18

Several issues are raised in determining whether a taxable
HMO (for example, an HMO that is not tax-exempt because it is
organized on a for-profit basis) sufficiently resembles a
property and casualty insurance company to be taxed as one. One
is whether deductions for reserves are appropriate to the
operation of an organization that directly provides medical care.

A central issue in determining whether an HMO should be
taxed as a property and casualty insurer is the method of
accounting for premium payments received. In general, property
and casualty insurance companies are entitled to deduct increases
in reserves which affect premium income. Organizations that are
not insurance companies, by contrast, are not entitled to deduct
increases in reserves but rather, generally account for
deductions in accordance with the all events test and the rules
for determining when economic performance has occurred. The
allowance of a deduction for Federal income tax purposes with
respect to reserves of property and casualty insurance companies
generally reflects the fact that payments (premium income) are
generally received in a taxable year earlier than the year in
which the loss is incurred or paid.

If an HMO receives payments that resemble the premiums
received by insurance companies in these respects, it appears
appropriate to tax them under the regime applicable to property
and casualty insurance companies. On the other hand, if an HMO
receives prepayments for medical services it directly provides,
reserve deductions are arguably inappropriate, and the
organization should not be treated as a property and casualty
insurance company. Because the manner of organization and
operation of HMOs varies and may change rapidly with business
trends, consideration should be given to whether one rule is
appropriate for all taxable HMOs. On the other hand, it may not
be administratively feasible to distinguish among types of
payments received by HMOs.

With respect to treatment of reserves, some taxable HMOs
take the position that they are subject to taxation as property
and casualty insurance companies. Others, however, may take the
position that, although they may be subject to State regulation
and financial reporting requirements as insurance companies, they
are not taxable as property and casualty insurers. Such
organizations nevertheless may claim tax deductions for reserves
on the theory that the risk of loss has shifted to them. These
organizations may argue that, because they are not taxable as
property and casualty insurers, they are not subject to the
limitations on reserve deductions imposed on property and
casualty insurance companies. Thus, as a practical matter, the
regime prescribed under the bill may represent a significant
change only for taxable HMOs that take the position that they are
not taxable as property and casualty companies.



39

advocates of taxation as a means of firearms control, such an
outcome would have the positive effect of making the existing
stock of firearms more expensive to obtain,” as well as reducing
the flow of new firearms into society. On the other hand, by
increasing the price of firearms, self-manufacture and the
smuggling of weapons, where possible, may become more attractive.
The extent of any increase in such illegal activities would
depend upon their cost compared to increased price of legal
firearms.

In practice, some ammunition also is a durable good.
Certain types of ammunition can be reloaded (the spent shell
casings may be recovered and repacked with a bullet or pellets,
powder, and primer); such reloading can occur several times,
although not indefinitely. Reloaded ammunition is exempt from
Federal excise taxes under certain conditions (as described above
in "Present Law"). As with firearms, increasing the price of new
ammunition through an increased excise tax would be expected to
increase the price of reloaded ammunition a 1, as consumers
increase their use of tax-free reloaded ammu: ion. It would
also be possible to tax reloading tools and materials. Higher
prices also would make the illegal manufacture or importation of
ammunition more attractive.

The overall effect of increased taxation of firearms and
ammunition on health care expenditures will depend on the effect
of higher firearm and ammunition prices on the use of firearms in
legal activities (which can be the source of accidental gunshot
wounds and suicide attempts) and illegal activities (which also
can be the source of gunshot wounds). Increases in price should
reduce the purchase of these goods for legal activities and
reduce the flow of these goods to illegal activities. However,
there is little evidence on how levels of legal and illegal
activities would respond to changes in the price of firearms and
ammunition.

The overall effect of increased taxation of firearms and
ammunition on health care expenditures also depends on the extent
to which firearms currently contribute to health care
expenditures.

Issues in targeting the taxation of firearms and ammunition

The observation that the majority of uses of firearms and
ammunition are legal and have little or no adverse medical
consequences has led some analysts to explore ways to target the
taxation of firearms and ammunition at firearms and ammunition

% price increases also would be expected in "black market"

sales of firearms as such weapons are substitutes for firearms
purchased legally.



35

mufflers or suppressors, silencer parts, machine gun receivers
and parts designed to convert a weapon into a machine gun
(generally, firearms subject to regulation under the National
Firearms Act ("NFA")).

In general, Federal, State and local governments are exempt
from the making and transfer taxes. In addition, transfers
between persons subject to the special occupational tax
(described below) are exempt from the transfer tax, as are
transfers of unserviceable firearms and exported firearms.

Special occupational tax.--All importers, manufacturers and
dealers in NFA firearms are required to register with the

Secretary of the Treasury. Importers and manufacturers are
subject to a special occupational tax of $1,000 per year (small
importers and manufacturers are eligible for a reduced rate of
tax); dealers are subject to a special occupational tax of $500
per year (Code sec. 5801).

An exemption from the special occupational tax is available
for persons who conduct business exclusively with or on behalf of
the United States.

Othe: i ion rms mmun i tio:

Firearms and ammunition also are subject to regulation under
the Gun Control Act of 1968 and the Arms Export Control Act of
1976, as amended. In general, the Bureau of Alcohol, Tobacco and
Firearms ("BATF") administers the Gun Control Act of 1968 and the
National Firearms Act (Code secs. 5801-5872). The United States
Postal Service administers the prohibition against mailing
firearms (18 U.S.C. 1715).

The Gun Control Act of 1968 ("GCA"), as amended, regulates
interstate and foreign commerce in firearms. Under the GCA,
manufacturers, importers, dealers and certain collectors are
licensed and must maintain various records regarding manufacture,
import, receipt, and disposition of firearms. Manufacturers and
importers of ammunition are licensed under the GCA. The GCA also
prohibits the disposition of firearms and ammunition to certain
proscribed categories of persons, e.g., felons. .The "Brady Law’
is also contained in the GCA. The GCA sets forth various civil
and criminal penalties and forfeiture provisions.

The Arms Export Control Act of 1976 ("AECA") regulates the
importation and exportation of arms, ammunition and implements of
war. The AECA contains registration and permit provisions, and
provides civil and criminal penalties and forfeitures. The BATF
administers the importation provisions and the Department of
State and Customs Service administers the exportation provisions.



12

status of regional alliances would apply to taxable years
beginning after the date of enactment, and the provision
regarding the treatment of parent organizations of health care
providers would take effect on the date of enactment.

Insur. activities of tax- organizatio:

Under the bill, health insurance provided by an HMO would be
treated as commercial-type insurance if such insurance relates to
care which is not provided pursuant to a pre-existing arrangement
between the HMO and a health care provider (other than emergency
care provided to a member of such organization at a location
outside such member’s area of residence). Under this rule,
commercial-type insurance would include plans under which an HMO
member can select any health-care provider, the HMO pays a
portion of the costs of such provider, and the member is
obligated to pay the remaining portion. Such arrangements are
commonly referred to as providing "point of service" or "fee-for-
service" benefits (i.e., the member decides which medical
provider to use at the point at which service is required).
However, the provision of emergency care, even if on a point of
service basis, to HMO members outside their area of residence
would not constitute commercial-type insurance.

The bill would specifically identify four types of health
insurance provided by an HMO that would not be treated as
commercial-type insurance and, thus, would not jeopardize the
organization’s tax-exempt status. Such non-commercial-type
health insurance coverages generally address emergency situations
and situations in which a health care provider has a pre-existing
relationship with an HMO whereby the HMO exerts control over
either the fee charged by the service provider or the member’s
use of such provider's services.

First, insurance relating to care provided by an HMO to its
members at its own facilities through health care professionals
who do not provide substantial health care services other than on
behalf of such HMO would not constitute commercial-type
insurance. Such arrangements are characteristic of "staff model"
or "group model" HMOs which hire health care providers (as
employees or independent contractors) to provide services to
members on an exclusive basis.

Second, insurance relating to primary care provided by a
health care professional to a member of an HMO on a basis under
which the amount paid to such professional does not vary with the
amount of care provided to such member would not constitute
commercial-type insurance. This rule addresses situations in
which an HMO pays health care providers on a "fixed" or
"capitated" basis for primary care services rendered to members.
Although such fees may be based on the number of members served
by such provider, they may not be based on the extent of services



22

igarette papers tubes

Cigarette papers®.......... 0.75 cent per 50
papers.

Cigarette tubesTM........... 1.5 cents per 50
tubes.

Sn chewing tobac ipe to’ fo}

Snuff....... 2... eee eee wees 36 cents per pound.

Chewing tobacco........ wees 12 cents per pound.

Pipe tobacco...... eee eee 67.5 cents per pound.

Ex ions; use re

No tax is imposed on tobacco products exported from the
United States. Exemptions also are allowed for (1) tobacco
products furnished by manufacturers for employee use or
experimental purposes; and (2) tobacco products to be used by the
United States. In addition, no tax is imposed on tobacco to be
used in "roll-your-own" cigarettes.

Revenues from the tobacco products excise taxes are retained
in the general fund of the Treasury. Revenues from taxes on
tobacco products brought into the United States from Puerto Rico
and the American Virgin Islands are transferred ("covered over")
to those possessions if the products satisfy a domestic content
requirement with respect to the possession from which they are
received.

B. Description of Bill (S. 1757--Sen. Mitchell and others
and S. 1775--Sen. Moynihan (The Health Security Act)
(secs. 7111-7113 of the bill)
Rate reases; xtens mn of coverage

The bill would increase the tax rate on all tobacco products
by approximately $12.50 per pound of tobacco content, and would

% Cigarette papers measuring more than 6-1/2 inches in

length are taxed at the rate prescribed, counting each 2-3/4
inches (or fraction thereof) as one cigarette paper. No tax is
imposed on a book or set of cigarette papers containing 25 or
fewer papers.

* Cigarette tubes measuring more than 6-1/2 inches in
length are taxed at the rate prescribed, counting each 2-3/4
inches (or fraction thereof) as one cigarette tube.



40

perceived to be most responsible for additional health care costs
and most likely to be used in illegal activities. These types of
firearms or ammunition, or both, could be singled out for
increased taxation. Targeting certain firearms and ammunition
may further health and law enforcement policy objectives. The
effectiveness of any targeting efforts that rely on increased
Federal taxes depends in large part, however, on whether the
measures are administrable and enforceable. Certain issues in
this regard are discussed further below.

Generally, there are four types of firearms: handguns;
shotguns; rifles; and machine guns. Firearms also can be
characterized as non-automatic, semi-automatic, and fully
automatic. Ammunition generally is characterized by its
caliber (diameter of the cartridge) ,* the length of the
cartridge ("long," "short," or "intermediate"), and by whether it
is rim-fire or center-fire.*

Tr in he t ion ir

Any proposal to increase the excise tax on a defined subset
of firearms must address certain administrative and compliance
issues. First, as discussed above in the case of increasing the
excise tax on all firearms, increasing the tax on firearms may
shift firearms transactions from licensed gun dealers to .
unlicensed or illegal sellers. Currently, a substantial number
of the firearms used in criminal activities are illegally
obtained. Although increased taxes on particular classes of
firearms will increase the cost of such firearms, whether
obtained legally or illegally, they also may encourage additional

3 Under present law, it is illegal to own machine guns

unless one is a licensed collector.

54 A weapon that fires each time one pulis the trigger and
uses the force of the prior shot to automatically reload the
chamber is characterized as "semi-automatic." A revolver
technically is not semi-automatic because it requires mechanical
force to bring the next round to the chamber after each shot. A
machine gun, or fully automatic firearm, is a firearm that fires
more than one round at the pull of the trigger.

"Gauge" in the case of shotgun ammunition.

%6 A rim-fire cartridge is fired by crushing the rim of the
shell casing to ignite the gunpowder inside the shell. A center-
fire cartridge is fired by striking a center-mounted primer to
ignite the gunpowder inside the shell. Rim-fire cartridges
cannot be reloaded. Center-fire cartridges generally permit a
more powerful charge and can be reloaded a limited number of
times.



3

section 501(c) (4) cannot accept tax-deductible contributions or
use tax-exempt financing, and generally are not exempt from State
and local taxes. :

Hospitals as tax-exempt entities

Although Code section 501(c) (3) does not specifically
mention furnishing medical care and operating a not-for-profit
hospital, such activities have long been considered to further
charitable purposes.‘ However, the mere provision of not-for-
profit medical care is not, by itself, sufficient to allow an
organization to qualify for exemption under section 501(c) (3).
Rather, an organization must demonstrate that its activities are
targeted to a charitable class. The precise nature of that
charitable class has been and continues to be a source of
controversy.

In 1956, the Internal Revenue Service (IRS) issued Revenue
Ruling 56-185, 1956-1 C.B. 202, setting forth the conditions that
a not-for-profit hospital must satisfy to qualify for recognition
as a tax-exempt charitable organization under section 501(c) (3).
The IRS ruled that a hospital would be exempt if it met the
following four conditions: (1) it must be organized as a
not-for-profit organization for the purpose of operating a
hospital for the care of the sick; (2) it must be operated, to
the extent of its financial ability, for those not able to pay
for the services rendered and not exclusively for those able and
expected to pay; (3) it must not restrict use of its facilities
to a particular group of physicians; and (4) its earnings must
not inure, directly or indirectly, to the benefit of any private
shareholder or individual (this last requirement merely restated
a restriction generally applicable to all organizations under
section 501(c) (3)).

With respect to the "financial ability" requirement, the
IRS noted that:

The fact that its charity record is relatively low
is not conclusive that a hospital is not operated for
charitable purposes to the full extent of its financial
ability. It may furnish services at reduced rates
which are below cost, and thereby render charity in
that manner. It may also set aside earnings which it
uses for improvements and additions to hospital
facilities. It must not, however, refuse to accept

* Although not-for-profit hospitals generally are

recognized as tax-exempt by virtue of being "charitable"
organizations, some may also qualify for exemption as
"educational organizations" because they are organized and
operated primarily for medical education purposes.



33

all State tax receipts. By contrast, the Federal Government
collected $4.5 billion in tobacco tax revenues in 1989,
representing less than one half of one percent of Federal tax
receipts.

Higher tobacco prices should induce fewer people to begin to
use tobacco products. Thus, even if no existing tobacco users
altered their behavior through time, a smaller percentage of the
population would use tobacco products. Therefore, an increase in
tobacco taxes could be expected to reduce the incidence of
tobacco use in the long run, by a greater amount than any
reduction achieved in the short run.“ In the past, in the United
States, population growth generally has made up for a reduced
incidence of smoking such that the revenue yield of tobacco taxes
has increased through time.“ However, if higher prices induce
substantial declines in the incidence of smoking, the short-run
revenue yield may overstate the long-run revenue yield. If the
tobacco taxes are earmarked for certain programs, the potential
for lower revenue in the long run than in the short run may be an
important consideration for Government policy.

“© Tax Foundation, Facts & Figures on Government Finance,
(Baltimore: The Johns Hopkins University Press), 1991. Some local
governments assess additional tobacco taxes which produced
approximately $200 million in 1988. These revenues also would be
expected to be reduced by reductions in tobacco consumption.

“7 The Canadian study finds that the price elasticity, that
is the behavioral response to price changes, is greater in the
short run than in the long run. The study attributes this to the
habitual nature of tobacco and argues that at first smokers quit,
but that they eventually start smoking again. (See, Tobacco Taxes
and Consumption). This analysis does not appear to account for
long-run aggregate behavior, such as fewer new-starting tobacco
users.

4 This is absent an accounting of tax rate increases.
However, if the downward trend in the incidence of smoking
continues, lower rates of population growth in the future could
cause tobacco revenues to fall in the absence of change in
tobacco tax rates.



19

An additional issue relates to the operation of the property
and casualty company tax regime. Treating HMOs as property and
casualty insurers could be criticized on the ground that the
present-law regime for taxing such entities is flawed in certain
respects. For example, present law provides for a pre-tax method
of discounting loss reserves of property and casualty insurance
companies which only partially takes account of the time value of
money. It is arguable whether taxpayers not explicitly subject
to this regime should be made explicitly subject to it without
addressing its failure to take account fully of the time value of
money. Further, some might assert that the regime of complete or
partial tax exemption for small property and casualty companies
may not be appropriate for HMOs that fail to qualify for tax-
exempt status under 501(c) (3) or 501(c) (4).

As a technical drafting matter, the statutory structure set
forth in the bill appears redundant in defining both criteria for
tax-exempt status and criteria for taxable status. Rather than
simply characterizing all organizations that are not tax-exempt
as taxable, the bill would set forth one standard for tax
exemption and another, different, standard for taxability.
Conceivably, some organizations could fail to meet either set of
criteria. In addition, the taxability standards themselves could
be criticized as vague. Because neither present law nor the bill
defines an HMO, the second standard ("operating as an HMO") is
difficult to apply at best.

The bill would also require that the three enumerated
activities constitute the primary and predominant business
activity of an organization. This standard is similar to a rule
set forth in Treasury regulations that describes an insurance
company as one whose primary and predominant business activity is
the issuing of insurance or annuity contracts or the reinsuring
of risks underwritten by insurance companies, and has been
variously interpreted in judicial decisions. While the bill does
state that administering accident and health insurance contracts
is treated as part of the activity of issuing accident and health
insurance contracts or reinsuring accident and health risks (for
an organization that has issuing such contracts or reinsuring
such risks as a material business activity), the bill would not
specify the nature and amount of other activities that a company
may conduct and still be treated as a property and casualty
insurance company. Because this standard does not provide a
bright-line test, without further clarification, it could be
criticized as an inadequate basis for determining the tax status
of an organization.

Finally, because the effective date of this provision would
be deferred until taxable years beginning after 1996, additional
rules may be needed to forestall opportunities for manipulation
of accounting items for organizations that become taxable under
the bill (or whose accounting method is changed) and, thus,


25

diseases--including cancer of the lungs, mouth and throat,
emphysema, chronic bronchitis, and heart disease.”” In addition,
smoking is believed to be a contributing factor to low birth
weight babies. The public’s increased awareness of these health
hazards has led to substantial declines over the past 30 years in
the percentage of the United States population that currently
uses tobacco products. The incidence of smoking among males 20
years old or older has fallen from approximately 50 percent in
1965 to approximately 31 percent in 1988. Over the same period,
the incidence of smoking among females 20 years old or older has
shown a similar though smaller decline. Table 1 details the
incidence of cigarette smoking for selected years between 1965
and 1988.

Table 1.--Incidence of Cigarette Smoking, by Male and
Female, Selected Years 1965 to 1988

[Percentage of individuals 20 years old and older]

1965 1970 1976 1980 1985 1988
Female... 31.9 30.8 31.3 29.0 28.0 23.3
Male..... 50.2 44.3 42.1 38.5 33.2 30.9

Source: Bureau of the Census, United States Departmerit of Commerce,
Statistical Abstract of the United States, 1992.

The incidence of smoking varies by age, gender, race, level
of education, and other demographic factors. Individuals with
more education tend to have a lower incidence of smoking than
those with less education. For example, the incidence of smoking
among individuals with college degrees was 15.6 percent in 1988,
while the incidence of smoking among individuals with less than a
high school diploma was 32.8 percent.” The incidence of smoking
among blacks is modestly greater than the incidence of smoking
among whites.” The incidence of smoking has fallen among all
groups.

The incidence of smoking in developed countries, including
the United States, has declined over the past 20 years. While the
incidence of smoking in the United States is not substantially

7 Department of Health and Human Services, Reducing the

Health Consequences of Smoking: 25 Years of Progress. A Report of
the Surgeon General, DHHS Publication No. (CDC) 89-8411

(prepublication version, January 11, 1989).

% Statistical Abstract of the United States, 1992.

* Ibid.



21
II. EXCISE TAXES ON TOBACCO PRODUCTS

A. Present Law

Tax rates

Excise taxes are imposed on the manufacture or importation
of cigarettes, cigarette papers and tubes, snuff, chewing
tobacco, and pipe tobacco. The present-law tax rates are as
follows:

Cigarettes

Small cigarettes (weighing
no more than 3 pounds per

thousand)7............068- : $12 per thousand (i.e., 24
cents per pack of 20
cigarettes) .

Large cigarettes (weighing
more than 3 pounds per
thousand)”. ............62- $25.20 per thousand.

Cigars
Small cigars (weighing no

more than 3 pounds per
thousand) ........-..-.-- oe $1.125 per thousand.

Large cigars (weighing

more than 3 pounds per

thousand) ........ cece cence 12.75 percent of
manufacturer’s
price (but not
more than $30
per thousand).

21 Most taxable cigarettes are small cigarettes.

2 Large cigarettes (measuring more than 6-1/2 inches in
length) are taxed at the rate prescribed for small cigarettes,
counting each 2-3/4 inches (or fraction thereof) as one
cigarette.



34
III. EXCISE TAXES ON FIREARMS AND AMMUNITION
A. Present Law
Ad_va xcise ta:

A 10-percent excise tax is imposed on the sale of pistols
and revolvers by a manufacturer, producer or importer thereof.
Other firearms and shells and cartridges are subject to an 11-
percent excise tax (Code sec. 4181) .*

An exemption is provided for sales of firearms and
ammunition for use by the United States Department of Defense.
In addition, no excise tax is imposed on sales by manufacturers,
producers or importers: (1) for use by the purchaser in further
manufacture, or for resale by the purchaser for use by the second
purchaser in further manufacture; (2) for export, or for resale
by the purchaser to a second purchaser for export; (3) for use by
the purchaser as supplies for vessels or aircraft; (4) to a State
or local government for their exclusive use; or (5) toa
nonprofit educational organization for its exclusive use. In
general, the effect of the State and local government exemption
is to exempt sales to State and local police departments.

Amounts equivalent to revenues from these excise taxes fund
the Federal Aid to Wildlife Program for use in making grants to
support State wildlife programs.

Trans nd makin ecial occupation axes
Transfer and making taxes.--Present law also imposes making

and transfer taxes on certain firearms and other destructive
devices. A transfer tax of $200 is imposed on each "firearm"
transferred, and a making tax at the rate of $200 is imposed on
each firearm made (Code secs. 5811 and 5821).° The ad valorem
excise taxes described above do not apply to firearms subject to
these making and transfer taxes.

Firearms subject to the making and transfer taxes are
machine guns, short-length or short-barrelled rifles or shotguns,
pen guns, handguns with smooth bore barrels, firearms silencers,

# A reloader of shells or cartridges is not considered a

manufacturer for purposes of the ad valorem excise tax if, in
return for a fee and expenses, the reloader reloads shells or
cartridges submitted by customer and returns the reloaded shells
or cartridges, with the identical casings provided by the
customer, to that customer (Treas. Reg. sec. 53.11).

50 A $5 transfer tax applies to articles defined as "any
other weapon" under Code section 5845(e).



16

The desirability of tax exemption also must be evaluated in
the context of the overall health care proposal. As described
above, under present law, the provision of medical care and
operation of a nonprofit hospital in a manner that satisfies the
"community benefit" standard is considered to further
"charitable" objectives. Although this community benefit
standard evolved in response to the expanded Federal role in
health care financing through programs such as Medicare and
Medicaid, payment for medical care remained largely the province
of the private sector.

The system of universal health care coverage envisioned
under the bill represents a significant quantitative, and perhaps
also qualitative, expansion of Federal participation in financing
health care. Accordingly, it may be appropriate to reexamine the
circumstances under which the provision of medical care would
constitute a charitable function in such a system. Presumably,
teaching institutions could continue to be eligible for tax
exemption as educational organizations. However, if all
Americans have access to health care, what other activities would
distinguish a nonprofit from a for-profit health care provider?
For example, would nonprofit hospitals provide charity care where
gaps exist in the system of universal coverage?

These questions are particularly apt in light of the
significant financial benefits for which charitable organizations
are eligible. It is not clear, for example, that allowing such
organizations continued access to tax-exempt financing is
appropriate in a system in which the Federal Government provides
considerable direct subsidies (for example, the Federal payments
to alliances outlined in Title IX, Subtitle B of the bill). With
respect to regional and corporate heaith alliances, section 7902
of the bill would provide that regional and corporate health
alliances be treated as private businesses that are not eligible
for tax-exempt financing. This raises the further question of
why such alliances should be treated differently than other
medical service providers exempt under section 501(c) (3).

Finally, it is not clear whether the community needs
assessment and plan development requirements set forth in the
bill are intended to replace or supplement present-law standards
for exemption. In addition, the scope of organizations subject
to the requirements is unclear. The bill states that the
requirements apply to hospitals, HMOs and "other entities
providing health care services." A wide variety of organizations
exempt under section 501(c) (3) provide an equally wide range of
health care services. For example, a half-way house for
alcoholics, a blood bank, a childbirth education organization, a
clinic to aid drug victims, an organization that provides home
health care, homes for the elderly, and nursing homes all have
qualified for exemption under section 501(c) (3). Do the
community needs assessment and plan development requirements



EM as ta: le entit

In fact, the majority of HMOs are not organized as tax-
exempt entities. At the beginning of 1990, there were 575 HMOs
nationwide, approximately two-thirds of which were organized and
operated as taxable, for-profit businesses.“ The primary issue
for such taxable HMOs concerns their ability to deduct additions
to reserves established out of premium payments to cover accrued
liabilities (so-called "incurred but not reported" or "IBNR"
claims). In general, accrual method taxpayers are not entitled
to deduct expenses until all events necessary to fix and
determine the taxpayer’s obligation have occurred (the "all
events" test). In addition, section 461(h) imposes an economic
performance requirement which, in general, postpones deductions
until payment.

Property and casualty insurance companies are entitled to
deduct IBNR reserves without regard to the "all events" test or
the economic performance requirement. Such reserve deductions
are, however, subject to certain limitations. For example,
reserve deductions by an insurance company must be discounted on
a pre-tax basis to take account partially of the time value of
money, and unearned premium reserve deductions must be reduced by
20 percent. Thus, the tax treatment of a taxable HMO depends
largely on the extent to which it qualifies as an insurance

are carried out under the supervision or control of an exempt
organization and could be carried out by the exempt organization
without constituting an unrelated trade or business. The Tax
Court noted that a taxpayer may qualify for exemption under the
integral part theory if the taxpayer performs an essential
service directly to its affiliates, but not if it provides such
services to unrelated organizations. Alternatively, the taxpayer
may provide services on behalf of its exempt affiliates directly
to the class of charitable beneficiaries of such affiliates. The
Tax Court concluded GHP did not qualify for tax-exempt status
under the integral part theory. Geisinger Health Plan v.
Commissioner, 100 T.C. No. 26, filed May 3, 1993.

4 gee, T.J. Sullivan, "The Tax Status of Nonprofit HMOs
After Section 501(m)", Tax Notes, January 7, 1991.

1 present law also provides that property and casualty
insurance companies are eligible for exemption from Federal
income tax if their net written premiums or direct written
premiums (whichever is greater) do not exceed $350,000; and
further provides that a company with such premiums in excess of
$350,000 but less than $1.2 million may elect to be taxed only
on taxable investment income (and thus, generally to exclude
underwriting income from tax) (sec. 501(c) (15)).



31

expectancy of smokers is less than that of nonsmokers, their
cumulative lifetime medical expenditures exceed that of those who
never smoke. One estimate places this excess at $2,500 over the
smoker’s lifetime. Some advocates of higher taxes on tobacco
products have argued that, by reducing the demand for tobacco
products, the Federal Government will reap savings in its
provision of health care. On the other hand, some have observed
that when the Federal Government’s enti idget is examined, —
tobacco use may not impose a net burden he government. They
observe that to the extent that tobacco users have shorter life
expectancies than nonsmokers, the Federal Government has lower
overall costs in the long run by making lower Social Security
payments .*°

It is difficult to measure the magnitude of such health
costs and savings from reduced retirement expenditures across
individuals’ lifetimes. One study has attempted to measure the
net external cost of smoking.“' This study included costs of
additional medical expenditures, the lost production from
additional sick leave taken by employees who smoke, higher costs
of group life insurance (from increased mortality rates), costs
from fires attributable to smoking, and lost tax revenues from
the earlier age of death of smokers. The study measured savings
to society as reductions in pension payments and reduced use of
nursing home care. The study concluded that the net costs of
smoking were less than present combined Federal and State tobacco
taxes. The study has been criticized for its failure to account
for potential costs from second-hand smoke. other potential
external costs such as increased litter from cigarettes or
annoyance on the part of nonsmokers. With all such calculations,
the results may be sensitive to the choice of the discount
rate.

etc.).
39 Ib i d .

40 John B. Shoven, Jeffrey 0. Sundberg, and John P. Bunker,
"The Social Security Cost of Smoking," National Bureau of
Economic Research, Working Paper No. 2234, Cambridge, MA., May
1987.

‘1 Willard G. Manning, Emmett B. Keeler, Joseph P. Newhouse,
Elizabeth M. Sloss, and Jeffrey Wasserman, The Costs of Poor
Health Habits, A RAND Study, (Cambridge, MA: Harvard University
Press), 1991.

*# A recent Congressional Research Service report reviews
both the study and criticisms of its results in more detail.
See, Jane G. Gravelle and Dennis Zimmerman, "Cigarette Taxes to
Fund Health Care Reform: An Economic Analysis," CRS Report for



28

brands of cigarettes for more expensive brands.*! Among smokers
who crave nicotine, some may reduce the number of cigarettes they
consume but switch to cigarettes with higher levels of nicotine.

Taxes on the consumption of specific products, as opposed to
broadly imposed consumption taxes, distort consumer behavior by
disfavoring certain goods in the economy relative to other goods.
Generally, market price distortion through taxes reduces consumer
well-being because the change in relative prices introduced by
the tax causes consumers to choose a less preferred good than
they would have in the absence of the tax. This general economic
analysis is based on assumptions that consumers are fully
informed about the product and that consumption of the product
imposes no externalities, i.e., additional costs on society as a
whole. Some public health analysts question the validity of these
assumptions in the case of tobacco use.

In addition, some public health analysts observe that, as a
major provider of health care, the Federal Government has an
interest in controlling health costs, and that tobacco use may
overly contribute to the Federal Government’s health and welfare
costs.

Informed versus uninformed choice

Some proponents of higher taxation of tobacco products argue
that consumers are not fully informed about the true costs and
benefits of the use of tobacco products, and that consumers do
not fully account for the harm such products can have on their
health. They argue that the higher prices that increased taxation
will produce are necessary to help potential consumers see the
true cost of tobacco products. They argue that this particularly
may be the case among younger individuals who do not recognize
the addictive power of nicotine or who otherwise might be
expected to be less informed about the potential health dangers
of tobacco use. There is evidence that younger individuals may be
more likely than the population at large to reduce their
consumption of tobacco products if the price rises.”

31 The market share of discount brands has grown in recent
years and now accounts for nearly one third of the cigarette
market. Michael Grossman, Jody L. Sindelar, John Mullahy, and
Richard Anderson, "Policy Watch: Alcohol and Cigarette Taxes,"
Journal of Economic Perspectives, 7, Fall 1993.

2 Department of Finance, Canada, Tobacco Taxes and
Consumption, June 1993 ("To co Taxes and Consumption"). Also
see, Eugene M. Lewit, Douglas Coate, and Michael Grossman, "The
Effects of Government Regulation on Teenage Smoking," The Journal
of Law and Economics, 24, December 1981. Because nicotine is
addictive, the price response of addicted consumers should be



sae A

5

also had a board of directors drawn from the community, an open
medical staff policy, treated persons paying their bills with the
aid of public programs (such as Medicare and Medicaid), and
applied any surplus receipts to improving facilities, equipment,
patient care, and medical training, education and research.

The community benefit standard was challenged in a class
action by various health and welfare organizations and several
private citizens on the grounds that it failed adequately to
identify a charitable class. In Easte We i
Organization v. Simon, 370 F. Supp. 325, 338 (D.D.C. 1973), a
Federal District Court sustained the challenge, and concluded
that Congress intended to restrict the term charitable to its
narrow sense of relief of the poor. The United States Court of
Appeals reversed the District Court, however, and upheld the IRS’
broader interpretation of "charitable" reflected in Revenue
Ruling 69-545.’ The Court of Appeals explained that the term
"charitable" is "capable of a definition far broader than merely
the relief of the poor." The Court also noted that the community
benefit standard did not supplant the "financial ability"
requirement of Revenue Ruling 56-185, but rather represented an
alternative method whereby a not-for-profit hospital could
qualify as a tax-exempt charitable organization.

Heal in bel anizations (HMOs) as tax-exempt entities

The same community benefit standard for determining whether
a hospital is a tax-exempt charitable organization applies in
determining whether a health maintenance organization ("HMO")
qualifies for tax-exempt status under section 501(c) (3). In this
context, the IRS has developed a fairly comprehensive list of
characteristics that distinguish tax-exempt charitable HMOs from
other HMOs. Although an HMO seeking exemption as a social
welfare organization under section 501(c) (4) is not required to
possess all of the same characteristics as an HMO that qualifies
for exemption under section 501(c) (3), its activities must
generally satisfy a community benefit standard similar to, but
less exacting than, that imposed on charitable HMOs.®

would be unnecessary and duplicative, and provided that other
factors set forth in Rev. Rul. 69-545 were present indicating
that the hospital promoted the health of a class of persons broad
enough to benefit the community.

7 Eastern Ky. Welfare Rights Org. v. Simon, 506 F.2d 1278
(D.C. Cir. 1974), vacated on other grounds, 426 U.S. 26 (1976).

5 See GCM 39829 (August 30, 1990) which reviews the IRS’
position regarding HMOs and considers the extent to which HMOs
customarily act as providers of health services or insurance.



4

patients in need of hospital care who cannot pay for
such services. Furthermore, if it operates with the
expectation of full payment from all those to whom it
renders services, it does not dispense charity merely
because some of its patients fail to pay for the
services rendered.

Three years after publication of Revenue Ruling 56-185, the
Treasury Department significantly revised its regulations
interpreting section 501(c) (3). The amended regulations provided
that:

The term "charitable" is used in section 501(c) (3)
in its generally accepted legal sense and is,
therefore, not to be construed as limited by the
separate enumeration in section 501(c) (3) of other
tax-exempt purposes which may fall within the broad
outlines of "charity" as developed by judicial
decisions.°

Relying upon the amended regulations, the IRS issued Revenue
Ruling 69-545, 1969-2 C.B. 117, which considered whether two
nonprofit hospitals qualified for Federal tax exemption. In
establishing the so-called "community benefit" standard, the IRS
noted that the promotion of health is "one of the purposes in the
general law of charity that is deemed beneficial to the community
as a whole even though the class of beneficiaries eligible to
receive a direct benefit from its activities does not include all
members of the community, such as indigent members of the
community, provided that the class is not so small that its
relief is not of benefit to the community." The IRS specifically
modified Revenue Ruling 56-185 to eliminate the requirement
relating to caring for patients without charge or at rates below
cost.

The “community benefit" standard, which remains the
principal standard applied by the IRS today, focuses on a number
of factors which indicate that the operation of a hospital
benefits the community rather than serving private interests. In
Revenue Ruling 69-545, the IRS determined that the standard was
satisfied by a hospital that operated an emergency room open to
all persons and provided hospital care in non-emergency
situations for everyone able to pay the cost thereof, either
themselves, or through third-party reimbursement.® The hospital

5 Treas. Reg. sec. 1.501(c) (3)-1(d) (2).

6 In Rev. Rul. 83-157, 1983-2 C.B. 94, the IRS clarified
that the operation of an emergency room was not a prerequisite
for hospital exemption, if a State health planning agency made an
independent determination that the operation of an emergency room



17

apply to all of these organizations, as well as to hospitals and
HMOs?

nsuran etivit £ tax- orga: tio:

Similarly, it may be appropriate to reexamine the
characterization of certain forms of insurance provided by HMOs
as commercial- or non-commercial-type insurance. The bill
generally appears to codify positions developed by the IRS with
respect to various payment arrangements established by HMOs under
a health care system very different from the one proposed in the
bill.

In addition, the provisions regarding characterizing
insurance arrangements as commercial or non-commercial appear
somewhat inconsistent with other provisions of the proposed
health plan. For example, the bill would characterize "point of
service" or "fee-for-service" plans offered by HMOs as
commercial-type insurance. However, section 1402(d) of the bill
would require certain health plans (e.g., those that offer
enrollees the lower cost sharing schedule described in section
1132 of the bill) to offer fee-for-service coverage. If
participants elect such coverage to the extent that it
constitutes a substantial portion of such HMO’s activities, the
HMO could lose its tax-exempt status.

Definition of taxable property and casualty insurance companies

The bill would expand the definition of taxable property and
casualty insurance companies to include organizations that are
not tax-exempt, are not life insurance companies, and that meet
one of three tests. The first is insurance or reinsurance of
accident and health risks (a traditional activity of insurance
companies). The second is operation as an HMO, and the third
appears to encompass arrangements similar to those which an HMO
might enter into, whether or not it purports to be an HMO (i.e.,
arrangements to receive fixed payments as consideration for
providing or arranging to provide health care services,
regardless of the amount of health care services provided) .

Thus, the bill would treat taxable HMOs and taxable organizations
that operate like HMOs as property and casualty insurance
companies.

However, it is not self-evident that all taxable HMOs should
be taxed as property and casualty insurance companies. The
underlying presumption appears to be that if an HMO is not tax-
exempt, its activities involve the provision of insurance
services as opposed to medical services. This presumption is
based on what traditionally has been a key distinction between
HMOs and hospitals; HMOs deliver prepaid benefits whereas
hospitals are paid on a fee-for-service basis.



7

stated that the characteristics of an HMO eligible for tax-
exemption under section 501(c) (3) include: actual provision of
health care services and maintenance of facilities and staff;
provision of services to nonmembers on a fee-for-service basis;
care and reduced rates for the indigent; care for those covered
by Medicare, Medicaid or other similar assistance programs;
emergency room facilities available to the community without
regard to their ability to pay (and communication of this fact to
the community); a meaningful subsidized membership program; a
board of directors broadly representative of the community;
health research programs; health care providers who are paid on a
fixed-fee basis; and the application of any surplus to improving
facilities, equipment, patient care, or to any of the above
programs. The IRS noted, however, that these factors are not
all-inclusive, nor is the absence of any one determinative of the
lack of a charitable operation.”

More recently, in Geisinger Health Plan v. Commissioner, 985
F.2d 1210 (3rd Cir. 1993), the Court of Appeals for the Third
Circuit applied the factors set forth in Sound Health Association
and held that Geisinger Health Plan (GHP), a network model HMO,
did not qualify for tax-exempt status under section 501(c) (3)
because its activities did not primarily benefit the community.
GHP did not provide any health services directly, but contracted
to provide health services with other health care providers
{which typically were other entities related to GHP). In
addition, the Court noted that operating a subsidized dues
program for 35 otherwise medically underserved individuals did
not benefit the community sufficiently to overcome GHP’s primary
purpose of providing benefits only to its members.”

particular issues.

2 See, e.g., GCM 38735 (May 29, 1981) (concluding that
staff model HMOs that have truly open membership, directly
provide services to members and nonmembers, maintain an open
emergency room, and treat patients regardless of ability to pay
may be exempt under section 501(c)(3)); and GCM 39057 (Nov. 9,
1983) (ruling that an IPA model HMO which arranged for health
care services through an affiliated, physician-owned IPA that
controlled the HMO does not qualify for exemption under section
501(c) (3)). In GCM 39057, the IRS explicitly expressed no
opinion as to whether the HMO in question could qualify for
exemption under section 501(c) (4).

8 The Court of Appeals remanded the case to the Tax Court
for a determination of whether GHP could qualify for 501(c) (3)
status as an "integral part" of an exempt organization. The
integral part theory set forth in Treas. Reg. sec. 1.502-1(b)
provides generally that an organization is entitled to exemption
as an integral part of a tax-exempt affiliate if its activities



23

extend the tax to tobacco to be used in
cigarettes. The new tax rates would be:

Cigarettes

Small cigarettes (weighing
no more than 3 pounds per
thousand) .....

Large cigarettes (weighing
more than 3 pounds per
thousand..........-

Cigars

Small cigars (weighing no
more than 3 pounds per

thousand..... wee wees
Large cigars (weighing
more than 3 pounds per
thousand.....

ape’ ne Ss
Cigarette papers..........

Cigarette tubes...........
Snuff, chewing tobacco,

pipe tobacco, "roll-your-own"
tobacco

Chewing tobacco..

Pipe tobacco.

"Roll-your-own" tobacco...

Ex tions; admin iv visions

"roll-your-own"

$49.50 per thousand
{i.e., 99 cents per
pack of 20 cigarettes).

$103.95 per thousand

$38.625 per thousand

52.594 percent of
manufacturer’s price
(but not more than
$123.75 per thousand).

3.09 cents per 50 papers

6.19 cents per 50 tubes

$12.86 per pound
$12.62 per pound
$13.175 per pound
$12.50 per pound

The bill would repeal the present-law exemptions for tobacco
products provided to employees of the manufacturer and for use by

the United States.



DESCRIPTION AND ANALYSIS OF PROPOSALS RELATING TO THE
TAX TREATMENT OF HEALTH CARE ORGANIZATIONS
AND EXCISE TAXES ON TOBACCO PRODUCTS AND
FIREARMS AND AMMUNITION

Scheduled for a Hearing
Before the
SENATE COMMITTEE ON FINANCE

on April 28, 1994

Prepared by the Staff
of the

JOINT COMMITTEE ON TAXATION

April 28, 1994

JCX-5-94


10

Section 833 provides three special rules for organizations
within its scope. First, eligible organizations are treated as
stock insurance companies. Second, section 833 exempts eligible
organizations from the rule (referred to above) that is generally
applicable to property and casualty insurance companies,
requiring a 20-percent reduction in the amount a company can
deduct for any increase in unearned premium reserves.!* Thus,
eligible organizations are not required to reduce the deduction
for increases in unearned premium reserves. Third, eligible
organizations are entitled to claima special deduction with
respect to their health business in an amount equal to 25 percent
of claims and expenses incurred during the taxable year, less
adjusted surplus at the beginning of the year.

The transition rules in section 833 provide that no
adjustment was to be made on account of a change in such an
organization’s method of accounting for its first taxable year
beginning after that date. The transition rules also provide
that, for purposes of determining gain or loss, the adjusted
basis of any asset of such an organization held on the first day
of the taxable year beginning after December 31, 1986, was
treated as equal to its fair market value as of such day. Rules
were also provided to limit adjustments to surplus that could
affect the amount of the special deduction, and to treat reserve
weakening after August 16, 1986, as occurring in the
organization’s first year as a taxable organization.”

differential (with a reasonable waiting period), and coverage is
without regard to age, income, or employment status of
individuals under age 65; (5) at least 35 percent of its premiums
are community rated; and (6) no part of its net earnings inures
to the benefit of any private shareholder or individual.

1s The 20-percent reduction requirement was added by the
1986 Act, effective for taxable years beginning after December
31, 1986. The 1986 Act also required the inclusion in income
ratably, over the ensuing six-year period, of 20 percent of the
unearned premium reserve outstanding at the end of the most
recent taxable year beginning before January 1, 1987. The
inclusion was required at the rate of 3-1/3 percent of such
outstanding unearned premium reserve in each of the first six
taxable years beginning after December 31, 1986.

20 Because increases in reserves are generally deductible
by a taxable insurer, a reduction in reserves (so-called "reserve
weakening") immediately prior to the time a tax-exempt
organization becomes a taxable insurer could allow the
organization to claim a bigger deduction than it would otherwise
be entitled to after it becomes taxable.



company . '¢
I: ea vities o ax- ex organizat

Under section 501(m), an organization described in section
501(c) (3) or 501(c) (4) of the Code is exempt from tax only if no
substantial part of its activities consists of providing
commercial-type insurance. Commercial-type insurance generally
includes any insurance of a type provided by commercial insurance
companies, subject to certain exceptions. For example,
commercial-type insurance does not include insurance provided at
substantially below cost to a class of charitable recipients. In
addition, section 501(m) (3) (B) provides that commercial-type
insurance does not include incidental health insurance provided
by an HMO, of a kind customarily provided by an HMO.”

pecia s2 able to ain taxable insurance companies

When section 501(m) was enacted in 1986, special rules were
added to benefit certain organizations that no longer qualified
as tax-exempt organizations and became subject to tax as
insurance companies under subchapter L. Section 833, enacted
concurrently with section 501(m), provides special relief for
Blue Cross and Blue Shield organizations existing on August 16,
1986, which were exempt from tax for their last taxable year
beginning before January 1, 1987, and which have experienced no
material change in their structure or operations since August 16,
1986. In addition, section 833 provides special relief for
certain other organizations, substantially all of the activities
of which involve the provision of health insurance, that meet
certain community-service-related requirements."

16 Under Treas. Reg. sec. 1.801-3(a), to constitute an
"insurance company," a company must be one whose primary and
predominant business activity is the issuing of insurance or
annuity contracts or the reinsurance of risks underwritten by
insurance companies.

17 See GCM 39829 (August 30, 1990) for a discussion of the
legislative history of the enactment of section 501(m) and the
HMO exception in section 501(m) (3) (B).

8 These community service requirements are: (1)
substantially all the activities of the organization involve
providing health insurance; (2) at least 10 percent of the health
insurance is provided to individuals and small groups (not taking
into account medicare supplemental coverage); (3) the
organization provides continuous full-year open enrollment
(including conversions) for individuals and small groups; (4) the
policies covering individuals provide full coverage of pre-
existing conditions of high-risk individuals without a price



42

between semi-automatic and automatic rifles. Some experts state
that it is a simple procedure to convert semi-automatic weapons
to automatic-fire weapons. For instance, gun enthusiast
magazines carry advertisements for kits to convert semi-automatic
fire weapons to automatic fire. As a result, what by outward
appearances is a hunting rifle becomes the equivalent of an
assault rifle.

Such convertibility may make it difficult to enforce a tax
that imposes a higher tax rate on weapons capable of automatic
fire than on semi-automatic fire weapons. This problem could be
addressed by subjecting such "conversion kits" to tax; however,
some experts state that, in many cases, conversions can be made
with "off-the-shelf" parts. Similarly, small magazines often are
easily replaced with larger magazines in a straightforward
procedure. In general, defining the tax base by the outward
appearance of firearms could create a secondary "conversion"
market in which it is difficult to collect the tax, and may
require repeated reactions to minor marketplace changes to ensure
accurate administration of the tax. Although the tax base of any
tax may change as the marketplace changes, the narrower the
defined tax base, the more likely it is that revisions will be
required.

Targeting the taxation of ammunition

As in the case of defining a subset of firearms to be
subject to a higher rate of tax, defining a subset of ammunition
to be subject to a higher rate of tax raises administrative and
enforcement issues. In some cases, differential taxation of
ammunition would be expected to lead to a substitution of lower
tax ammunition for high tax ammunition. This would tend to
increase the price of all ammunition, implying that part of the
burden of the tax would fall on consumers of non-targeted
ammunition.

Typically the firing chamber of a firearm is designed to
accept only one type of cartridge. Therefore, it is possible to

8 It is currently illegal to convert semi-automatic fire

weapons to automatic fire.

© To the extent that firearms require specific ammunition,
differential taxation of ammunition also would affect the demand
for, and hence price of, different types of firearms. The demand
for firearms using lightly taxed ammunition would increase
relative to the demand for firearms using heavily taxed
ammunition. Thus, purchasers of firearms may also bear some of
the burden of the ammunition tax. However, because firearms
purchasers are also ammunition purchasers, this potential
shifting of the tax burden may not be deemed important.



30

equal to the additional harm created by the externality, then the
market price will fully reflect all benefits and costs to society
from the production and consumption of the product. Assuming that
second-hand smoke is an externality, a tax on smoking tobacco
could improve economic efficiency. However, the difficulty is in
choosing the correct level of the tax. Too great a tax could
reduce economic efficiency by discouraging more tobacco use than
the harm caused by second-hand smoke might justify. Critics of
increases in tobacco taxes contend that there are no good
measures of the value of possible external harms from tobacco
products.

Some suggest that current pricing practices for medical
insurance may create a negative externality. Whereas life
insurance policy premium rates often vary based upon whether the
consumer is a smoker or a nonsmoker, medical insurance premium
rates typically are the same regardless of tobacco use by the
consumer. If tobacco users have greater insured medical expenses
than other consumers, then some of the increased health costs
of tobacco use may be borne, not by the tobacco user, but by all
consumers in the form of higher insurance premiums.” By reducing
the incidence of tobacco use, increased tobacco taxes would
reduce the magnitude of this problem; however, given the current
pricing practices for health insurance, the problem will exist as
long as anyone uses tobacco.

Tobacco- rel. expenditures on he hh ca:

Researchers have found that smokers of all ages require more
medical care than those who have never smoked.* While the life

36 See the discussion in the paragraph below titled
"Tobacco-related expenditures on health care" for evidence
relating to medical expenditures by smokers versus nonsmokers.

37 The pricing of many employer-provided retirement
annuities has an effect opposite that of the pricing of health
insurance. When a retirement annuity is valued based on average
life expectancy after retirement, on average, nonsmokers benefit
at the expense of smokers, because smokers have a shorter life
expectancy. In the case of retirement annuities, such pricing of
annuities would overcharge smokers and undercharge nonsmokers.
(See the discussion of social security below.)

38 C. Stephen Redhead, "Mortality and Economic Costs
Attributable to Smoking and Alcohol Abuse," Congressional
Research Service (CRS) Report for Congress, 93-426 SPR, April 20,
1993. These findings do not necessarily mean that the smoking
causes all the additional medical expenditures. Individuals
predisposed to smoke may be predisposed to certain other
unhealthy behavior, such as other drug use (alcohol, marijuana,



29

There is some survey evidence, however, that both smokers
and nonsmokers overestimate the probability of death and illness
from tobacco use. Moreover, that survey suggested that teenagers
attach a higher risk to smoking than do adults.* Opponents of
higher tobacco taxes also argue that if the primary concern is to
reduce the demand by young individuals who may be uninformed, a
tax increase is inefficient because the tax also imposes large
costs on older, informed individuals who derive pleasure from
tobacco products. They argue that more targeted remedies such as
greater penalties for sales to minors may be more efficient. Some
argue for both higher tobacco taxes and greater penalties for
sales to minors.

Externality

Economists say that an externality arises when the
consumption (or production) of a good by one individual imposes a
cost (or benefit) on society as a whole. For example, emissions
of volatile organic compounds from automobiles contribute to
urban smog, which imposes health and other costs on society at
large. When all such external costs (or benefits) are not
accounted for by the individual purchaser/user, there is too much
(or too little) of the good produced and consumed. Recent medical
research suggests that "second-hand smoke," that is, the smoke
from smokers inhaled by nonsmokers, creates health risks and
costs for nonsmokers.” Thus, while potential health damage of
smoking is a direct cost to the smoker, second-hand smoke creates
a cost for nonsmokers for which the smoker does not account in
making the decision to smoke. Such costs are referred to by
economists as negative externalities.

Economists often propose corrective taxation as a remedy for
existence of a negative externality.* The idea is that if a tax
is imposed on the product that creates the externality at a rate

less than that of nonaddicted consumers. It is probable that
older smokers are more likely to be addicted than would younger
smokers.

3 ow. Kip Viscusi, Smoking: Making the Risky Decision,
{London: Oxford University Press), 1992.

3% Department of Health and Human Services, The Health

Consequences of Involuntary Smoking. A Report of the Surgeon
General, DHHS Publication No. (CDC) 87-8398, 1986.

3 These taxes often are called "Pigouvian taxes" after
economist Alfred Pigou who first proposed such a policy. In the
case of a beneficial externality, a subsidy would be provided
instead of a tax to encourage the behavior producing the
beneficial externality.



6

In general, HMOs represent one form of managed health care
delivery organization. Although there is case law regarding the
tax treatment of HMOs, the Code does not define an HMO.® In
general, HMOs have structured their delivery of medical care in
accordance with four basic models: (1) a "staff model" HMO
employs its own doctors and staff and serves its members at its
own central location; (2) a "group model" HMO contracts with an
existing group of physicians to perform services at the HMO’s
central location; (3) an "IPA model" HMO contracts with
physicians, often through an individual practice association
("IPA"), to provide care to HMO members at the physicians’ own
offices; and (4) a "network model" HMO provides care to its
members through a network of independent medical groups.!°

The IRS initially took the position that, while HMOs could
qualify for tax-exempt status as social welfare organizations
under section 501(c) (4), they could not qualify as charitable
organizations under section 501(c) (3) because the preferential
treatment provided to members/subscribers represented private,
rather than public, benefit. However, the United States Tax
Court rejected this position in Sound Hea. Association v.
Commissioner, 71 T.C. 158 (1978). The Court held that the
programs and facilities of the staff model HMO benefited the
community because its membership class was so open as to be
practically unlimited; where possible membership is so broad,
benefit to the membership constitutes benefit to the community.

In response to the Sound Health Association decision, the
IRS issued several GCMs identifying certain factors which
differentiate HMOs exempt under section 501(c) (3) from other
HMOs.!! In GCM 39828 (August 30, 1990), for example, the IRS

9 Both State and Federal law regulate the operation of
HMOs. For Federal purposes, the Health Maintenance Organization
Act of 1973, Pub. L. No. 93-222, codified as amended at 42 U.S.C.
300e - 300e17, defines a health maintenance organization and
prescribes the manner in which such organizations must be
organized and provide health services to be qualified under the
Act and eligible for certain Federal developmental loans, grants
and guarantees. In GCM 39829, the IRS suggested that an HMO’s
qualification under the Act could be considered as evidence of
community benefit, noting that the Act imposes requirements in
the areas of quality assurance, community rating and continuation
of coverage that tend to suggest that the HMO’s operations would
benefit the community.

10 See GCM 39829 (August 30, 1990).
u Although general counsel memoranda may not be relied

upon as precedent, these documents are made public under section
6110 of the Code and may be indicative of the IRS’ position on



20

become subject to the provision. For example, the bill does not
contain a rule comparable to that provided in the Tax Reform Act
of 1986 (the "1986 Act") to limit reserve weakening by
organizations immediately prior to the point at which they become
taxable.

cia i applicab: certal Le_insurance anie:

Some might argue that the present-law special rules under
Code section 833 (enacted in 1986) for Blue Cross and Blue Shield
organizations that became taxable was intended merely to ease the
transition from tax-exempt to taxable status and should now be
repealed. It could be argued that sufficient time has elapsed
since the 1986 Act changed the tax status of these organizations
for them to adjust to operation as taxable entities, and that
repeal of the special deduction, as provided by the bili, is now
appropriate. Others might assert that this purpose was not
stated in the legislative history, and, in fact, the provision
was not temporary when enacted.



37

percent. A 10,000-percent rate would apply to (1) jacketed,
hollow point projectiles which may be used in a handgun and are
designed to produce, upon impact, evenly-spaced sharp or barb-
like projections that extend beyond the diameter of the unfired
projectile; and (2) cartridges with a projectile measuring 0.500
inch or greater in diameter which may be used in a handgun.

The bill also would impose a special occupational tax on
each importer and manufacturer of handgun ammunition of $10,000
per year.

4. S. 1798 ("Gun Violence Health Care Costs Prevention Act") --
Senator Bradley

The bill would increase the ad valorem excise tax rate to 30
percent on handguns, semiautomatic assault weapons and shells and
cartridges used in handguns and semiautomatic assault weapons.

In addition, the bill would impose a 30-percent transfer tax
on any subsequent sale, transfer, or other disposition of a
handgun, semiautomatic assault weapon or shells and cartridges
used in handguns and semiautomatic assault weapons. The 30-
percent tax would not be imposed on any such article taxed under
the revised Federal manufacturer’s level excise tax.

Revenues from the increased tax rates would be dedicated to
a new Gun Violence Trauma Care Trust Fund.

5. S. 1878 ("Gun Violence Prevention Act of 1994") --Senators
Metzenbaum, Bradley, Chafee, Kennedy, Lautenberg, Boxer, and
Pell

The bill would increase the ad valorem excise tax rate on
handguns to 30 percent and the tax rate on handgun ammunition to
50 percent.

Revenues derived from the excise tax on handguns and handgun
ammunition would be used to fund a new Health Care Trust Fund.

C. Discussion of Issues
The taxation of firearms and ammunition

Rationale for increased taxation of firearms
and ammunition

Some portion of health care expenditures is incurred to
treat victims of gunshot wounds. Because public funds often are
expended to treat gunshot wounds, it may be appropriate to charge
those who purchase firearms and ammunition for the additional
public expenditures resulting from such wounds. In this way,
theoretically, these purchasers would bear a greater portion of



38

the costs of their behavior and the purchase and misuse of
firearms would be discouraged.

On the other hand, taxes on the consumption of specific
products, as opposed to broadly imposed consumption taxes, may
distort consumer behavior by disfavoring certain goods in the
economy relative to other goods. Generally, economists believe
that market price distortion through taxes reduces consumer well-
being because the change in relative prices introduced by the
taxes causes consumers to choose a less preferred good than they
would have in the absence of the tax. In addition, excise taxes
applied to all purchases of firearms and ammunition for the
purpose of accounting for the costs that arise from gunshot
wounds arguably may be inefficient because such taxes impose
costs on consumers whose use of firearms and ammunition does not
lead to gunshot wounds or public expenditures. The majority of
firearms and ammunition sales are to consumers who purchase these
goods for sport (hunting, skeet, and target shooting) or for
their personal protection.

Advocates of increased taxation argue that even firearms and
ammunition purchased for sporting or personal protection purposes
are the source of many suicide attempts and may result in
accidental gunshot wounds, and some enter the supply of illegal
weapons.*! In addition, firearms increasingly are being used in
homicides and other criminal activities. Advocates of higher
taxes on firearms and ammunition argue that such taxes not only
generate needed revenue to finance health care reforms or other
policies, but also further the goal of firearms control.

momic effect increased t ion of
firearms and ammunition

The higher prices of firearms and ammunition resulting from
increases in excise taxes could be expected to reduce purchases
by consumers of these products. To maximize this effect, it
would be necessary to increase existing excise taxes applicable
to the purchase of new firearms and ammunition, but also to tax
subsequent transfers. Firearms are durable goods. There is a
substantial market in used firearms, and sales of those firearms
generally are beyond the application of current Federal excise
taxes.

By increasing the price of new firearms, the market value of
existing firearms could be expected to rise as well, as consumers
substitute the purchase of old firearms for new firearms. For

51 Under this view, taxes on firearms and ammunition might
be interpreted, in part, as insurance premiums to cover costs
that arise from caring for gunshot wound victims (because any
firearm may potentially lead to such wounds).



26

different from that of other developed countries,” it is
generally conceded that health care costs in the United States
exceed those abroad. Such aggregate data do not reveal the extent
to which United States expenditures on health care are, or are
not, attributable to tobacco-related health problems.

Table 2.--Incidence of Cigarette Smoking in Certain
Foreign Countries, 1986

[Percentage of individuals 20 years old and older]

Great
Britain Australia Norway! Sweden?
Female..... 31.0 30.6 32.4 30.0
Male.......- 35.0 32.9 43.8 24.0
Notes: 1--Ages 20 to 70 only. 2--Ages 18 to 70 only.

Source: John P. Pierce, "International Comparisons of Trends in
Cigarette Smoking Prevalence," American Journal lic Hea 1 79,
February 1989.

Many countries tax cigarettes at a higher total rate than
does the United States. Some of this higher total tax is due to
other countries’ use of value-added taxes which generally tax all
consumption items. However, when the effect of value-added or
general sales taxes is removed, the cigarette taxes in the United
States remain relatively low. Table 3 shows cigarette excise
taxes as a percentage of retail prices in selected OECD countries

for 1987.

30 See Table 2 below.



2
I. TAX TREATMENT OF HEALTH CARE ORGANIZATIONS?
A. Background and Present Law
Tax- t izatio: nerall

Code section 501(a) provides that certain organizations
listed in sections 501(c) and (d) are exempt from Federal income
tax. Among the organizations listed in section 501(c) are those
organized and operated exclusively for religious, charitable,
scientific, testing for public safety, literary, or educational
purposes, no part of the net earnings of which inures to the
benefit of any private shareholder or individual (sec.

501(c) (3)), and civic leagues and organizations not organized for
profit which are operated exclusively for the promotion of social
welfare (section 501(c) (4))-

Charitable organizations described in section 501(c) (3) are
classified either as public charities or private foundations. In
general, an organization will be classified as a public charity
if it (1) receives significant support (generally more than one
third) in the form of contributions from the general public or
(2) is a church, school or hospital. In addition, section
509 (a) (3) provides that public charities include certain
"support" organizations which are organized and operated
exclusively to benefit one or more specified public or publicly
supported charitable organizations. Public charities are not
subject to the special rules applicable to private foundations,
such as a prohibition against self-dealing and tax on net
investment income, and contributions to public charities are
subject to more liberal deduction rules than are contributions to
private foundations.

Charitable organizations exempt under section 501(c) (3)
receive four major tax benefits: (1) exemption from Federal
income tax; (2) ability to accept tax-deductible contributions;
(3) ability to benefit from tax-exempt financing; and (4)
exemption from certain State and local taxes.> In contrast,
social welfare organizations exempt from Federal income tax under

2 This description and discussion is principally derived

from the previous Joint Committee pamphlet: Joint Committee on
Taxation, Description and Analysis of Title VIT of H.R. 3600, S.
1757, and §. 1775 ("Health Security Act") (JCS-20-93), December
20, 1993.

3° The extent to which an organization is eligible for
exemption from State and local taxes depends on the laws of the
local jurisdiction; while local exemption is frequently
conditioned upon Federal exempt status, it does not flow
automatically from such status.



43

impose a higher rate of tax on ammunition designed for a specific
subset of firearms. For example, "short" ammunition generally is
used only in handguns.‘! The Federal Bureau of Investigation
reports that, in 1992, of the 15,377 murders due to firearms,
12,489 (81.2 percent) were due to handguns.” A tax targeted at
handgun ammunition may reduce the use of such weapons.

However, just as firearms can be put to a variety of uses
(i.e., handguns can be used for sport, personal protection, or
crime), so too can a wide variety of firearms be put to the same
use (i.e., both rifles and handguns can be used for sport or in
illegal activities). This interchangeability means that it is
difficult to identify types of ammunition that are used in all
criminal activities or that are responsible for all gunshot
wounds. Substitutability also may make it difficult to predict
future patterns of ammunition use. On the other hand, if
specific types of ammunition cause substantial public health
expenditures because of the severity of the wounds inflicted or
the frequency of occurrence of such wounds, an increased rate of
tax on those types of ammunition could reduce public health
expenditures by reducing demand for, and use of, the specified
ammunition.

61 Some guns designed for long ammunition can accept short

ammunition; the reverse is not true.

62 U.S. Department of Justice, Federal Bureau of
Investigation, Crime in the United States, Washington, D.C.,
1992. Figures reported include data from all States except
Maine.



13
provided to a member.

Third, insurance which relates to the provision of services
other than primary care, if provided pursuant to a pre-existing
arrangement with an HMO, would not be commercial-type insurance.
This exception is intended to address situations in which an HMO
member is referred by his or her primary care provider to a
specialist who is a member of an HMO’s so-called "provider
network," even if the amount paid to the specialist varies with
the amount of care provided. Unlike the "point of service"
situation described above, the HMO in these cases, rather than
the member, controls the decision regarding the appropriate
health care provider.

Fourth, insurance relating to emergency care provided to a
member of an HMO at a location outside such member’s area of
residence would not constitute commercial-type insurance. This
exception would apply, for example, when an HMO reimburses health
care providers for the provision of emergency care to HMO
members, outside of their area of residence, irrespective of
whether such providers have a pre-existing arrangement with the
HMO.

Effective date.--These provisions would be effective on the
date of enactment.

Definition of taxable property and casualty insurance companies

In general, the bill would redefine the scope of
organizations treated as taxable property and casualty insurance
companies. Under the bill, any organization that is not tax-
exempt, is not a life insurance company, and whose primary and
predominant business activity during the taxable year falls in
one of three categories, would be treated as a property and
casualty insurance company. The three categories of activities
are: (1) issuing accident and health insurance contracts or
reinsuring accident and health risks; (2) operating as an HMO; or
(3) entering into arrangements to provide or arrange for the
provision of health care services in exchange for fixed payments
or premiums that do not vary depending on the amount of health
care services provided. The bill would modify the "primary and
predominant" requirement in the case of organizations that have,
as a material business activity, the issuing or reinsurance of
accident and health insurance contracts. For such organizations,
the administering of accident and health insurance contracts
would be treated as part of such business activity for purposes
of determining whether the organization’s activities fall within
the scope of category (1) above.

Effective date.--This provision would be effective for
taxable years beginning after December 31, 1996.



15

For an organization that is tax-exempt for its last taxable
year beginning before January 1, 1997, no adjustment would be
taken into account under section 481 or any other provision for
the company’s first taxable year beginning after December 31,
1996, on account of a change in method of accounting required by
the amendments to section 833. In addition, for purposes of
determining gain or loss, the adjusted basis of any asset held by
such an organization on the first day of its first taxable year
beginning after December 31, 1996, would be deemed equal to the
fair market value of the asset on that date.

The bill would also specify that the above amendments do not
affect the adjusted basis of any asset determined under the
transition rule provided for existing Blue Cross and Blue Shield
organizations in the 1986 Act (i.e., generally, that basis
equalled fair market value as of the first day of the
organization’s taxable year beginning after December 31, 1986).
In addition, the bill would eliminate the requirement that
existing Blue Cross and Blue Shield organizations not experience
any material change in their operations or structure to be
eligible for the basis adjustment, and would further provide
that, on January 1, 1997, such basis adjustment is made
permanent.

Effective date.--These provisions would generally be
effective for taxable years beginning after December 31, 1996,
subject to the special income inclusion rule (with respect to the
repeal of the 20 percent reduction), the phase-out rule for
certain organizations (with respect to the repeal of the special
deduction for 25 percent of claims), and the transition rules
described above.

Cc. Discussion of Issues

Tax-exempt status of certain organizations

In general, tax exemption is a form of subsidy administered
through the tax system (sometimes referred to as a "tax
expenditure"). It is granted to, among other organizations,
certain private organizations that conduct activities which
Congress deems to further worthy public objectives.

As a threshold matter, it is important to assess whether the
subsidization of the operation of hospitals and HMOs, as well as
regional health alliances, through tax expenditures, rather than
through direct outlays or other means of finance, is appropriate.
In general, such subsidization means that the true cost of such
activities appears understated in relation to the cost of other
goods and services because they do not appear as outlays in
budget reporting. In addition, such tax expenditures are not
subject to the annual appropriations process.


INTRODUCTION

The Senate Committee on Finance has scheduled a public
hearing on April 28, 1994, on the tax treatment of health care
organizations and excise taxes on tobacco products and firearms and
ammunition. This document,' prepared by the staff of the Joint
Committee on Taxation, provides a description of present law and
proposals and also a brief discussion of related issues.

Part I of the document relates to the tax treatment of health
care organizations; Part II relates to excise taxes on tobacco
products; and Part III relates to excise taxes on firearms and
ammunition.

' This document may be cited as follows: Joint Committee

on Taxation, Tax Treatme: of ith e Organiz n
Excise Taxes on Tobacco Products and Firearms and Ammunition

(JCX-5-94), April 28, 1994.



36
B. Description of Bills

None of the comprehensive health care proposals introduced
in the 103rd Congress contain proposals for modifying the tax
treatment of firearms and ammunition. However, several other
bills have been introduced that would increase Federal taxes on
firearms and ammunition.

The following is a brief description of the bills that
provide for increases in the present-law excise and special
occupational taxes. Many of these bills also contain extensive
non-tax provisions amending the Federal regulation of firearms
and ammunition through increased licensing fees, criminal
penalties and other requirements. Some of these provisions may
interact with the current excise and special occupational tax
regimes contained in the Internal Revenue Code; however, a
complete description of these bills is beyond the scope of this
document.

1. S. 32 ("Violent Crime Control Act of 1993") and S. 179 ("Real
Cost of Ammunition Act")--Senators Moynihan, Chafee, and
Simon

The bills would increase the rate of the present ad valorem
excise tax on certain ammunition--9 millimeter, .25 caliber and
.32 caliber ammunition--to 1,000 percent.

2. S. 868 ("Firearm Victims Prevention Act")--Senators Murray,
Bradley, Simon, Kerry, Moseley-Braun, Mathews, and Bingaman

The bill would increase the rate of the present ad valorem
excise tax on handguns, assault weapons, large capacity
magazines, and shells and cartridges used in handguns and assault
weapons to 25 percent.

The bill also would impose a 25-percent retail excise tax on
the sale, transfer, or other disposition of a handgun, assault
weapon, large capacity magazine, or shells and cartridges used in
handguns and assault weapons. Where the manufacturers’ tax was
paid, the retail tax would not be imposed until after the first
retail sale of the article.

Revenues from the 25-percent excise taxes would be used to
fund a new Health Care Trust Fund.

3. S. 1616 ("Real Cost of Handgun Ammunition Act") --
Senator Moynihan

The bill would increase the ad valorem excise tax rate on
certain handgun ammunition. Centerfire cartridges with a
cartridge case of less than 1.3 inches in length and cartridge
cases of less than 1.3 inches in length would be taxed at 50



24

The bill also includes several administrative and compliance
provisions. First, the exemption for exports would be limited to
products that are marked or labelled under Treasury Department
rules designed to prevent the diversion of such products into the
domestic market. Second, re-importation of tobacco products
previously exported without payment of tax (other than for return
to the manufacturer) would be prohibited and a new penalty, equal
to the greater of $1,000 or five times the amount of tax imposed
would be assessed against all parties involved in any prohibited
re-importation. All tobacco products and cigarette papers and
tubes, as well as all vessels, vehicles, and aircraft used in
such re-importations, would be subject to seizure by the United
States.

Third, the bill would extend current manufacturer inventory
maintenance, reporting requirements, criminal penalties, and
forfeiture rules to importers of tobacco products.

Fourth, the bill would repeal the present-law exemption for
books or sets of cigarette papers containing 25 or fewer papers.

Fifth, the bill would limit the cover over of tobacco
product revenues to Puerto Rico and the Virgin Islands to
present-law tax levels.

Eff ve d

The provisions would be effective for tobacco products
removed after September 30, 1994. A floor stocks tax would be
imposed on taxed tobacco products held on the effective date.

C. Discussion of Issues”TM

Statistics relating to incidence of tobacco use

The United States National Institute on Drug Abuse estimates
that, in 1991, 27 percent of the United States population
currently smoked cigarettes and that 3.4 percent of the
population currently used smokeless tobacco. Medical research
has linked the use of tobacco products to a number of

2% The following discussion draws substantially on the
analysis presented in Joint Committee on Taxation, Description
a Analysi f£ Title Vv: f H.R 600 ~ 1757, and S. 177

("Health Security Act") (JCS-20-93), December 20, 1993.

% "Current" use of cigarettes or other tobacco products is

defined as use of the product within the last month. The estimate
is based on a household survey. Bureau of the Census, United
States Department of Commerce, Statistical Abstract of the United

States, 1992.



INTRODUCTION 2. 2 6 ee ee ee ee ee ee ee ee
I. TAX TREATMENT OF HEALTH CARE ORGANIZATIONS .. .

A. Background and Present Law ... +++ + +:+ +

Il.

IItr.

B. Description of Bill (S. 1757--Sen. Mitchell and
others and S. 1775--Sen. Moynihan) .

c.

EXCISE TAXES ON TOBACCO PRODUCTS

A.

B.

c.

Discussion of Issues

Present Law... .-

Description of Bill (S. 1757--Sen. Mitchell and
others and S. 1775--Sen. Moynihan) :

Discussion of Issues

EXCISE TAXES ON FIREARMS AND AMMUNITION .

A.

B.

c.

Present Law...
Description of Bills

Discussion of Issues

11
15
21

21

22
24
34
34
36
37



32
Other issues related to tobacco taxation

Excise taxes are perceived as imposing a larger burden on
lower-income families (relative to income) than on middle- and
higher-income families. Some economists argue that family
expenditures may be a better measure of ability to pay than is
annual family income. Measured against expenditures, tobacco
taxes appear less regressive than when measured against income.*
Tobacco excise taxes also have a varying impact on families with
similar incomes, because the incidence of tobacco use varies
across families.

If increases in tobacco excise taxes succeed in reducing
consumption of tobacco products, the domestic tobacco industry
may be expected to contract.“ To the extent that the farming of
tobacco and production of tobacco products is geographically
specialized, reduction in demand may lead to at least short-term
economic dislocations in these geographic areas. For example,
unemployment may rise among those currently employed in tobacco
farming and tobacco product manufacturing. The severity of this
economic dislocation would depend in part on the ability of the
affected individuals to gain employment in different industries.
Finding new employment may require some individuals to relocate
to another region and/or undergo substanti retraining. The
major tobacco growing States are North Carolina, Kentucky, and
South Carolina, followed by Virginia, Georgia, and Tennessee .*

In addition to possible economic dislocations in tobacco
producing States, substantial reductions in tobacco consumption
may be expected to reduce the revenues of all State governments,
as all States impose tobacco taxes at the State level. At the
present, tobacco taxes are a more important revenue source for
States than for the Federal Government. In 1989, States collected
$5 billion in tobacco tax revenues, representing 1.8 percent of

Congress, 94-214E, March 8, 1994.

4 United States Congress, Congressional Budget Office,
Fi ral tion Tobac Alcoholic B es Motor
Fuels, June 1990.

“# Some tobacco products are produced for export.
Generally, exported tobacco products would be exempt from
proposed increases in domestic excise taxes. The extent of
production for export would mitigate the extent of contraction of
the industry.

4 Gravelle and Zimmerman, "Cigarette Taxes to Fund Health
Care Reform" reviews recent estimates of potential employment
effects that may result from increased taxation of tobacco
products.



41

smuggling and illegal sale of these highly taxed items, further
exacerbating law enforcement problems with unlicensed firearms
dealers. To the extent this shift in purchases occurs, a
disproportionate share of those who bear the burden of the tax

arguably may be law-abiding consumers, rather than those involved
in criminal activities.”

Second, restricting the tax to those firearms associated
primarily with criminal activities and gunshot wounds, as opposed
to those used in recreational endeavors, may raise difficult
definitional issues. Some experts note that it is difficult to
distinguish firearms used for sporting purposes from those that
would be subject to an increased tax rate. For example, while
handguns are not generally used in hunting, they are used in
target shooting competitions; they are also often used in
criminal activities. Similarly, rifles may be used in both
hunting and target shooting, as well as in criminal activities.
For instance, many hunting rifles are semi-automatic, a feature
that makes them popular for criminal use.

One way to distinguish among firearms is their caliber.
However, this method does not distinguish effectively firearms
used for hunting from those used for other purposes by their
caliber. Firearms of many caliber sizes are used for hunting.
Generally, small caliber firearms are used for small game and
larger caliber firearms are used for larger game. In addition,
characteristics other than caliber are important in
distinguishing firearms. The caliber of the popular .22 hunting
rifle is essentially the same as that of the United States’
military M-16. Further, as new weapons of different calibers are
manufactured, it would be necessary to determine whether each
weapon would be subject to tax.

Another way of distinguishing "street" weapons from sporting
weapons is by their style or appearance, or by the size of the
magazine the firearm accepts. However, differential tax rates
for firearms (e.g., higher tax rates on assault rifles® or
higher rates on firearms with larger magazines) may create
enforceability questions, especially if the tax rate
differentials are large. For example, while it may be possible
to distinguish a handgun froma rifle, it is more problematic to

57 In addition, to the extent that the firearms targeted for

taxation are substitutes for firearms not subject to taxation,
one would expect the tax to increase the price of the untaxed
firearms as would-be buyers substitute untaxed firearms for taxed
firearms.

58 In military parlance, an "assault weapon" is a shoulder-
fired, select-fire (ability to choose single fire or fully
automatic) weapon that fires an intermediate cartridge.



27

Table 3.--Cigarette Excise Taxes (Excluding
Value-Added and General Sales Taxes) as a
Percentage of Retail Cigarette Prices in
Selected OECD Countries, 1987

Tax a percentage

Country of price
United States............ 30.1
Australia..... 32.3
Belgium....... 64.4
France......-- 49.2
Germany......... wees 59.8
Portugal.........- wees 58.0
Spain......-....0- wees 32.8
United Kingdom........... 61.3

Source: Congressional Budget Office, "Federal Taxation
of Tobacco, Alcoholic Beverages, and Motor Fuels,"
dune 1990.

Federal excise taxes on tobacco products are imposed in
nominal terms, that is, they do not rise with inflation of the
general price level. Cigarette taxes, imposed at eight cents per
pack in 1951, remained unchanged until 1983. Subsequent
increases under the Omnibus Budget Reconciliation Act of 1990
have increased the tax to 24 cents per pack, or three times the
nominal 1951 level. The general price level today is more than
five and one half times that prevailing in 1951, implying a
substantial decline in the real (inflation-adjusted) burden of
tobacco excise taxes. On the other hand, it may be inappropriate
to compare tax rates prevailing today with those imposed during
the Second World War or the Korean War. — 7

Health policy and control of tobacco
In_general

The medical research cited above has motivated many public
health analysts to advocate greater governmental action to help
reduce the use of tobacco among the population. Such non-tax
action could range from increased expenditures on public service
announcements detailing the risks associated with tobacco use to
increased penalties for sales of tobacco products to minors. Some
analysts advocate increasing tobacco taxes to provide a market
incentive to individuals to reduce their consumption of unhealthy
products. The higher prices of tobacco products resulting from
increases in tobacco excises taxes would be expected to reduce
consumption by consumers of tobacco products. Some consumers may
cease using such products altogether, while others moderate their
current level of consumption. Among smokers, some smokers may
maintain their current rates of smoking by substituting discount



11

B. Description of Bill (S. 1757--Sen. Mitchell and others
and §. 1775--Sen. Moynihan (The "Health Security Act")
(secs. 7601-7603 of bill)

Tax-ex EY of ita. fet in pare:
or zat nd_ regi alliances :

The bill would establish certain new requirements applicable
to nonprofit health care providers (hospitals and HMOs) seeking
to qualify as tax-exempt charitable organizations under section
501(c) (3).

In particular, the bill would amend the Code specifically to
require that, in order for the provision of health care services
to constitute a charitable activity for purposes of section
501(c) (3), the organization providing such services must
periodically assess the health care needs of its community and
develop a plan to meet those needs. Such assessment and plan
development must take place at least annually and must include
the participation of community representatives.

In addition, the bill would provide that an HMO seeking tax-
exempt status under section 501(c) (3) must furnish health care
services to its members at its own facilities through health care
professionals who do not provide substantial health care services
other than on behalf of such organization.

The bill would further provide that organizations which
serve as parent holding companies for hospitals or medical
research organizations constitute public charities rather than
private foundations. Thus, the bill would add to the list of
organizations described in section 509(a) any organization which
is organized and operated for the benefit of, and which directly
or indirectly controls, (1) a hospital, the principal purpose or
function of which is the provision of medical or hospital care or
medical education or medical research; or (2) a medical research
organization if such organization is directly engaged in the
continuous active conduct of medical research in conjunction with
a hospital and, during the calendar year in which the
contribution is made, such organization is committed to spend
such contribution for medical research not later than the
beginning of the fifth calendar year. beginning after the date
such contribution is made.

Finally, section 7603 of the bill would add the to-be-
established regional alliances described in section 1301 of the
bill to the list of tax-exempt organizations set forth in Code
section 501(c).

Effective date.--The provisions regarding the definition of
charitable activities of medical service providers and HMOs would
be effective January 1, 1995. The provision regarding the exempt



14
Special appli le to rtain t. le insurance companies

The bill would repeal the special rules provided under
section 833 to Blue Cross and Blue Shield organizations and other
eligible organizations, and would provide transition rules for
organizations that become subject to section 833 after the
effective date (generally, taxable years beginning after December
31, 1996). The provision would treat such organizations as
insurance companies, but would not specify that such
organizations be treated as stock companies.

The bill would repeal the special exception to the 20-
percent reduction with respect to unearned premium reserves. The
bill would require inclusion in income ratably, over a six-year
period following the effective date, of 20 percent of the
unearned premium reserve outstanding at the end of the most
recent taxable year beginning before January 1, 1997. The
inclusion would be required at the rate of 3-1/3 percent of such
outstanding unearned premium reserve in each of the first six
taxable years beginning after December 31, 1996.

The bill would also repeal the special deduction for .25
percent of claims. A special phase-out rule would apply to an
organization that meets the community-service-related
requirements of present law for each of its taxable years
beginning in 1995 and 1996. For such organizations, the
deduction would be phased out at a specified rate over the
organization’s first two years following the effective date; 67
percent of the otherwise allowable amount of the special
deduction would be allowed for such an organization’s taxable
year beginning in 1997, and 33 percent would be allowed for its
taxable year beginning in 1998. As under present law, the
deduction would not be allowable during the phase-out period in
determining the organization's alternative minimum taxable
income.

The bill would provide transition rules for organizations
that become subject to section 833, as amended, after the
effective date (generally, taxable years beginning after December
31, 1996). For an organization that is not tax-exempt for its
last taxable year beginning before January 1, 1997 (and is taxed
other than under the property and casualty insurance company
regime for taxable years beginning in 1992 through 1996), the
amendments to section 833 would be treated as a change in method
of accounting, and all adjustments required to be taken into
account under section 481 would be taken into account in one
taxable year, i.e., the company’s first taxable year beginning
after December 31, 1996. No special transition rule would apply
to organizations that treat themselves as subject to tax under
the property and casualty insurance company regime for taxable
years beginning in 1992 through 1996.