California’s Illegal Medicaid Tax

California politicians and interest groups have been working overtime to figure out a way to fix an illegal Medicaid provider tax—the subject of my recent Mercatus Center study. These taxes are problematic because they are generally accompanied with the guarantee of increased Medicaid payments to the providers paying the tax—payments largely financed with federal matching funds. As a result, provider taxes, which reek of government favoritism because of how the benefits often target select providers, raise Medicaid spending.

California’s tax is illegal under federal law because the state was holding numerous insurers harmless from the tax that should not have been. The state has recently come up with a revised tax plan that it is submitting for federal approval. California Governor Jerry Brown has called the new plan “extremely complex,” and suggested that he does not want to reveal the details, remarking that “very few people understand it, so I’m not going to try to explain it to you because I couldn’t explain it to you if I wanted to.” [emphasis added]

Root of the Problem: Open-Ended Federal Medicaid Reimbursement

The federal government provides states with what amounts to a blank check to cover state Medicaid spending. In 2015, the federal government spent $350 billion reimbursing state Medicaid expenditures—an amount roughly equal to 63% of total program spending.

The open-ended reimbursement causes states to spend more on Medicaid relative to other state priorities. For example, state Medicaid spending rose an inflation-adjusted 357% between 1990 and 2015, nearly five times more than the increase in state spending on education. The open-ended reimbursement also results in states developing ways to artificially inflate expenditures in order to secure additional federal funding. One such scheme is provider taxes.

 Illegal Taxes on Medicaid Managed Care Organizations

The federal government permits provider taxes within an extraordinarily complicated set of constraints. One is that the same tax rate apply to all providers in a given class, such as hospitals. This constraint aims to prevent states from only raising revenue from providers that will then benefit from the higher Medicaid payments. However, the federal government provides ineffective oversight of provider tax arrangements and states often use supplemental payments to target Medicaid funds to favored providers.

In July 2014, the Centers for Medicare and Medicaid Services (CMS) wrote a letter to states because of “confusion among states” about provider taxes. According to the letter, some states were violating a 2005 law that expressly prohibited states from taxing only Medicaid managed care organizations (MCOs) as opposed to all insurers. It is worth noting that Medicaid MCOs support these schemes since they generally recover at least as much money through higher payment rates as they pay in taxes.

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