social good in the form of charity care, research, education, etc. Early in ... donation is assumed to be permanent with a perpetual annual return. Note also that in ... fund raising would never approach 100percent of the marginal funds raised, as ...
Returns on Equity for Not-For-Profit Hospitals: Some Comments J. B. Silvers and Robert T Kauer
The provocative article by Professor Pauly that begins this issue of HSR: Health Services Research provides a valuable additional framework for our understanding of the difficult problem of an appropriate return on equity for not-for-profit or, more properly, "tax-exempt" hospital corporations (NFP/TE) relative to for-profit or, again more correctly, "investor-owned" hospital corporations (FP/IO). It is especially useful in opening up further the question of what motivates donors and managers. The problem is that it does not go far enough. There are at least three main problem areas. First, the central question: Why, exactly, do donors make contributions? What do they expect in return, how much do they expect, and who is the beneficiary? Pauly simply assumes they are offered a valueless "bribe" in exchange for their gift. This is not very convincing. The second problem is a confusion or lack of precision in this article-and in most other prior work (Conrad [1], Long [2, 3] and even Long and Silvers [4]). The distinction is poorly made between cash profits (or "net revenues") and in-kind profits provided in the form of "dividends" on behalf of a community stakeholder. Of course, NFP accounting recognizes these social dividend/returns only as expenses. Without clarification here, all arguments remain purely conceptual with little practical application. The third difficulty lies in the level of analysis chosen by Pauly. A look only at direct costs to the consumer/patient cannot lead to an accurate model or to an economically efficient answer to the correct Address correspondence and requests for reprints to J. B. Silvers, Ph.D., Health Systems Management Center, Case Western Reserve University, Cleveland, OH 44106. Robert T. Kauer is also affiliated with the Health Systems Management Center, Case Western Reserve University.
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NFP/TE rate of return on equity either to allow as a purchaser/ regulator or to expect as a donor/investor/manager. In particular, very substantial tax subsidies simply cannot be ignored if the total payment for direct health care services and related social goods is to be appropriate and if we are to understand the incentives of donors and investors.
WHAT Do CONTRIBUTORS REALLY EXPECT? At a fundamental level, the 501(c)(3) tax-exempt, not-for-profit hospital corporation (NFP/TE) must be functionally equivalent to its taxpaying, for-profit, investor-owned (FP/IO) sister. They both provide basic patient services that are demanded by purchasers - in particular, by purchasers who have money and a well-defined preference for the homogeneous product Pauly proposes. However, the former historically has supplied a second product-a social good in the form of charity care, research, education, etc. Early in the development of the industry, probably more of this second good was produced than the first. This mixed set of private and public goods was thought to be too important to be left to the government! But entrepreneurs, of course, could not be expected to fill the need for such a noncommercial product -and thus evolved the NFP form of community and religious ownership for hospitals. For obvious reasons, their primary form of financing was through voluntary contributions. Contrary to this development, Pauly assumes that whatever is spent beyond the cost of basic patient services is an economically worthkss excess. It is coerced from the unwilling hospital by the donors whose capital is needed to provide basic patient services. Pauly refers to this as a future fundraising cost. Alternatively, the excess can be seen as a bribe to entice reluctant contributors to come forth. In any event, the article assumes that it is not a valuable social good but only an agency cost or a necessary evil of doing business in this organizational form. However, in light of the historical pattern of philanthropy, it would be much more convincing to assume that the excess spent beyond basic patient costs primarily consists of a valuable social good. If this is so, and if it were not provided to society by this traditional mechanism, then our political process would have to invent another way to make it available. Of course our tastes for social goods vary among individuals and change over time-but a perceived market demand clearly exists. Also, some social goods we choose to finance on a collective basis (i.e.,
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Medicare and Medicaid) and others we leave to the tastes of local communities and their voluntary mechanisms, such as the NFP/TE hospital. Certainly this conclusion is not to deny that agency costs for donors, trustees, and managers undoubtedly exist in this industry as in others. It merely argues that they are highly unlikely to be the primary factor explaining "excess" costs beyond basic patient services. In this alternative world, then, contributors make capital donations which allow the NFP/TE to provide basic patient services. Historically, they have expected a return in the form of the second (social) product. While it is arguable that the level of this return might be zero, as in Pauly's region OD in Figure 1, it is unlikely. This is true because the opportunity costs to the investor/donor are clearly non-zero and the alternative exists to buy the basic patient services alone, without the complicating social good, from the nearby FP/IO hospital. The return to the contributor on a capital donation under the law can only be in the form of the traditional social goods provided as a second product outside the competitive economic market by the NFP/ TE. The law for 501(c)(3) tax-exempt status both helps subsidize this socially desirable outcome and guarantees that donors will not be tempted to convert residual equity income into personal gain.
How MUCH SHOULD THE RETURN ON EQUITY BE? At this point, a more precise exposition and example might make the above conclusion more clear, assuming, first, that no taxes exist and then exploring the critical role of tax subsidies. Consider Pauly's world of a homogeneous basic patient service. Whether produced by the NFP/TE or by the FP/IO, this service requires a fixed capital investment I supplied by donors in the form of a capital contribution C for the first and by capital market investors in the form of equity E for the second, where I = C = E. In either case, the investment or capital donation is assumed to be permanent with a perpetual annual return. Note also that in reality donors and investors both are drawn largely from the same subset of higher-income individuals -in contrast to the inference in the Pauly article. Consider the first strategy for the potential donor. Assume that the investment E allows production of basic patient services as the only product of the FP/IO and yields a competitive, risk-adjusted capital market return rc. Further assuming a full payout of earnings and a
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propensity to contribute, the investor has rcE cash available each year for this purpose. Thus, an amount of the social good up to rcE could be purchased directly from the NFP/TE with this cash (i.e., direct contribution for charity care, etc.). Alternatively, as a second strategy, the investor could make an equal capital donation C to the NFP/TE. But if the investment is in the form of a capital donation, the NFP/TE will produce a certain amount of social good as the return, as well as basic patient service. But if the returns from the two corporations are unequal in terms of the social goods ultimately purchased, the investor/donor will choose the one resulting in more social good for the same cash investment or donation. Thus, both basic patient care services and the desired social good must be equally available via either strategy in an efficient capital market. This is a classic financial economics arbitrage argument (see, for instance, Modigliani and Miller [5]). It means that the amount of social good that must be produced by the NFP/TF is at least rOE. Then, if k, is the return on contributed capital C, the following must hold:
kCC
=
rcE
(1)
But since the contribution and equity investment are identical, we have the important result that the required rate of return on contributed equity capital for the NFP/TE must be the same as the market rate of return on invested equity for the FP/IO in the absence of taxes: (2) k, = r, In this situation, there is also no inherent reason to expect donations to be maximized independent of the amount of social good demanded in the way assumed by Pauly. Certainly the marginal cost of fund raising would never approach 100 percent of the marginal funds raised, as the experience of any typical institution would confirm. Rather, fund raising is driven by the trustees' perception of the need for the two products produced and the degree to which this perception is shared by capital donors and direct social good purchasers (contribu-
tors).
CAN THE MARKET RETURN ALLOW EXCESSIVE SOCIAL GOOD PRODUCTION? The implicit assumption so far is that the need for social goods is at least as great as rcE. But the possibility exists that the need, as per-
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25
ceived by the relevant quasi-public set of purchaser/donors, might be less than this dollar amount. Then, if the full capital requirement C is provided, Pauly's "valueless excess" will be a reality unless prices are lowered below the competitive market rate P,, for the basic patient service product. However, the opportunity cost to the donor/investor remains the same, and the possibility for arbitrage between the two providers still exists. In this case, the donor/investor simply switches all or a portion of his or her capital to the FP/IO and uses only the correct portion of the return rcE to buy social goods while redirecting the remainder to other investment opportunities. Without the full required capital contribution C necessary to produce the basic patient service product, the NFP/TE is forced either to cut back production to the appropriate level or to replace the missing contribution with borrowed capital - either of which might be optimal. Unfortunately, a thorough discussion of this tradeoff is beyond the scope of this commentary. But the important point is that the price continues at the market rate PJ,, the return remains at the required return r,, and the amount of donated capital shifts, in line with the "social market" perception of need for the second (social) product of the NFP/TE sector. Arbitrage possibilities and investor/donor opportunity costs dictate this result. In fact, the presence of the pure, single-product FP/IO in the patient service market results in a market check on the production of excessive social goods by the NFP/TE. This conclusion does require a static equilibrium or growth situation. The obvious difficulty, also beyond our scope here, is the lack of mobility of prior sunk capital investment when tastes and demands for social goods change. This may aptly characterize the period we have before us now. But further analysis of this will have to wait.
WHAT IMPACT DO TAX SUBSIDIES HAVE ON REQUIRED RETURNS? Of course, the above tax-free world is unrealistic. Pauly, however, recognizes this fact only in noting that the borrowing rate for the NFP/ TE should be less than the market equity rate r,. He does not try to separate the amount of this that might be due to the difference between the risk assumed by debt versus equity suppliers and the amount that is a welfare transfer from taxpayers to NFP/TE institutions. Both are present-but let us focus only on the latter. A few things are clear even though a full analysis of tax subsidy
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effects also will have to wait for further detailed consideration beyond these remarks. First, the initial cash contribution C is substantially inflated beyond the equivalent FP/IO investment E by the fact that it is immediately and totally deductible against the donor/investor's taxes at a marginal rate of T. Thus, a $100 contribution produces a $40 reduction in taxes at a marginal tax rate of T = 40 percent. For the two possible donor/investor strategies to be equivalent on a net out-ofpocket basis, this extra cash would also have to be contributed, thus producing a further tax reduction of $16 (i.e., $40 x .40). Continuing the infinite stream of donations reveals that the cash contribution C (where C - 1), plus additional contributions resulting from tax reductions, produces C/(1-T) in actual cash available to the NFP/TE with the same net cash effect for the donor as an equity investment E = I. This amount would first be applied to the capital C necessary to produce basic patient services. But the extra amount available beyond C, which turns out to be (C)(T)/(1-T), can be applied to the production of the social good. The clear implication is that kss return on donated capital must be earned after the receipt of this tax subsidy in order for the donor/investor to be indifferent in considering the two available strategies. A second effect is that the return on investment E in the FP/IO is now taxable to the investor. However, it is only the portion of the earnings contributed to the NFP/TE to purchase the social good directly that is relevant to this logic. Since this amount is taxdeductible, the tax on earnings for this portion is "undone," leaving all or any portion of the earnings r;E available for purchase of the social good if contributed to a tax-exempt provider. The end result is that, from the investor/donor's point of view, the present value of the social goods available from both strategies must be equal. Thus, the present value of an infinite stream of earnings rcE from the FP/IO must be equivalent to the present value of the additional tax subsidy (C)(T)/(1-T) available from the initial capital donation C (where C = E), plus the annual return on contributed capital k,C. If the appropriate discount rate is the after-tax market return available to the investor/donor rc(l-T), then the result is the following: (3) rcEl[rc(l-T)] = CT/(1-T) + k,C/[rc(l-T)] Then solving for k yields the fundamental relationship:
k,
=
rc(1-T)
(4)
In other words, the proper required return on donated capital in a taxable world is lower for the NFP/TE hospital corporation than for the
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27
FP/IO. The difference is the amount of the tax subsidy that can be passed on to the tax-exempt institution by the donor and will still maintain an identical final endowment of wealth and social goods for the donor. Thus, with two desired products-one an economic commodity and the other a social good -and two types of providers, the NFP/TE institution can be paid less, as Professor Pauly concluded-but for an entirely different set of reasons. Furthermore, the discriminating monopsonist envisioned by Pauly had better be very careful to set prices to reflect the appropriate marginal tax rate of the relevant set of donor/investors. Otherwise, an inappropriate production of the social good may occur, and/or the mix between the two types of providers that results may be suboptimal.
WHAT IS THE RETURN REQUIRED ON RETAINED EARNINGS? A final note is necessary on the difference between the return required on retained earnings and on contributed capital. The higher opportunity cost assumed by Pauly for "forced" contributions via retained earnings is inconsistent with the parallel assumption of zero (or at least a lower) return expected on "voluntary" contributed capital. Efficient capital markets, intermediation of savings (i.e., IRAs, pension plans, etc.), and discretionary savings plans would argue for closer opportunity rates. But the logical flaw is the assumption that the purchasers of service are paying an excessive rate to generate these "forced" capital contributions, which then "belong" to them in some sense. As shown above, the earnings generated at an appropriate price represent a return on the prior donated capital of contributors. In general, one would expect this return to be used to provide the social good as an inkind dividend (thus producing a zero accounting income under generally accepted accounting procedures). However, one could also argue that it might be efficient to retain and reinvest some profit or net revenue in patient services rather than always returning to donors for new capital. While development of this thought is also beyond the scope of this commentary, the donor's opportunity to receive a substantial tax subsidy for new contributions, but nothing similar for indirect equivalent donations in the form of retained earnings, makes the generation of new equity from retained
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earnings for NFP/TEs probably inappropriate. Again, this was also Pauly's conclusion, but for different reasons.
CONCLUSION All of the arguments in this discussion are only preliminary conceptual and theoretical developments preceding normative recommendations for managers, payers, and the government. They cannot yet be used to guide so critical a matter as Medicare payment policy (as recommended by Pauly). But both competition and the growing role of investor-owned chains will soon force us to make some very important decisions in both the public and private arenas. We can be hopeful that exchanges such as this will help us accelerate the search for meaningful conclusions.
REFERENCES 1. Conrad, D. A. Returns on equity to not-for-profit hospitals. Health Services Research 19(1):41-63, April 1984. 2. Long, H. W. Valuation as a criterion in not-for-profit decision making. Health Care Management Review 1(3):34-52, Summer 1976. 3. Long, H. W. Investment decision-making in the health care industry: The future. Health Services Research 14(3):183-205, Fall 1979. 4. Long, H. W., and J. B. Silvers-. Health care reimbursement is federal taxation of tax-exempt providers. Health Care Management Review 1(1):19-22, Winter 1976. 5. Modigliani, F., and M. Miller. The cost of capital, corporation finance and the theory of investment. American Economic Review 48(2):261-97, 1958.
