Dead $14 billion loophole could sink corporate health care

(Fortune) -- With President Obama still glowing over last week's passage of health-care reform, it's a good time to ask why American businesses ever began providing health-care coverage, and especially prescription drug benefits, to begin with. Out of all industrialized nations, only the United States has tied employment to health care and retirement coverage.

Incredibly, our health-care system is an outgrowth of 1950s union-busting efforts. That's right: Carmakers didn't want unions to form their own benefits co-ops. So they instead provided the very health care and retiree coverage that ended up destroying them.

Of course, from the moment health-care benefits became a part of employee compensation, they also became a bargaining chip and a distraction from the work at hand.

There's no better example of this than the complex employer-based prescription drug programs that were created under Medicare Part D, and which is now the cause of so much handwringing and billion dollar write-offs by some of the largest companies in America.

The 2003 law that created Medicare Part D was designed to set up public plans for millions of seniors without retirement plans. But there was also an employer-based plan created, and big industrial businesses like Deere (DE, Fortune 500), Caterpillar (CAT, Fortune 500), AT&T (T, Fortune 500) and Verizon (VZ, Fortune 500) quickly signed up to offer it to their thousands of retirees. The generous tax-free subsidy the government gives companies that set up and administer a plan -- $665 per person this year, according to benefits consulting firm Towers Watson --didn't exactly dampen their enthusiasm.

But what has left them wet is the closing of a $14 billion tax loophole on those benefits under the new health-care reform law. The subsidy comes tax-free, plus the companies get to write off the subsidy again, once it's spent funding their plans.

That's one of the sweetest double bonuses on the books. "The extra subsidy for retiree prescription drug coverage provided an extra financial boost for AT&T, Caterpillar, et al.," writes economist Donald Marron. "Eliminating the loophole will thus reduce the value of the companies and the wealth of their shareholders, just as the [Wall Street Journal] alleges. But it's hard to get too teary-eyed since that value and wealth were created by the loophole in the first place."

End of a lucrative loophole

Deere says that change will cost it $150 million. Caterpillar claims it will lose $100 million. AT&T weighed in with a $1 billion charge from the law's change. It's worth noting, as the Wall Street Journal did, that AT&T quietly booked a $1.6 billion decrease in liabilities back in 2006.

That money wasn't real either, just a change in accounting. Now, a trade group representing the companies is demanding the government repeal the Part D changes, claiming it will cost the companies billions. But that's just not true.

Accounting rules say companies have to recognize the financial impact of the new legislation immediately. But it will be three years before the changes roll out. And those big numbers above will actually be paid out in dribbles over many years, as corporate tax.

Companies who offer drug plans will still receive their federal cash subsidy, estimated to be $5 billion. They just won't get the double tax break. A Credit Suisse analyst report for investors is actually subtitled, "Don't Overreact to the Hit to Earnings."

The end of this bit of corporate welfare was to find cash to close the so-called donut hole, a provision in the public Part D drug plan that left millions of seniors on the hook for thousands of dollars in drug costs. In fact, the loss of the tax might change whether employers continue providing expensive employer-based prescription drug plans at all. A better plan: subsidize the cost of their retirees to go into the standard Part D plan.

The closed loophole, in other words, could provide an incentive to companies to exit at least one part of the benefits business. "Longer term, employers may find they could be better off under that arrangement than they are today," says Roland McDevitt of Towers Watson. That may be part of the overall strategy of health-care reform: getting companies to use their resources to create new jobs and be innovative, not to administer prescription drug plans.

Nudging industry out of the benefits business

Shortly after Obama's election, much ink was spilled regarding Harvard Law Professor Cass Sunstein's advice to the president on how to use legislation to "nudge" people into making better choices.

Sunstein co-authored a book, Nudge with Richard Thaler, explaining that by changing default choices, like automatically enrolling workers in retirement plans rather than having them opt-in, people are more likely to stay in them, and provide for their own retirement. Prescription drug reform might actually be the first real "nudge" the Obama team has turned into law.

The nudge here is for companies to re-evaluate why they provide benefits coverage to retirees, rather than support a public-private plan like Part D, that relieves them of that obligation.

There may be other nudges that move companies even further away from playing such fundamental roles in their employees' medical benefits: Medicare is not allowed, for example, to negotiate drug prices for Part D plans, even though corporate sponsored plans are.

This puts millions of retirees covered under Part D at a disadvantage to the few hundred thousand under employer-sponsored plans. Indeed, Caterpillar has partnered with Walgreens (WAG, Fortune 500) and Wal-Mart (WMT, Fortune 500) to provide retirees with discount drugs, and more companies were poised to follow suit.

But under the law change, if companies start covering Part D premiums for their retirees instead -- and paying more for the same drugs -- they might just rethink why the ban exists. If that leads them to push for a repeal of the negotiation ban, drugs should become cheaper not just for their thousands of retirees but for millions more Americans.

Though corporations, lobbyists, and politicians are already seizing upon the change as evidence of a socialist takeover of medicine, employers are still free to offer their private plans if they want -- they just won't be as handsomely rewarded for doing so. And the clamor over the huge earnings announcements has culminated in an absurd plan for congressional hearings into long-established accounting practices.

Meanwhile, the Credit Suisse report estimates that in the S&P 500, there are "only eight companies where the estimated charge to earnings is more than 0.5% of market cap." That doesn't sound like an Obamapocalypse. More like a nudge.