Why Health Care Reform Is Critical for Tax Reform

Ever since President Obama’s signature health care reform, the Affordable Care Act (ACA), became law in 2010, Republicans have tried to dismantle it. They voted to repeal the law 56 times, but President Obama vetoed every bill that arrived on his desk. With President Trump taking office, Republicans are now in control of the Presidency, Senate and Congress, giving them the opportunity to deliver on a long-standing promise.At the same time, President Trump and Congressional Republicans are also keen on delivering an even larger policy priority, namely, comprehensive tax reform. Their proposed tax reform blueprints would slash tax rates on individuals and corporations. However, with a fiscal deficit that stands at -3.2% of GDP , and federal debt (at 105% of GDP ) at its highest level since the late 1940s, there is little appetite in Congress, especially amongst fiscal conservatives, to drive these numbers deeper into a hole with a tax bill that does not contain provisions to raise revenue.The question is why Congressional Republicans chose to delay tax reform until health care reform was done. Especially since the former would potentially have a much larger impact on the U.S. economy and has been a core policy priority for Republicans over decades, not to mention garners wide support from the business community. Reforming the tax code would be a complicated enough process, but conditioning it on healthcare reform, which is just as thorny an issue, reduces the likelihood of comprehensive tax reform becoming a reality.On the face of it, it would appear that Republicans are poised to deliver on their top two legislative priorities, and in rather quick order. However, the problem is that Republicans have only a 52-vote majority in the Senate, which means they are eight votes short of a filibuster-proof majority. At this point, it seems extremely unlikely that they would get the extra votes from Democrats to pass legislation, especially on a repeal of ACA.Which means they had to come up with another idea.

The original plan

The plan that was devised by Republicans in November 2016, after the election, was to quickly repeal the ACA through a procedure called budget , and then move on to tax reform.Reconciliation allows budget legislation to get through the Senate without a filibuster, giving Republicans an opportunity to get a bill through the Senate with a simple majority of 51 votes. However, to fulfill reconciliation rules, legislation would have to directly impact federal government revenue and spending. Another key requirement for reconciliation is that a bill cannot increase the federal deficit outside of a ten-year window, i.e. the bill would have to be revenue-neutral after ten years. This was the reason why the Bush-era tax cuts, passed in 2001, expired after the ten-year window. Also, the Senate can do only one of these for every fiscal year budget.Since Congress did not pass a budget last year (for fiscal year 2017), the plan was to pass ACA repeal through a budget resolution for this fiscal year as soon as Congress convened in January. Once this went through, ideally by spring, Congress could take up tax reform and pass it through reconciliation under the fiscal year 2018 budget. So healthcare and tax reform would both get done well before the end of the year, perhaps even by the end of summer.Republicans originally planned to straight up repeal the budget related elements of the ACA through reconciliation, including

Medicaid expansion

Insurance subsidies (income based tax credits)

The individual mandate – which requires people to pay an additional tax to the federal government if they do not purchase health insurance

Taxes – including the 3.8% investment income tax, Medicare surcharge on high-income earners, as well as taxes on prescription drugs, medical devices, expensive employer-provided health plans

At the same time, the legislation would keep the non-budgetary provisions of ACA in place, including

Banning discrimination against people with pre-existing conditions

Allowing people age 26 and under to stay on parents insurance plan

Banning annual/lifetime coverage limits

Mandating insurance plans to cover a certain minimum set of patient benefits

Cuts to Medicare

The revenue lost through repealing the individual mandate and various excise taxes would be made up by pulling back Medicaid expansion and insurance subsidies, while also maintaining ACA’s cuts to Medicare. This would allow the bill to meet the reconciliation requirement of not raising the deficit outside of the ten-year window.A key rationale for putting healthcare repeal ahead of tax reform is the fact that repealing all the various tax provisions in ACA would lower the tax revenue baseline for the all-important tax legislation. Under this scenario, tax reform would have to make up less ground than it would otherwise have to.Our prior release in the Roadmap to 2017 series, on tax reform, showed that the Republican plan on tax reform (“A Better Way”) tries to balance individual and business tax cuts by eliminating personal and business deductions and credits, interest deductibility on new loans and a controversial border adjustment tax provision – all of which are difficult trade-offs in their own right and would run up against powerful lobbying efforts. As Exhibit 1 (top panel) illustrates, even with the “pay-fors”, it still leaves a $2.4 trillion hole in the deficit (over ten years), per an analysis by the Tax Foundation.However, once health care reform is done, and its associated taxes repealed, Exhibit 1 (bottom panel) shows that the revenue baseline against which a tax bill is measured will be lowered by almost $900 billion. In other words, tax reform legislation would have to claw- back $900 billion less in revenue, making passage through Congress easier.In the case of the Republican plan, the revenue gap would be lowered to about $1.5 trillion if health care reform is carried out first. This is still short of revenue-neutrality but Republicans hope to make up that gap by using a technique called “ dynamic scoring” to measure the cost of the bill. As we discussed in our previous paper on tax reform, a dynamic scoring model also accounts for the (positive) impact of tax reform on the macroeconomy. Comprehensive tax reform would potentially create a larger economy, with more people working and paying taxes, in addition to higher wages. This would result in more tax revenue than that estimated when scoring on a static basis (which does not account for macroeconomic effects). Lowering corporate taxes and allowing businesses to fully expense investments could also result in more economic growth as companies can make more productivity- enhancing investments. This would also broaden the corporate tax base. Thus, on a dynamic basis, the cost of tax reform reduces considerably.Note that under reconciliation rules, legislation can increase the deficit over the course of ten years, but it is prevented from doing so beyond this period. In addition to the various “pay-fors” mentioned above, the Republican plan for tax reform would also allow businesses to deduct all their acquisition costs immediately, instead of having them deduct these costs over the period when these investments are used (as in current law). While this provision would cost the Federal government revenue in the first ten years, it would raise revenue over the next ten years since companies will not have depreciation deductions during that period and will pay more taxes.At the same time, the tax reform plan will not permit deductions for interest expenses, or else a company could potentially take a loan to acquire assets and deduct their cost as well as interest on the loan. Now, existing loans would be grandfathered in and so the provision would not raise significant revenue over the first ten years. However, it is expected to do so over the subsequent ten-year period.In summary, Republicans planned to get comprehensive tax reform through the reconciliation process by following a clever sequence of legislation that included passing ACA repeal first – to lower the baseline against which the cost of tax reform would be measured – followed by passing provisions like eliminating personal and business deductions and credits, interest deductibility on new loans and a border adjustment tax as part of tax reform. Finally, dynamic scoring would allow the legislation to get through via the reconciliation procedure.

From full repeal to repeal and replace

As part of the original plan to repeal ACA, Republicans had hoped to take up dealing with a potential replacement later in the year, possibly after tax reform was completed. However, even as the House passed a budget resolution for fiscal year 2017 in January, which basically instructed House committees to produce reconciliation legislation, many legislators were increasingly concerned about the impact of repealing ACA without a replacement. There was even pressure from President Trump, who continuously suggested that repeal and replace should happen simultaneously.House Republicans finally introduced the American Health Care Act (AHCA) on March 6th 2017, which proposed to repeal and replace most elements of the ACA. However, while repeal by itself would have been difficult to get through both chambers of Congress, the trade-offs involved when coming up with a replacement make it just as hard, if not harder, to pass.The key provisions of AHCA include

Repealing the individual mandate

Halting Medicaid expansion beyond 2020

Transforming ACA’s tax credits from income-based to age-based

Allowing insurers to charge older enrollees more

Repealing all of ACA’s excise taxes – thereby lowering the tax revenue baseline

Non-budgetary elements of ACA were kept in place so that the bill could conform to reconciliation rules, including provisions like banning discrimination against people with pre-existing conditions and allowing people age 26 and under to stay on their parent’s plan. The proposed legislation also maintained ACA’s cuts to Medicare, so that the bill would be revenue-neutral.However, the AHCA proposal has come under widespread criticism from all sides, and more so after the Congressional Budget Office projected that the bill would leave about 24 million additional people uninsured over the next ten years. They also estimated that the bill would reduce the federal deficit by $337 billion over the same ten-year period, equivalent to about 0.2% of GDP.At this point, it is an open question as to whether the health care legislation, as it stands, will ever reach President Trump’s desk, given the political blowback. While several legislators hope to offer amendments to the bill, the leadership in the House and Senate are not keen on this since that would only add more time to the legislative calendar, making it less likely that the bill will pass amid increasing opposition in Washington D.C., and beyond.Passing any sort of tax reform legislation has never been an easy task. The Reagan and Bush tax cuts were made temporary to facilitate passage through Congress, not to mention the fact that they were done during economic downturns. The current proposals intend to make significant long-term changes to the U.S. tax code, which means passage will be even more difficult. The negotiations were also going to be arduous, given the various trade-offs that would have to be made and the powerful groups lined up for and against almost every single provision.The decision to pass comprehensive tax reform under the reconciliation procedure also put the constraint of revenue-neutrality (after the first ten years) on the legislation. Ironically, this led to tax reform being dependent on another equally thorny piece of legislation, namely health care reform. The trade-offs involved with health care are just as contentious and Republicans must thread a fine needle to pass their proposals. Only then can they even begin to consider tax legislation. Conditioning tax reform on ACA repeal (and replace) reduces the likelihood of tax legislation passing, and this will drop even further the more time Congress spends negotiating health care reform.As we wrote in our previous paper in this series, financial markets appear to be expecting a large tax cut package that puts more money in individuals’ pockets and significantly lowers the cost of doing business in the U.S. Yet, they appear to be ignoring the fact that Congress must execute a series of legislative maneuvers, each of which would be difficult and ambitious on their own, before a final bill ends up on the President’s desk for his signature.