There are numerous macroeconomic headwinds that could harm the US and world economies in 2014. Investors are already wary of the eurozone crisis, and many are cognizant of major issues here in the US as well as East Asia. Yet, I’ve noticed very few seem to be worried about the impact of the Affordable Care Act (commonly known as “Obamacare”).
In my view, the ACA is the single most likely factor that could hamper US economic growth within the next 12 – 24 months. Not only will the act create major employment headaches, but it also has the potential to hit consumer spending, lower gross private domestic investment, and constrain GDP growth. In a worst-case scenario, it could possibly even lead to recession.
There are several major issues with the act that could cause significant economic harm:
(1) Imposition of higher direct taxes,
(2) Imposition of stealth (hidden) taxes,
(3) Restrictions on employment,
(4) Restrictions on high-deductible insurance plans, and
(5) Higher costs imposed on low-skilled laborers
In Part I of this series, I examined the direct taxes in the ACA. With this article, I want to focus on two even bigger issues: stealth taxes and the healthcare cost-spiral.
My view is that the stealth taxes in the act, combined with the direct taxes, have potential to hit consumer spending and investment significantly, which could lead to lower-than-expected economic growth in 2014.
Imposition of Stealth (Hidden) Taxes
While the direct taxes imposed by Obamacare are no laughing matter, it’s the hidden taxes that have far greater potential for damage. One of the selling points behind the ACA is that it ends “discrimination” in pricing, but this has always been a misleading claim. What proponents of the ACA have termed “pricing discrimination” is actually insurers passing on costs to customers that consume more healthcare. By trying to eliminate this so-called “price discrimination,” the act imposes massive stealth taxes on young, healthy, middle-income Americans.
In a recent IBD article, John Merline explores this issue and asks, “Will Only Suckers Buy Obamacare Insurance?” Merline’s title may overstate the extent of the problem, but the article nevertheless raises important questions, such as why young and healthy Americans will purchase insurance that is priced artificially high?
Proponents of the law often respond to this criticism with two counter-arguments. The first is that the mandate will encourage younger, healthier individuals to buy insurance. The second argument is that the subsidies in the act will encourage individuals with below-average income to purchase insurance.
Both of these arguments are flawed. The mandate is too small to offset the massive distortions inherent in the act. The subsidies argument makes more sense, but begs even more questions, such as how does this impact the non-subsidized consumers? More importantly, why is this arrangement beneficial to begin with?
The ACA Cost-Spiral and the Stealth Tax
In the push to end so-called “price discrimination,” Obamacare tries to eliminate pricing disparities. The actual provisions of the act are infinitely complex, but in a nutshell, the authors decided that it would be beneficial for everyone within certain categories to pay close to the exact same rates for insurance coverage, regardless of consumption (or expected consumption).
This is where the “stealth taxes” come in. If Obamacare pushes premiums towards “the average,” then what happens if you are very healthy, and have below-average healthcare consumption? Conversely, what happens if you are less healthy than average, and have sky-high healthcare consumption?
The answer is that the low-consumption individual pays a “stealth tax” to subsidize the high-consumption individual. In this sense, the ACA actually turns insurers into privatized tax collectors and welfare distribution agencies; a role they are poorly suited for. But it also imposes a huge hidden cost on the economy.
Modeling the Cost Spiral
In order to explain this phenomenon better, I’ve created two models. The first one is a very simplified scenario that shows why a “cost spiral” will occur. The second model adds wages, subsidies, and more accurate taxes to give a better sense of how things will work under the act.
The purpose in this experiment is to not to provide total accuracy, which is virtually impossible here as there are too many variables. Rather, it’s to show how dramatic the cost distortions in the act can become in very simple examples. These models will help explain why many individuals will choose to opt-out, and why many that purchase insurance will pay large stealth taxes for that privilege.
Here is the first stage of the first model. In this simplified model, I’ve created 15 consumers with varying healthcare needs. The two lowest cost individuals (Customers #1 and #2) consume about $500 per year of healthcare over the next decade. The highest cost individual (Customer #15) consumes $15,000 per year over the next decade. The rest of the customers are at various places in between these two extremes.
I explain the rest of the model below the chart.
Total Value of Coverage
Insurance, at its core, is a product designed to reduce risk associated with lumpy costs. For instance, one consumer may have $500 of healthcare expenses for 9 out of 10 years, but in the other year, they have $7,000 in expenses. The average healthcare expenditure for the 10-year period is $1,150, but that one year with $7,000 in expenses can be difficult to deal with. Insurance solves this problem, by spreading the cash flow stream out over a longer time frame. With insurance, rather than dealing with this lumpy cash flow structure, the customer should instead pay closer to $1,150 annually, plus some premium for risk, and profit for the insurer.
It’s difficult to determine the exact value of this “risk hedge,” but for this model, I assume it’s about 10% of average healthcare expenses. In the third column in the chart above, you see “Value of Risk Hedge” and this is the estimated premium consumers are willing to pay to hedge their cash flows. The fourth column, “Total Value of Coverage” merely adds together the annual healthcare consumption costs with the “value of the risk hedge.”
For instance, an individual that consumes $500 in healthcare per year, gains $100 in value from the cash flow hedge (10% of $500) via insurance, meaning that they gain $600 in total value ($500 in expenses plus $100 for hedging risk) for insurance.
Economic Profit (Loss)
Economic profit (loss) is how much better or worse the customer would be by purchasing insurance under the ACA. For example, if the value is negative $3,000, then the customer would be $3,000 better off if they self-insured.
There is a second column for “economic profit (loss) with taxes.” This column factors in the impact of the mandate tax. I have simplified this as well for the first model, and assumed everyone pays $695 to opt-out. This isn’t strictly true, because the tax gradually phases in from 2014 – 2016, and it’s technically $695 or 2.5% of adjusted gross income, but it’s fine for this simplified model.
The Result of Stage #1
In the simple example above, Customers #1 through #6 would all be significantly worse off under ACA, while Customers #7 and #8 would break-even. Customers #10 – #15 would significantly benefit, with #15 gaining an economic benefit of $13,700 per year.
Customer #9 is the most interesting one here. #9 is slightly worse off under Obamacare, but the mandate tax of $695 means that she will incur an economic loss if she chooses to opt out. Therefore, it still makes sense for her to purchase insurance, even though the ACA imposes an extra cost on her to do so.
Cost Spiral, Stage #2
My view is that some individuals will immediately realize that they are better off opting-out. Some will slowly come to this realization over time. Meanwhile, other may put a psychological value on having insurance and chose to purchase it in spite of the economics. Also remember, while my example looks clear-cut, in reality, none of us know our annual healthcare consumption over the next decade; this uncertainty means that many will continue to buy insurance even if they are significantly worse off.
For stage #2, I decided that Customers #1, #3, and #5 will opt-out after getting a better understanding of their economics. All three are significantly worse off under Obamacare and all three have lower-than-average healthcare costs. This causes the average premium to rise from $4,300 in our prior example to $5,083, an increase of 18.2% for the remaining customers.
After these three low-cost customers opt-out, we can see that the economics get significantly uglier for the remaining low-cost customers. This pushes Customers #7 and #8 out of “break-even” territory and means they would now be better off paying the mandate tax. Meanwhile Customer #9 is very slightly better off now even after paying the mandate tax.
Let’s move onto Stage #3, where Customers #2, #4, and #7 now opt-out, as well. This causes the average premium to rise from $5,083 to $6,278, a 23.5% increase. This is why I call this a “cost spiral;” as more low-cost customers continue to opt-out, the economics become less and less attractive to the remaining customers.
With six consumers opting out, we can now see that Customers #1 through #9 are all better off not buying insurance and paying the mandate’s penalty tax. Customer #10’s economics are also starting to look very ugly, as they would be slightly better off paying the mandate penalty tax, as well. Even Customer #11 is starting to get squeezed in this scenario, with only Customers #12 – #15 seeing clear benefits.
This cost-spiral showcases how Obamacare can become a stealth tax. Customers that do not chose to opt-out will be subject to higher healthcare premiums that are, in effect, hidden taxes. Those that do chose to opt-out will be subject to a direct tax of either $695 or 2.5% of gross income (whichever is greater). For these reasons, it’s difficult to argue then that this act does not implement a significant tax increase on many middle income earners.
The Cost-Spiral with Wages, Subsidies, and Taxes
Let’s add a little complexity to the model above. In this new model, we still have 15 customers. 8 customers earn $30,000 in taxable income per year. The other 7 customers earn $50,000 in taxable income.
Under the ACA, individuals that make less than 400% of the poverty limit are eligible for scaling subsidies. The Federal poverty line is slightly over $11,000 for an individual with no dependents. This means that subsidies are available up to around $45,000 in taxable income. Subsidies vary based on income, but in the $30K – $45K range, the rule (i.e. subsidy) is that an individual pays no more than 9.5% of adjusted gross income in insurance premiums.
For the second model, I’ve estimated the subsidies, and I’ve also more precisely calculated the mandate penalty tax, which when fully implemented, will be equal to $695 or 2.5% of taxable income, whichever is greater. In these examples, “wages” are analogous to “taxable income” to keep things simple.
Stage #1 of the adjusted model is below.
You can immediately see that things change quite a bit with the subsidies included. In order to account for the subsidies, however, I had to increase the costs for all the non-subsidized customers, which makes a huge impact. Even with the higher tax (2.5% of income, rather than a flat $695), the economics look even worse for Customer #2, who earns $50K in taxable income and has $500 in annual healthcare consumption. He now is $4,107 better off by opting-out, even in spite of a $1,250 mandate tax.
Meanwhile, Customer #5, who earns $30K and has $2,000 in consumption looks significantly better off than in the last example, with an economic loss of only $450 (versus $1900 before). As you may be able to see, the clear difference in this example is that those who earn $30K are much better off than in the first model and those earning $50K are much worse off.
For Stage #2, I decide that Customers #2, #4, and #6 all opt-out and pay the mandate tax of $1,250. All three are significantly better off going this route. Instead of blacking all the data for the opted-out customers, I’ll allow you to see their economic losses if they had purchased insurance under ACA.
Stage #2 raises the premium for the $50K customers from $5,957 to $6,740, a 13% increase. It does not affect the premiums for the $30K customers who gain subsidies. The effect is to make the economics significantly uglier for many of the remaining $50K customers, with Customer #8 being particularly affected.
In Stage #3, I assume that Customer #8 and the partly subsidized Customer #1 opt-out. Even though Customer #1 is receiving subsidies, he’s still significantly better off opting out.
After this change, the average premium for the unsubsidized customers rises to $7,407, a 10% increase. The economics for Customer #10 are looking uglier with two more customers opting-out. Naturally, the subsidized customers are immune to this affect.
This leads to an interesting conclusion that the act may force individuals making slightly-above median income to pay higher and higher stealth taxes every year to subsidize those who happen to fall under an arbitrarily set income level. Hence, one may be better off making $43,000 in taxable income rather than $46,000.
The Overall Impact of the Cost-Spiral
My models are not meant to completely accurately show what will happen. Indeed, it’s impossible to create a model with 320 million different people and all the provisions of the law. Nevertheless, we can see on a small scale in these models how some of the provisions in this act can create very significant economic distortions. It leads to stealth taxes that will likely deprive many younger, middle-income consumers of income that would otherwise used for savings or consumption.
In my second model above (in Stage #1), an individual making $50,000 with $1,000 average annual healthcare consumption would be paying a stealth tax of $5,300. That’s about 10.6% of their taxable income. If they opt-out, it drops to a 2.5% tax. Either way, that’s a significant chunk of change and seems very likely to result in many middle-income consumers having significantly less take-home pay in the next few years. For this reason, it’s probable that one result of the ACA will be lower consumer spending.
In my prior article, I noted how some large retailers, such as Wal-Mart, are already feeling the impact of the payroll tax expiration, which imposed a 2% tax on most lower- and middle-income earners. The ACA includes both a 0.9% Medicare tax, and the stealth taxes mentioned here. Many consumers could find themselves paying new stealth (or direct) taxes ranging from 2.5% – 11% of income.
How much of an increase is this? Quite a lot!
I looked at the Tax Foundation’s tax calculator to get a sense of how much our hypothetical consumer would pay. In my model above, I assumed $50,000 in taxable income, which would be about $60,000 in gross income. Tax Foundation estimates that this individual would currently pay $13,000 in Federal taxes, or about 22% of income.
If that individual pays the stealth taxes, their effective tax rate could jump from 22% to 33%! Even if they opt-out of ACA insurance, it could still be in the 25.4% range, a 15.5% increase in tax burden. It’s also equal to a 27% tax increase over the course of a few years (including the fiscal cliff deal taxes).
This of course begs the question, if some individuals are worse off under ACA, what about those who are better off? Won’t they have more money to spend?
I suspect the answer is yes, but I suspect it’s not a 1:1 ratio or anywhere close to that. Much of that extra money is going towards more healthcare expenditures (not to mention other government expenses), and my view is that the price of healthcare is so high in the US largely because of Federal programs such as Medicare and Medicaid that result in artificially reduced supply, stealth taxes (e.g. Medicaid causes private insurance premiums to go up), and very inefficient bureaucracy.
So while some high-consumption individuals will effectively get a tax cut, not all of that money is going directly back into the real economy. A good portion of it goes towards waste. Regardless, the direct taxes will almost certainly result in less money in the private sector.
It’s likely that the direct taxes mentioned in Part I of this series, coupled with the stealth taxes mentioned here, will lead to reduced or stagnant consumer spending. Since consumer spending is 71% of the US economy, any reduction in that would need to be offset by a large increase in either exports or gross private domestic investment to see further economic growth. It’s difficult to comment on exports, but at least a large increase in private investment seems unlikely with higher taxes.
For this reason, it seems likely to me that real GDP growth in 2014 will be lower than expected. The Federal Reserve and CBO are forecasting growth in the 3.0% – 3.5% range; I think it’s completely possible we see sub-2% growth instead, which might hamper the stock market, or even lead to a market downturn.
In my upcoming articles, I’ll examine the ACA’s impact on employment, focus on industries that are likely to get hit, and talk about some of the investment implications. I’ll also talk about how my own investment thesis ties in with the ACA.