Quarterly commentary: April 2017

Thankfully, 2017 started out on a far more positive note than the first quarter of 2016.

Last year’s record-breaking poor first quarter performance seemed like a distant memory, as corporate earnings growth and prospects for newfound economic prosperity under the Trump administration continued to feed the post-election rally.  For the quarter, the S&P 500 gained 6.1% and smaller companies in the Russell 2000, which had outperformed large caps by a significant margin in 2016, advanced 2.47%. Foreign stocks, as measured by the MSCI World ex USA Index, grew by 6.81% topping US large caps, while fixed income, despite continued talk of Fed rate hikes, had positive returns with the Barclays U.S. Aggregate Bond Index up .82%.

The markets have certainly benefitted from the so-called “Trump trade,” and while most Americans have focused on all the drama surrounding the election, the world economy has quietly continued to improve as well. That said, as we approached the end of the quarter, both the U.S. stock and bond market were signaling that the promises made during the Trump campaign are far easier said than done, especially in a country so divided on many of the key economic issues at hand. Abroad, the implementation of Brexit, elections in France and Germany, as well as a myriad of other geopolitical issues like North Korea’s rumblings and new “red lines” in Syria, have international markets on edge as well.

Now that we are rapidly approaching the end of President Trump’s First One Hundred Days, we thought we would weigh in on where things stand with regard to the Trump administration, Congress’s plan to revisit a repeal and replacement for Obamacare, and how it is inextricably tied to tax reform.

“Nobody Knew Health Care Could Be So Complicated”
– President Donald Trump

President Trump was just coming into office when we wrote our last letter. We knew the fate of Obamacare was on a short list of issues he intended to tackle, so it was no surprise that it would be the first one out of the gate. However, as his quote suggests, Obamacare, and to a greater extent, general healthcare reform, has presented a very complex set of issues with far reaching ramifications to many government programs.

On March 24th, we witnessed the end of the first attempt by Congress to repeal and replace Obamacare through the proposed American Health Care Act (AHCA).  In fact, it couldn’t even muster a vote in the House due to the division within the Republican Party over key elements of the replacement. Not only were there tactical disagreements, but there remains a philosophical debate about the role government should play in the delivery and payment of healthcare coverage for Americans. While Americans remain split on their support of Obamacare, most support a few key aspects of the plan, such as protecting coverage for those with pre-existing conditions and coverage for children under 26 on parent’s plans. In the end, the most conservative wing of the party and their more moderate counterparts could not agree on a set of provisions that were satisfactory to garner enough votes among Republicans, much less Democrats, for a successful outcome.

To avoid losing momentum, President Trump moved on to tax reform.  In doing so, the administration has quickly found that it is nearly impossible to propose a viable tax reform bill in the absence of dealing with significant tax and spending aspects of our present methods of paying for the delivery of healthcare to the non-elderly.  At the root of this discussion is a debate about three key elements of our present system- the substantial subsidy provided to those covered under an employer-sponsored insurance plan (ESI), subsidies offered to those who qualify under Obamacare, and whether Medicaid subsidy is to be a federal or state matter and the degree of subsidy.

Dominos fallingIn order to make coverage under Obamacare more affordable, new premium subsidies were offered to those who qualify.  The cost of these subsidies was $45 billion in 2014 and projected to increase to $146 billion in 2017 according to the Congressional Budget Office (CBO).  Interestingly, this pales in comparison to the cost of federal and state tax subsidies for employer sponsored insurance, a subsidy that has been in place since the 1940’s covering roughly 60% of working Americans!

Employer contributions for health insurance are deductible to the business, but are not included in the taxable income of employees, and employee-paid premiums are generally excluded as well.  Not only does this result in lost tax revenue for federal and state governments, but it also lowers the amount employees and employers contribute in payroll taxes  to fund Medicare and Social Security.

The value of these tax benefits is significant, resulting in an estimated $260 billion in lost federal tax revenue in 2016, making it the single largest tax expenditure in the budget.   As the cost of health insurance rises, this subsidy goes up with it.   In a recent study, this tax subsidy is projected to total $3.6 trillion over the next 10 years.  In addition, there is a federal tax deduction for individuals who incur annual health expenses for the portion of their AGI exceeding 10%, which results in $13 billion more in lost tax revenue.

Most employees do not recognize that they receive a government subsidy by having an employer-sponsored plan.  The following is an example of differences in cash flow for two individuals with the same gross compensation- one who has employer-sponsored insurance and one who doesn’t.

Compensation of tax liabilities of two workers with and without health insurance

Person A
(without health insurance)
Person B
(with health insurance)
(Person A –
Person B)
Total Compensation $100,000  $100,000  $0.0
Taxable Wages $100,000  $85,000  $15,000
Employer Contributions to Health Insurance $0.00  $12,000  ($12,000)
Employee Contributions to Health Insurance through 125 Plan $0.00  $3,000  ($3,000)
Taxes (Total Tax Liability) $34,864.58  $28,225.58  $6,639.00
Federal Income Tax $16,542.50  $12,792.50  $3,750.00
Ohio Income Tax $3,022.08  $2,428.08  $594.00
Employer FICA $7,650.00  $6,502.50  $1,147.50
Employee FICA $7,650.00  $6,502.50  $1,147.50

Government subsidy of employer-sponsored health insurance

This table illustrates the effective tax subsidy for employer-sponsored health insurance.  In this example, Person A does not have employer provided health insurance and is required to purchase insurance through private coverage.  Person A must pay taxes on all compensation as taxable earnings and his employer must pay FICA (social security and Medicare tax) on all of their compensation.  Person B has employer provided health insurance as portion of total compensation and contributes a portion of wages toward the premium.   The employer paid premium plus the employee premium contribution are excluded from Person B’s taxable income, thereby providing a subsidy by lowering the overall taxes by $6,639.

If you add the costs of employer-sponsored insurance, tax breaks, and Obamacare subsidies with the cost of Medicaid benefits of $300 billion annually, you can see why attempts at meaningful tax reform without dealing first with healthcare reform is impractical.

Can we reach consensus on healthcare reform?

In order to have a long-standing, bipartisan improvement or replacement of Obamacare, we have to come to a consensus as a nation on whether we intend to provide a way for everyone to have affordable health care coverage, as well as how we will deliver and pay for these services.  Before Obamacare, many working Americans had access to healthcare through employer-sponsored insurance plans, Medicare and Medicaid, while millions were uninsured.  But the fact remained that care was also being delivered, whether patients had coverage or the funds to pay for care or not.  This standard of care was mandated with the passage of The Emergency Medical Treatment and Active Labor Act (EMTALA) in 1986 under President Ronald Reagan, which required hospitals to care for individuals seeking assessment for a medical condition, regardless of citizenship, legal status or ability to pay. Over time, these legal standards, in the presence of the Hippocratic Oath of physicians and the general spirit of those in the medical community, resulted in an implied obligation to care for all those in need. There was no argumentHealthcare Cartoon that there were many inefficiencies, both financial and otherwise, in this haphazard delivery of services, yet it persisted.  After years of inaction on this matter, Obamacare, with all its shortcomings, was the first attempt to try to deliver and fund healthcare for all.  Unfortunately, the bill was passed under duress in a partisan fashion due to “politics as usual”. More importantly, there is still a fundamental divide between conservatives and liberals, even within party lines, as to the responsibility to provide healthcare to all.

The flaws in Obamacare are becoming more apparent–availability to exchanges is shrinking, healthy individuals are ignoring the penalties and refusing to buy coverage in adequate numbers, federal Medicaid expansion monies are declining while enrollment is up causing an increasing financial burden on states, etc. This is being exacerbated by moves made through the new administration, such as President Trump’s executive order, signed within hours of taking oath, with the intent of dismantling Obamacare.

Healthcare tax reform

While there are philosophical aspects to replacing Obamacare, the urgency in this debate is much more about entitlement costs that are surging out of control, which is limiting the ability of Congress to move forward with other tax reforms. With the cost of subsidizing tax-free employer sponsored health insurance, health premiums for those receiving premium assistance under Obamacare, and assistance to states to cover 90% of new Medicaid recipient costs, it has become structurally unsustainable. As it stands now, these government expenditures will grow by the rate of increase in health care costs in the U.S. Consequently, if health care costs grow by 10% annually, these government costs will grow by at least 10%, eventually forcing Congress to make dramatic cuts in other programs. Couple this with the equally burgeoning costs of Medicare and it becomes critically important that we no longer kick this can down the road.

This system would replace the Obamacare subsidies that currently have no limits on expenditure growth.  Under the current system, the majority of the escalating costs are born by the government through progressively larger subsidies.  By employing this alternative program, the government can control the growth of mandatory spending by adjusting the deduction or credit amount or even phasing it out as a taxpayer’s income increases, the same way Medicare premiums are now increased based on income.  In addition, as individuals share to a greater degree in the cost equation, the expectation is they will be better consumers when it comes to controlling health care costs.In order to slow down this expenditure growth, balance the disparity of tax subsidies provided to those who have employer-sponsored insurance, and provide some coverage for those who cannot afford care on their own, Republicans are proposing replacement programs with tax changes intended to begin to rein in government costs. One way to do this is through taxation of employer-sponsored insurance premiums coupled with a tax offset. This would require employers to include all employer and employee-paid health benefits in taxable wages. Everyone would then be provided a standard deduction or tax credit for health insurance that would offset all or a portion of the newly-included taxable income. If you do not have employer-sponsored insurance, the credit would be refundable and could be used toward the purchase of individual coverage. Taxpayers would pay taxes on any amounts that exceed the standard deduction or equivalent credit, and they would be indexed annually by the Consumer Price Index-Urban. This method would cap government subsidies at current levels and limit annual increases to CPI. By simply capping the growth in the subsidy of Employer-sponsored insurance, the government will save an estimated $800 billion over 10 years and $4 trillion over 20 years whether Obamacare exists or not.  Many people are unaware that starting in 2012, the IRS began phasing in a requirement for employers to report “Cost of Employer-Sponsored Health Coverage” that was not included in taxable wages on an employee’s W-2 in Box 12 code “DD”.   It is reported, but not currently used in preparation of taxes.  Open Pill with moneyLogistically, it would be easy to begin taxing this subsidy.

There is little doubt that Americans will be forced to accept responsibility for a greater portion of their healthcare expenses either through direct expense, higher taxes, or a combination of both.

In summary

It remains to be seen what healthcare and tax reform packages will be implemented, but you can rest assured that these issues will have a measurable impact on your financial future.  As these new policies are debated, we will stay on top of the developments, as your advisor, so that we can address them in your financial plan as they apply to your situation and keep you on track toward your goals.  We remain hopeful that both parties will eventually be able to agree on policies that are fair and promote the health and economic welfare of our country.

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