in property tax comes even as prices have increased, the number of uninsured Americans has grown, and total health care expenditures have increased.[22]
B.Three Models for Reform
The current method for property tax exemptions for nonprofit hospitals should be discontinued. State and local governments, the latter of which are highly dependent on real property taxes as a primary revenue source, should not grant blanket exemptions and then assert, after the fact, that charity is not being advanced. There are three potential options that could assist in solving this problem.