The Dishonor System
A user’s guide to committing fraud on the Obamacare exchanges
Aug 5, 2013, Vol. 18, No. 44 • By CHRISTOPHER J. CONOVER
Let me stipulate that I do not condone fraud in any form. Moreover, I assume all Weekly Standard readers are law-abiding citizens who would neither commit fraud themselves nor encourage others to do so. My purpose is to inform such readers just how tempting fraud on the Obamacare health insurance exchanges will be in light of the recently announced delays in employer reporting and employer mandates.
Obamacare creates many grossly unfair situations.
There are three types of fraud worth considering, each reflecting different motivations and degrees of risk tolerance among the hypothetical individuals considered.
Low-income, full-time worker in a large firm offering health coverage.
Mike’s situation: Let’s start with Mistreated Mike, a $14.00-per-hour janitor in a 200-person law firm already offering health coverage. He works 40 hours a week, 50 weeks a year, making his total wage income $28,000. At 116 percent of the federal poverty level, it’s tough to provide for his stay-at-home spouse caring for two toddlers, but he gets $6,026 in Earned Income Tax Credit (EITC) that helps out. Mike’s proud that he’s managed to provide health insurance for his family for years, but it’s expensive. For 2014, he’s selected the most affordable plan his company offers, but he’s crossing his fingers that his family’s out-of-pocket spending won’t reach the average level expected for those who select such a plan: $5,000. Mike’s employer pays much of the $14,100 family premium and fortunately has set up a Section 125 plan so that every penny of Mike’s $3,241 contribution is tax-deductible. Still, that’s a hefty 11.6 percent of his wage income, which might make it appear that Mike’s coverage meets Obama-care’s definition of “unaffordable.” In that case, he would qualify for subsidized coverage on the exchange. Unfortunately, exchange eligibility is restricted to those whose cost for “self-only” coverage under their employer plan exceeds 9.5 percent of household income, and Mike has family coverage. Since Mike’s share of a “self-only” premium would be only 4.9 percent of his income, he is not legally permitted to buy subsidized coverage through the exchange.
But Mike realizes that he is, in effect, also paying the employer’s share of his premium in reduced wages. How? He has a twin brother doing the same work as a janitor for a neighboring law firm of the same size. However, because that firm consists only of a few high-paid partners and associates, along with an army of paralegals and legal assistants, it has decided to drop its health benefits in 2014. To replace the lost benefit, the company has already announced it will instead pay his brother about $8,000 more a year to do the identical job.
Mike’s motivation: Here’s what frosts Mike. His brother will get not only a much higher cash wage in 2014, but also a “Silver” health plan comparable to Mike’s, paid for with $15,616 worth of taxpayer-financed exchange subsidies! (A Silver plan, under the Affordable Care Act, covers 70 percent of a typical plan member’s expenses. In addition to the subsidy to pay the premium, someone at the income level of Mike’s brother will also receive a cost-sharing subsidy to raise the coverage from 70 to 94 percent of his health spending.) After deducting all taxes and health expenses, Mike’s net income is expected to be $26,884, whereas his brother’s will be $33,350. Mike does not live in one of the 24 states moving forward with Medicaid expansion, so his only prospect for subsidized coverage is through the exchange. In short, Mike can boost his cash income considerably if he can get exchange-subsidized coverage.
The way Mike sees it, Uncle Sam is levying a substantial tax on him simply for working for a large employer that responsibly offers health benefits. How is that fair? Mike appreciates that by not taxing his health benefits Uncle Sam is giving him roughly a 10 percent discount on all his health spending. He just can’t figure out why his brother is getting an 82 percent discount, especially now that his brother’s wages are substantially higher than Mike’s.
Given how well-informed Mike is, it won’t surprise you to learn that he remembers all the sordid backroom deals that were required to secure votes for Obamacare—the “Louisiana Purchase,” “Gator Aid,” the “Cornhusker Kickback,” and a deal with big hospitals, among others. And he’s been appalled by the flagrant favoritism accorded certain political groups such as unions and public employees in Obamacare’s rollout to date. Not surprisingly, the entire law is feeling to Mike like an organized kleptocracy—with vast amounts of taxpayer resources redistributed in a manner no one could possibly claim is fair. Mike has concluded that a government that gives his higher-wage brother a $15,616 subsidy for identical coverage clearly is not watching out for him. He’s decided to do what it takes to tip a very unlevel playing field back in his own favor.
Mike’s calculation: The administration’s ineptitude in rolling out Obama-care has given Mike a lucky break. In 2014, his employer may not be reporting to the exchange any details about the coverage offered him at work. The final rule on premium tax-credit eligibility verification requires that any applicant for premium tax credits attest to the exchange whether he or she has employer coverage, its cost, and extent. Specifically, he will be asked:
For the lowest-cost plan that meets the minimum value standard offered only to the employee (don’t include family plans): . . .
a. How much would the employee have to pay in premiums for this plan? $________
b. How often?
[ ] Weekly
[ ] Every 2 weeks
[ ] Twice a month
[ ] Quarterly
[ ] Yearly
Even though reporting to the exchanges has been delayed one year, all employers subject to the minimum-wage laws are required to send a notice to all employees by October 1, 2013. Also, the plan affordability/minimum-value information still must be provided.
What are the risks? Let’s be clear: There are potentially steep penalties—up to $250,000—for committing fraud but not for making an honest mistake. According to legal site Nolo.com: “Although auditors are trained to look for fraud, they do not routinely suspect it. . . . They will give you the benefit of the doubt most of the time and not go after you for tax fraud if you make an honest mistake.”
Indeed, the IRS flagged nearly five million tax returns for math errors in fiscal year 2011. This is many multiples of the 4,720 criminal prosecutions initiated by the IRS that year. Since the exchange will be electronically cross-checking income information against information it gets from tax filings, Social Security data, and current wages, Mike would be safest by honestly reporting his income to the penny and instead fudging the cost of coverage so that his company plan seems to fail the affordability test.
Depending on how Mike’s employer reports this premium information to him (i.e., as a weekly, monthly, or yearly amount), he can simply make a convenient mistake. $2,660 a year is the magic number, i.e., greater than 9.5 percent of his income. So he needs to convince the exchange that his share of the premium exceeds this amount. If, say, his employer reports the actual employee-only premium as $26.54 weekly, he could report $56.54 as the amount the employee has to pay. This is not a flagrantly suspicious amount. Moreover, if later challenged, Mike could chalk it up to sloppy handwriting (“Oh, that’s a 2, not a 5”) or an inadvertent transcribing error.
Will Mike get caught? According to Timothy Jost at the HealthAffairs blog,
The rule does not articulate what is meant by “statistically significant random sample of cases.” However, we can get a rough idea from the EITC program, where the IRS in fiscal year 2011 audited 2.2 percent of returns claiming such credits. Thus, Mike’s odds of getting caught through the random sample are pretty slim; if he is unlucky enough to be caught, he essentially will be given advance notice that they suspect something and an opportunity to come clean.
Potentially, there is another way Mike could get caught. Both the exchange and the IRS are required (even in 2014) to notify employers every time one of their employees receives premium tax credits. After 2014, employers will be liable for a penalty if one of their employees gets subsidized coverage on the exchange. But in 2014, the question is what Mike’s employer will do when notification is sent that he has obtained subsidized exchange coverage.
Quite likely, nothing at all. After all, what is the employer’s incentive to respond to this notice? No adverse consequence would arise from ignoring it. Hypothetically, a highly diligent human resource employee with ethical objections to claiming a tax benefit improperly might elect to blow the whistle. But an employee that hyper-aware presumably also would recognize the gross inequity of the entire employer-mandate structure and the fact that Uncle Sam is effectively imposing a tax on workers in large firms, even as it provides massive subsidies to their equivalently compensated counterparts at large firms that “pay” rather than “play”—i.e., decide that paying the penalty is cheaper than providing health benefits. All things considered, it seems likely either that Mike’s transgression will be ignored or that he will have the same opportunity to rectify his “inadvertent” error.
Far below poverty, full-time worker in a large firm offering coverage.
Dan’s situation: Desperate Dan is in the same boat as Mike, except that he’s a much lower wage ($8 per hour) groundskeeper working at a law firm that already offers health benefits. His total wage income is $16,000 (plus an EITC payment of $5,355). He’s divorced with three kids aged 19, 20, and 22; all have full scholarships to attend college but live at home since their scholarships only cover tuition. Moreover, like most public universities (70 percent), theirs don’t provide health coverage for students. Because his children are too old to qualify for Medicaid coverage, Dan’s bitten the bullet to help them out by buying the same policy that Mike did and including them as dependents on his plan. His state is not expanding Medicaid, but since his family’s income is well below the poverty level (68 percent), he’s not legally permitted to buy subsidized coverage through his state’s exchange. You heard that right: Congress, in its infinite wisdom, made everyone below the poverty line ineligible to purchase private coverage through the exchange. Go figure.
Dan’s motivation: As it turns out, Dan also has a twin brother who (I know this is incredible) works as a grounds-keeper at the very same large firm as Mike’s brother! He too gets paid an extra $8,000 a year for essentially the identical job since his employer has decided to drop health benefits. What’s truly incredible, however, is that while Dan’s brother obviously ends up paying higher payroll taxes than Dan—after all, his income is higher—he actually gets a bigger EITC check ($1,768 larger). His net after-tax, after-health-cost income ends up being $15,972 higher than Dan’s. But even if Dan didn’t have a brother making him feel resentful, he still would have a very strong motivation to find a way to break through the poverty-level income floor required to get exchange coverage.
Realistically, Dan’s employer is not going to pay him $8,000 more in 2014 simply because he elects to forgo his employer-offered coverage in order to get heavily subsidized exchange coverage. Nevertheless, if he could obtain exchange coverage, then in return for paying merely $502 in premiums, he would get back $4,834 in subsidies to offset his $5,000 in out-of-pocket expenses for him and his sons. Including the $3,241 saved by forgoing his employer plan, he’d be ahead by $7,573, which is equivalent to a 50 percent boost in his after-tax, after-health-costs cash income. As we’ll see, the payoff actually is $2,600 higher than this since, in order to get away with claiming a high enough income to qualify for exchange coverage, Dan will have to feed the IRS a parallel set of lies that will culminate in his qualifying for larger EITC checks in 2013 and 2014. Readers can judge for themselves whether the boost in Dan’s income would be enough to tempt him into cheating.
Dan’s calculation: Mike’s experience shows it’s pretty easy to get away with inaccurately reporting that the coverage offered at work is unaffordable. Dan’s bigger challenge is needing to inflate his reported income by 30 percent, which amounts to $154 a week. But even if he claims to be doing handyman chores at only $10 hourly, it’s not a stretch to pretend that he managed 16 hours weekly of such work on top of a 40-hour-per-week job. However, since the exchange will cross-check his income claim against IRS records, it is critical that whatever income amount he reports to the IRS matches up.
A rather bizarre side-benefit of fudging his income on his exchange application is that the parallel tax filing will qualify Dan for an additional $1,768 in EITC payments in 2014! But it gets better. The exchange application form asks Dan for his income this year (2013) and for next year (if he thinks it will be different). Claiming that next year’s income is going to go up by 50 percent might raise some red flags. Dan would be safest boosting his reported income this year by 25 percent and by an additional similar amount next year. He’d obviously have to adjust his books to reflect a steadily growing new handyman business. And doing so would mean an extra $884 EITC check for this year’s return.
The IRS expects all self-employed individuals to keep and retain timely records of all business income and expenses. At this time, the law requires issuance of a Form 1099-MISC for payments of $600 or more for services performed for a trade or business by people not treated as its employees. So Dan must be sure that none of his records list clients for whom he did more than $600 in business during the calendar year. Thus, to report a fictional $8,000 in annual income, all he really needs is 14 “clients” who paid him an hour a week at $11 an hour for his services. These payments obviously need to be in cash (to explain why they leave no paper trail of checks or bank deposits). The only record would be Dan’s meticulous log of who paid him when for what. As well, self-employed individuals are required to deduct all allowable business expenses, so he’d need to include a plausible amount of business expenses (which is why payments for basic chores requiring no tools might be the safest bet since otherwise he might have to be prepared to show an auditor receipts for purchase of gas for a lawnmower or similar expenses). Let’s say it takes Dan five hours to create his fictitious business records. I’m guessing that from where he sits, over $10,000 in extra income (the health subsidies plus the savings on the employer plan plus the EITC) for five hours of work likely wouldn’t seem too shabby.
Will Dan get caught? According to Nolo.com, “While auditors aren’t detectives, they are trained to spot common types of wrongdoing, called badges of fraud. Examples include a business with two sets of books or without any records at all, freshly made false receipts, and checks altered to increase deductions.” So long as Dan maintains only a single set of books for a cash-only business of plausible scale and scope, with entries that appear to have been made throughout the year, he isn’t likely to raise suspicions.
Of more than 230 million tax returns filed in 2011, there were 2,340 convictions for tax crimes (that’s 1 in 100,000). Moreover, remember that the IRS audits only 2.2 percent of returns under $25,000 claiming the EITC. And nearly 95 percent of these are done through the mail, rather than in face-to-face desk audits. Perhaps not surprisingly, the Treasury auditor “estimates that 21 to 25 percent of EITC payments were issued improperly in Fiscal Year 2012.” (Similarly, about one-quarter of those receiving free and reduced-cost school lunches are not eligible.)
Leaving aside the lackadaisical enforcement posture in this administration, there’s no good reason to suppose that IRS performance will improve in 2014. After all, according to Treasury, “At least 42 of the 514 Affordable Care Act provisions add to or amend the Internal Revenue Code, and at least eight require the IRS to establish new operations. Collectively, these provisions represent the largest set of tax law changes in 20 years.” The IRS is going to be extremely strapped trying to manage all its new responsibilities next year. As things already stand, it cannot effectively manage the 27 million returns claiming the EITC each year. Now imagine trying to police 7 million people coming onto the exchanges in 2014.
Given that the IRS faces up to half a trillion dollars in uncollected taxes each year, how much effort do you think they’ll invest in trying to round up $1,768 in EITC overpayments to Dan? And if they cannot catch him on the EITC side, there is no plausible way to catch him from the exchange side since his reported income will exactly match IRS records. Besides, can you picture the political optics of an exchange trying to take back health coverage from someone at 68 percent of poverty? Any number of progressive activists would no doubt eagerly challenge this on Dan’s behalf.
Slightly below poverty, full-time worker in a firm without coverage.
Pete’s situation: Puzzled Pete is in the same boat as Dan, except that his hourly wage ($10.38) and greater number of hours (40 a week x 52 weeks) give him an annual income ($21,600) that puts him at 90 percent of the federal poverty level for a family of four. He’s at a company that offers no health benefits. He’s also divorced with three kids aged 20, 22, and 24; like Dan’s, all have gotten full scholarships to attend college but are living at home without college-provided health benefits. Similarly, neither Pete nor his kids qualify for either Medicaid or the exchange.
Pete’s motivation: Unlike Mike and Dan, Pete doesn’t have a higher-wage twin brother fueling resentment. But he is definitely puzzled: He keeps reading about the extraordinary subsidies available on the exchange to those with the lowest incomes, but is astonished that having an income below the poverty level makes him ineligible. Unlike Dan, whose truth-twisting will yield “only” $10,000 in extra cash income, Pete can net $18,433 in exchange subsidies if he’s willing to contribute only $667 in premiums and out-of-pocket expenses and will fib a little to boost his reported income by 10 percent to put it over the poverty line. Pete’s incentive to lie is thus much greater than Dan’s. And the legal risks of getting caught—already pretty small in Dan’s case—are minuscule in Pete’s situation.
Pete’s calculation: When reported income falls within 10 percent of the amount that can be confirmed using electronic records (e.g., last year’s tax returns), the exchange is not required to do any further verification. Thus, unlike Dan, Pete has no need to fabricate EITC income for 2013; creating an income stream of only $2,400 for 2014 using Dan’s method should be a piece of cake. Unless Pete is incredibly sloppy, it is hard to see how this would raise any red flags, especially given that each year, about one-third of individuals initially deemed eligible for Medicaid in states that expand it are likely to see their incomes increase enough to no longer qualify for Medicaid and instead become exchange-eligible. In short, the exchange is going to have its hands plenty full without worrying about verifying Pete’s small income to the very last 10 percent.
Let me reiterate my sincere hope that not a single Mike, Dan, or Pete commits fraud to get on the Obamacare exchanges. But policy needs to be based on real-world human behavior and motivations, not behavior as we might wish it to be. In light of the rampant improper payments under the EITC and school lunch programs (which have had many years over which to perfect fraud-detection and enforcement measures), it is naïve at best not to expect similar levels of inaccurate income reporting in the exchanges, now that employers have been given a one-year reprieve on reporting the information that exchanges need to do their jobs.
Only 2.7 percent of full-time year-round workers have incomes below poverty, but that’s still 2.7 million workers. Moreover, that’s using a 35-hour-per-week threshold; among all workers, the poverty rate is 6.9 percent, or 10.7 million workers. However, not all are uninsured, and not all work for firms subject to the employer mandate. So while we cannot say precisely how many people like Dan or Pete are out there, it is more than a handful. How many feel sufficiently motivated to commit fraud is a big unknown, but no one should be surprised if the number can be counted in millions. Whatever the number, there probably will be far more people like Mike who end up on the exchanges. As the accompanying chart illustrates, the payoff for committing fraud rises dramatically as family income declines. So leaving aside the pressure this will create on employers to drop coverage for such workers or to make it unaffordable, the mandate delay gives such workers an unprecedented opportunity to save themselves thousands of dollars by claiming they do not have access to affordable coverage.
Finally, 46 percent of uninsured workers now work for large firms subject to the employer mandate. People forget that only 82 percent of eligible employees actually enroll in their employer health plan—even among the very largest firms (5,000 or more workers). In some cases these are married people who can obtain better or more affordable coverage through a working spouse. Because the employer mandate does not require workers to cover their spouses, many in this situation may well turn to the exchange if feasible.
The administration has opened the door to rampant fraud. It remains to be seen how many low-income workers end up walking through that door. Tax compliance is contingent on taxpayer perceptions of fairness, and Obamacare is about to create many individual situations that are grossly unfair. In light of the 20-25 percent overpayment rates in the EITC and school lunch programs, is it realistic to expect overpayments on the exchanges—especially in their very first chaotic year of operation—to be any smaller? Taxpayers beware: You ain’t seen nothing yet.
Christopher J. Conover is a research scholar in the Center for Health Policy & Inequalities Research at Duke University, an adjunct scholar at the American Enterprise Institute, and a senior scholar affiliated with the Mercatus Center at George Mason University.
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