Note. Some Further Thoughts. Paying a Return on Equity. to Not-For-Profit Hospitals - Mark V Pauly

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1 Note Paying a Return on Equity to Not-For-Profit Hospitals - Some Further Thoughts Mark V Pauly There has been a controversy over whether not-for-profit hospitals should receive a return on equity, and whether that return should equal the return paid to for-profit hospitals. The recent discussion of this question in this journal has helped to clarify the issues somewhat. In this note I will offer a interpretation of the critiques by Conrad [1] and Silvers and Kauer [2] of my earlier contribution [3], which will, I hope, advance matters yet further. I will present a way of reconciling the theories that the participants in the discussion have in mind. The dispute, I will argue, is not over the theory, but over the empirical facts. While I will then offer some of my own conjecture on these facts, my major purpose here is to indicate the importance of the empirical verification which has not yet occurred. The general question is whether third-party payers should include a return on equity in the price they pay not-for-profit firms for hospital care. I argued that, whether one's objective is to maximize social efficiency or to minimize the cost to a payer for a given amount of care, the return on equity that ought to be included in the price paid to a notfor-profit hospital could well be less than the normal profit or economywide opportunity cost of capital one might pay to for-profit firms, and could even be zero. In comments on my article, both Conrad [4] and Silvers and Kauer [2] reiterated their earlier views that the return included in the price should always be the same for all types of hospitals, and should always equal the opportunity cost of the capital. There is general agreement among all of us that the key to understanding price determination is the reward that must be paid to philan- Address correspondence and requests for reprints to Mark V. Pauly, Ph.D., Executive Director, Leonard Davis Institute of Health Economics, 3641 Locust Walk, Philadelphia, PA

2 272 HSR: Health Services Research 22:2 (June 1987) thropic donors of equity capital to the not-for-profit firm. In this connection, I did indeed assume (and quoted Conrad [4] in support) that philanthropists require a return on the after-tax value of their donations beyond some point; Conrad's notion that I limited the reward to tax deductions is not consistent with my statement that "[hospitals] may be able to obtain additional donations by promising costly but attractive emoluments to donors in the future." [3, p. 6] This reward to donors must be paid "in kind" but may, as I noted, take many forms: programs the donor favors, subsidization of the cost of care to groups the donor favors, bronze plaques, etc.' One can then draw a supply curve of donations to the hospital as a function of the level of the rewards-in-kind to donors. The critical issue that distinguishes my analysis from that of Conrad and of Silvers and Kauer is the shape of this curve. I drew it as upward sloping-larger and larger rewards to donors elicit higher levels of donations. I interpret both sets of critics as arguing, in contrast, that (tax considerations aside) the curve is really horizontal at a "price" equal to the marginal opportunity cost of capital to for-profit firms. If it is horizontal, then none of my conclusions follow, and I would agree that a return equal to the market rate should be paid to not-for-profit firms. The assumption of a horizontal or perfectly elastic supply curve is made most explicitly in Silvers and Kauer's comment. They describe the reasons why people make philanthropic contributions to hospitals. In their model, donor-investors seek to provide a social good ("in the form of charity care, research, education, etc.") with the perpetual annual return on the donated funds. They can do so in one of two ways: by simply buying the good from a for-profit firm and distributing it free of charge, or by making a donation to a not-for-profit firm, which would then finance the good with the return and make it available at no charge. If one assumes that the good can be purchased from the for-profit firm at a constant competitive price, then the donor will be indifferent between the two strategies. More to the point, he will only donate to the not-for-profit firm if the amount of good that firm is willing to furnish equals what could have been obtained under the direct purchase option. The "social good dividend" the donor requires from the not-for-profit firm must be equal in cost to the market rate of return. Hence, the supply curve of donated equity to the not-for-profit hospital is horizontal at an annual cost level equal to the market rate of return. But is the supply curve of donations to hospitals really horizontal? Here is the nub of the argument, and the only way to settle the matter would be an empirical investigation of how donations to hospitals

3 Return on Equity: Further Thoughts 273 would vary with the extent of costly donor-pleasing activities by the hospital. However, I do find the assumption of a horizontal supply curve implausible, to say the least. If the curve were horizontal, that would imply that a hospital could have all the philanthropic donations it wanted by increasing its donor-pleasing activities slightly from current levels, while moderate cuts would cause donations to dry up entirely. Either scenario seems quite unlikely. But if a little bit more attention to free care, or to donor desires for recognition, would raise some limited amount of additional money, with yet more donation requiring larger rewards, then the curve slopes upward, and my analysis follows. A conjecture which supports this view is that donations used to purchase services from for-profit firms are to some extent substitutes for direct donations to not-for-profit hospitals, but are not perfect substitutes. The question then becomes-which form will a donor prefer? It would seem that there are some advantages to not-for-profit production; as much of the recent discussion of not-for-profit firms has emphasized, this form of ownership may be preferred by a "customer" when he has difficulty monitoring quality (Hansmann [5]). While the argument about inability to monitor quality has usually been developed for the direct purchaser of services, it probably applies even more strongly to the donor, who does not typically even observe the rendering of service itself. Indeed, Thompson [6] has made just such an argument. Moreover, the bricks and mortar, bronze-plaque, visible nature of donated hospital physical capital is probably another advantage to donations directly to the hospital. Even when donations are used to provide resources to nonpaying patients, more equity also does doubleduty by improving the financial position of the hospital, and thereby permitting it to better serve the nonpoor segments of the community. For all of these reasons, it is likely that, at least up to a point, the availability of purchased services from for-profit firms does not provide a perfect substitute for hospital donations. Hospital donations must yield as much or more utility to donors as does the purchased-services alternative, but over some range these dividends-in-kind may well have a lower cost to the not-for-profit hospital for the same level of donor satisfaction. The major purchaser of hospital care only needs to pay enough for care to cover the least-cost reward to donors. The notion of a horizontal supply curve is also present, I believe, in Conrad's statement that "the philanthropist donating capital to a not-for-profit is foregoing the dollar return from an investment in a comparably risky financial security or real asset" [1, p. 18]. At least over some range of donations, this return is likely to be constant. But

4 274 HSR: Health Services Research 22:2 (June 1987) here again the point I would make is that, while the benefits to the donor must yield as much utility or benefit as could be generated by clipping the coupons on a bond, there is no necessary implication that the cost to the hospital of furnishing this dividend-in-kind is equal to the dollar value of the return on a financial investment. Bronze plaques may be cheap, but given the feeling of satisfaction and pride they bestow on donors, the major purchaser of care need only cover the cost of the plaques. This last remark points to perhaps another way of reconciling these views. If the market for donations from philanthropists were itself perfectly competitive, then the value of dividends-in-kind would come to equal their cost. Bronze plaques would so proliferate that they would be awarded to anyone willing to donate enough to cover the cost of the plaque with just a little to spare. For my argument to hold, the hospitals in an area must have some type of market power in the market for philanthropy, something special about Memorial Hospital that Instant- Care Clinic cannot offer. I believe that it is reasonable to suppose that not-for-profit hospitals do have such special advantages. But, in any case, the fact that all of our arguments have led to this type of discussion only reinforces my major point - that a seemingly clear, accounting-type question like return on equity becomes imponderable and, if not unmeasurable, at least something which has yet to be measured. That being so, I think my conclusion - and it is a negative conclusion - still stands: it is not legitimate to conclude, either from theory or empirical evidence, that we know that the return to not-for-profit equity should equal the opportunity cost of capital. At present, we do not know that this is true (nor do we know for sure that it is false). We do know that there are possible cases in which efficiency, whether for a major purchaser or for society, is consistent with paying less than the market rate to not-forprofit equity. But the truest thing we know is that much more research on the elusive concepts of philanthropic donations and the behavior of not-for-profit firms is needed before we can move even to a good guess. NOTE 1. A somewhat similar misinterpretation is also present in Silvers and Kauer. They allege that "Pauly assumes that whatever is spent beyond the cost of patient resources is an economically worthkss excess." (emphasis in original) Since I only quoted Conrad, it is not clear why they say that I made this assumption. A correct statement of what I (and Conrad) assumed is that the return to donors, far from being economically value-

5 Return on Equity: Further Thoughts less, is valued by the donors. Since the donors can well have some notion of the social good, I most emphatically did not assume "that a donation is not a social good but only an agency cost or necessary evil of doing business in the form." A valuable good to the donor is a valuable good to society. I do admit to not exploring the motivation for donations in more detail than did Conrad, and to considering that sometimes donations are made because of solicitation cost per se. REFERENCES Conrad, D. A. Returns on equity for not-for-profit hospitals: A commentary and elaboration. Health Services Research 21(1):17-20, April Silvers, J. B., and R. T. Kauer. Returns on equity for not-for-profit hospitals: Some comments. Health Services Research 21(1):21-28, April Pauly, M. V. Returns on equity for not-for-profit hospitals. Health Services Research 21(1):1-16, April Conrad, D. A. Returns on equity to not-for-profit hospitals: Theory and implementation. Health Services Research 19(1):41-63, April Hansmann, H. The role of nonprofit enterprise. Yale Law Journal 89(3): , April Thompson, E. A. Charity and Nonprofit Organization. In R. Zerbe (ed.). The Economics of Nonproprietary Institutions. Greenwich, CN: JAI Press, 1980, pp