Hurricane Tax Threatens to Batter Tax Reform

As appeared in Forbes.

Tax wonks in Washington are expecting a bit of a policy hurricane on November 1st when the House Ways and Means Committee releases its tax reform draft. But that’s nothing compared to the actual hurricane season just experienced in Texas, Louisiana, Florida, and especially Puerto Rico. The two types of hurricanes–one metaphorical, others very much not–have more in common than you might think.

How does the tax code deal with huge natural disasters (“nat cats” for “natural catastrophes” in industry parlance)? First and foremost, there is a typical toolkit of items that gets triggered whenever there is an earthquake, wildfire, hurricane, tornado, or flood. This release on tax breaks available in Georgia in the wake of Hurricane Irma is typical:

• extended deadlines for filing tax returns and paying estimated income taxes
• waiver of penalties on late deposits for things like FICA taxes
• easier ability to write off casualty losses as an itemized deduction, and to do so a year early
• other administrative aids such as dedicated 1-800 numbers

In addition to this, there’s the usual business of running property and casualty insurance companies. Most of us who have hazard insurance on our homes pay a modest monthly premium on it with our mortgage payments as part of escrow, and our insurance companies make a profit by paying out less in claims than they collect in premiums. But what happens when an insurance company has a generational issue like a Katrina, a Sandy, or whatever we’re going to call this latest hurricane season?

In that case, insurance companies hedge against risk by purchasing “reinsurance,” which is insurance for the insurance companies. They buy a policy that cashes in when there is an out-sized number of claims coming in after a natural disaster. Often after one of these “nat cats,” it’s actually reinsurance companies who pay most of the damages, not the primary insurers we all pay every month.

According to industry data, the current hurricane season’s tab paid by reinsurance companies is $35 billion and rising. This comes from a mixture of reinsurance companies located in America and in places like London, Bermuda, and Switzerland, but the bulk of the money actually comes from the global reinsurers.

How does the tax code treat reinsurance? It’s pretty neutral today. Reinsurance is treated as a tax deductible, ordinary and necessary business expense of property/casualty insurance companies. Further, the income tax code doesn’t care whether the reinsurance policy is bought in the United States or somewhere else–in other words, the tax code is neutral (almost neutral–there is actually an excise tax on reinsurance bought overseas, meaning the tax code is already in favor of domestic reinsurance today).

This neutral tax treatment of reinsurance is clearly the correct tax policy, and conservative tax experts agree. All the major groups that have taken a look at this–Americans for Tax Reform, the National Taxpayers Union, the Tax Foundation, and the R Street Institute–think the tax code has by and large gotten this one right. And that’s saying a lot considering how broken our tax code is.

Congress, however, might not leave well enough alone. Policymakers are considering introducing a “picking winners and losers” tax policy faux-pas into the tax reform mix by continuing to let companies deduct premiums for domestic reinsurance policies, but not global ones. They would target the affiliate transactions, ironically of those global insurers that have invested in U.S. subsidiaries, for a tax penalty. If that sounds like rent seeking on the part of the domestic reinsurance industry, it should–and it’s why the strongest supporters of this protectionist policy are liberals like Congressman Richard Neal (D-Mass.) It also appeared routinely in “dead on arrival” budgets submitted by President Barack Obama.

Needless to say, an idea supported by liberals and opposed by every conservative tax group has no place in tax reform.

Supporters argue that such a measure is a necessary hedge against “base erosion.” The fear is that U.S. insurance companies will buy a phony reinsurance product overseas (which they in fact also control), pay premiums tax deductibly to get the money out of this country, and then spend their winnings on a tropical island somewhere. That fantasyland scenario is ludicrous for two reasons–first, state insurance commissioners would never let such a criminal enterprise happen on their watch, and secondly the IRS already has powers to prevent economically unsubstantive arrangements merely for the sake of tax evasion or avoidance.

Furthermore, this alleged “base erosion” protection is not used by other developed countries, even those with territorial tax systems like tax reform will implement. The OECD in its recent review of base erosion found that affiliate reinsurance was legitimate and real risk transfer and thus was not singled out for separate treatment. In other words, the U.S. would be going even further here than socialist European taxation technocrats. The Tax Foundation found that for every $1.00 raised by this measure, the U.S. economy would shrink by $4.00.

So the arguments for this policy are not very good and have not been persuasive to conservatives.

What would such discriminatory tax treatment do to the premiums you and I pay every month on our mortgage? According to the R Street Institute, it isn’t good. Discriminating in the tax code against global reinsurance would mean $1.3 billion in higher premiums over the next decade in Arkansas, Missouri, and Tennessee. It means $3.35 billion in higher next-decade premiums in New York. In California, it’s $4.8 billion. There’s more data than you can shake a stick at in a comprehensive report by the Brattle Group, who estimate that increased costs in Florida would be $2.59 billion over a decade, and an additional $620 million over ten years in Louisiana. When people use the term “hurricane tax,” this is what they mean.

If consumers don’t pick up this tab, the rest of us will. Taxpayers could very well see a massive increase in federal disaster supplementals, like the double digit billion dollar packages already passed by Congress this fall and added to the national debt. As large as they are, these bills will only get more expensive if discriminatory taxation of global reinsurance is pursued in tax reform.

As Congress gets more into the details of tax reform, they would do well to avoid picking winners and losers in the tax code in a lame attempt to chase base erosion ghosts. This is particularly true when it comes to monkeying around with how we pay for natural disasters like hurricanes.

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