The Supreme Court Rules on Health Care Reform: What It Means For Investors

The Washington Update from Andy Friedman

The Supreme Court has now upheld the individual mandate, the controversial part of the health care reform law (The Patient Protection and Affordable Care Act) that requires individuals to carry health insurance.  At the same time, the Court struck down the requirement that states expand their Medicaid coverage to include more low-income families. These rulings will have significant implications on the country’s fiscal situation.  Perhaps most important for investors, the Court’s decision virtually assures that the new taxes imposed by the law will take effect on schedule in 2013.

The Law.  By way of background, the Patient Protection and Affordable Care Act has five main elements;

An employer mandate (“pay or play”):  Employers with fifty or more employees must provide health insurance to their employees (“play”) or pay a new tax (“pay”).

An individual mandate:  Every American must have health insurance.  Those individuals who do not receive coverage from their employer or under Medicare or Medicaid must either purchase it or pay a penalty for failing to do so.

Restrictions on health insurers:  Health insurers may no longer reject applicants for coverage or charge higher premiums based on pre-existing health conditions.

Exchanges:  Each state is to set up an “exchange” where people can get information about various insurance policies and compare terms and pricing.

Subsidies:  Families with income under about $88,000 will get subsidies to help them purchase insurance, and (under the law as enacted) families with income below about $30,000 will get it for free under Medicaid.

The Individual Mandate.  Most observers (and even the lawyers undertaking the oral arguments) believed that the issue before the Supreme Court was whether the Commerce Clause of the Constitution gives Congress the power to require that everyone carry health insurance or pay a penalty (the “individual mandate”).  The Commerce Clause typically allows Congress to pass laws that affect items in interstate commerce.  A majority of the Court (the four conservative justices plus Justice Kennedy, who is often a swing vote) held that Congress does not have the power to require the purchase of insurance under the Commerce Clause.  They reasoned that, while Congress has the power to regulate commerce, it does not have the power to regulate a lack of commerce (that is, a decision not to purchase a product).

Chief Justice Roberts then broke with the other conservative justices to uphold the mandate on an entirely different ground.  He concluded that the penalty imposed on people who do not buy insurance is in effect a tax.  The Supreme Court has long held that Congress’ power to tax is virtually plenary, and that Congress can determine who to tax and for what reason.  With that holding, Roberts joined the four liberal justices who concluded that the individual mandate is permissible under the Commerce Clause.  With five justices thus upholding the mandate (albeit for different reasons), the mandate survived.

Roberts’ conclusion that the mandate penalty is a tax is curious, because when it passed the law Congress went out of its way to say the penalty was not a tax.  Congress did so because it did not want to appear to be imposing new taxes, which are unpopular.  Indeed, elsewhere in his opinion Roberts concluded that the penalty was not a tax for purposes of the Anti-Injunction Act, which precludes the Court from hearing a tax case before the tax is actually paid.  Thus in the course of the same opinion Roberts concluded the penalty was a tax for one purpose but was not a tax for another.

Read closely, Roberts’ opinion suggests that he undertook this legal ju-jitsu for a higher purpose.  As chief justice, Roberts is keenly aware of his responsibility for the Supreme Court’s legacy.  He is concerned by the public perception, particularly in the wake of Bush v. Gore, that the Court has devolved into a partisan political divide.  Roberts likely felt that a decision by the five Republican-appointed justices over the four Democratic-appointed justices to overturn a law enacted by a Democratic Congress and President would have eroded support for the Court inalterably.  Thus, even though Roberts might personally have found the law distasteful, he strained to find a plausible reason to save it (“it is not our job to protect the people from the consequences of their political choices”).

By straining to find an alternative ground to uphold the law Roberts gave both sides a victory.  The President gets his signature legislation.  But the conservatives get a narrower scope to the Commerce Clause which they’ve long sought, a precedent that no doubt will serve them well in later Court challenges to other laws.

The Fiscal Implications.  The health care reform law is likely to add significantly to an already swollen federal budget deficit.  Using the government’s own numbers from the time the law was passed (the most conservative numbers), health care reform will cost a trillion dollars over ten years.  Yet, according to the official estimates, the law is “revenue neutral”, meaning it does not add to the deficit.  This conclusion rests on two other provisions in the law.

First, half of the cost of the law (about $500 billion) is recouped through new taxes that begin in 2013, the implementation of which remain undisturbed by the Court’s majority holding:

A 0.9% increase in the Medicare tax on annual family wages above $250,000 ($200,000 for individual taxpayers).

An additional 3.8% tax on taxable investment income received by families with adjusted gross income over $250,000 ($200,000 for individual taxpayers).  This additional tax applies to investment income that is otherwise subject to tax, such as dividends, interest, capital gains, rents, royalties and distributions from annuity contracts.  The tax does not apply to income that is not taxable, such as tax-exempt municipal bond interest and life insurance death proceeds, or to amounts withdrawn from qualified pension plans and IRAs.

The 3.8% tax applies to taxable investment income only to the extent that income, plus all other adjusted gross income, exceeds $250,000 for a family ($200,000 for an individual).  For instance, suppose a family has $200,000 of wage income and $80,000 of dividend income.  Total adjusted gross income of $280,000 exceeds $250,000 by $30,000.  Thus the 3.8% tax would apply to $30,000 of the dividend income.

The remaining $500 billion cost of health care reform is to be made up by reducing Medicare reimbursement rates, lowering the payments received by doctors, hospitals, and drug companies who minister to Medicare patients.  The concern here is that reducing Medicare reimbursement rates will result in a shortage of doctors who will see Medicare patients.  Faced with the prospect of significantly reduced income, fewer college graduates will choose to undertake the financial burdens of medical school.  And more practicing doctors will take the “concierge” route, seeing only wealthy patients who can afford to pay “full price” for care.

This result will put Congress in a difficult position:  either accept de facto rationing of medical services, or contravene the new law and keep Medicare reimbursement rates at current levels.  Experience suggests Congress will do the latter.  Since the health care reform law was passed in 2009, Congress has overridden scheduled Medicare rate cuts four times, and there is every indication it will continue to do so.  If this trend continues, health care reform — far from being revenue neutral — will add $500 billion to the federal budget deficit.

And that estimate uses the government’s own numbers.  In reality, the cost is likely to be much greater because the system can be gamed.  As health care costs increase, many businesses likely will choose not to provide health insurance to employees, opting instead to pay the penalty.  The penalty on employers is only $2000 per year per employee, much cheaper than paying for insurance.  To date businesses typically have provided coverage for competitive reasons, or because employees with poor health histories would otherwise be unable to obtain it.  But these concerns disappear in a difficult job market and under a law that assures universal coverage regardless of health.  Thus, many businesses will save money by paying the penalty in lieu of providing insurance.  (Businesses with fewer than fifty employees don’t even have to pay the penalty.)  Perhaps they will use a portion of the savings to give employees additional bonuses to keep everyone happy.

If employers do not provide insurance, individuals will have to purchase it on their own.  But many healthy individuals may choose not to do so, opting to pay the penalty (or, as Justice Roberts would say, the tax).  For most families, the penalty will not exceed $2085 a year ($625 for single adults), a lower cost than paying for insurance.  Indeed, Roberts himself noted that “for most Americans the amount due will be far less than the price of insurance, and, by statute, it can never be more.”

Instead, individuals may wait until they are sick to purchase coverage, a right they are assured under the law.  Insurers cannot long survive a system where only sick people buy insurance.  Either they will have to raise premiums enormously, or more likely they eventually will exit the business.  In that event, sick people will have to obtain coverage elsewhere.  Presumably the federal government — the payer of last resort — will need to step in to provide it.

Of course, the status quo (pre-health care reform) is not acceptable either.  The United States has an aging population.  People without insurance go to the emergency room for a runny nose, a cost everyone bears.  Thus, if the health care reform law is to serve as the answer, then Congress must raise the penalties on employers and individuals high enough so they buy insurance, and find $500 billion in savings elsewhere in the federal budget.

Medicaid Expansion.  Another aspect of the Supreme Court decision may further increase the federal government’s cost of implementing the health care reform law.  As noted above, the law seeks to extend Medicaid coverage (free insurance) to all families earning less than about $30,000 a year (133% of the federal poverty level).  Currently only certain families with earnings under the poverty level (about $23,000 for a family of four) are eligible for Medicaid.  Thus the law would significantly expand Medicaid coverage to families above the poverty line, as well as to additional families below the poverty line.  The federal government will finance the full cost of this Medicaid expansion through 2016.  Beginning in 2017, the states are to fund a small part, topping out in 2020 at 10% of the total cost.

The law permits the federal government to withhold all Medicaid contributions — including those for existing programs — from states that decline to participate in this expansion of Medicaid coverage.  (Currently the federal government reimburses states for approximately 57% of Medicaid costs.)  The Court (in a 7-2 vote) rejected this part of the law, holding that the potential loss of full Medicaid funding was a penalty so great as to constitute federal coercion of state action impermissible under the Constitution.  According to the Court, the federal government may withhold from a non-participating state the federal government’s contribution to the Medicaid expansion (90% of the cost of the expansion), but it may not withhold funds previously granted to fund the existing Medicaid program.

The Court’s decision leaves the Medicaid expansion in limbo, as each state may now decide what it wants to do.  Many states are likely to expand Medicaid coverage anyway, given that the federal government will bear the brunt of the increased cost.  But some states may refuse to do so.  In that case, some low-income families may be entitled to federal subsidies to purchase insurance.  But others may simply be left without coverage.  Because such a gap in coverage would appear to be untenable, the federal government may end up funding a larger portion of the Medicaid expansion than anticipated, at least for residents of recalcitrant states.

Higher Taxes.  In upholding the bulk of the health care reform law, the Court’s decision assures that the law’s surtaxes on compensation and investment income will take effect as scheduled next year.  Thus, we now know with virtual certainty that income taxes next year will increase, regardless of whether Congress permits some or all of the Bush tax cuts to expire. My white paper, Investing in a Rising Tax Environment, provides strategies that investors can consider now to help blunt the effects of these higher taxes.

The Washington Update