Medicaid Explained: How Would Lower Provider Taxes Affect State Budgets?

The Obama administration’s current deficit reduction proposal, now before the so-called congressional “Super Committee,” includes a variety of measures designed to roll back federal Medicaid spending. But one — a lower cap on the taxes that states charge hospitals, nursing homes and other health care organizations — would have the biggest potential impact on state budgets.

These taxes account for a sizeable portion of the revenues states raise every year to pay for their share of the $370 billion Medicaid program. How would the administration’s proposal affect states’ ability to finance the low-income health care program that serves nearly 70 million Americans? The following primer provides answers to some of the crucial questions. 

What exactly are provider taxes?  They are taxes states levy on hospitals, pharmacies, managed care organizations and other health care providers to raise revenues to pay for their share of Medicaid programs. Under Medicaid’s federal-state cost sharing arrangement, the federal government pays from 50 percent to 85 percent of total Medicaid costs. But states can only draw down that money if they pay their share of the total first.

Are these taxes controversial?  Yes. In a number of states, federal auditors have found provider tax schemes to be a clever method of shifting more costs to the federal government. Here’s how the system works:

A hospital pays $1 million in provider taxes to the state. The state in turn writes a check to the same hospital for $1 million for additional Medicaid payments. Once the state pays the hospital, it reports the payment to the federal government. The federal government then pays its share by sending the state $1 million or more in matching funds to be forwarded to the hospital. The only party out any money is the federal government. Instead of a 50 percent federal matching rate, the federal government is paying 100 percent.

To critics, Medicaid provider taxes are little more than a shell game — a way for states to impose a tax on institutions that know they will be getting the money back. The taxes are legal and highly regulated, but have long been a sore point in the fiscal relationship between states and the federal government. Critics argue such schemes violate the spirit of Medicaid’s federal-state cost sharing rules.

Are all provider taxes suspect?  No. The federal government routinely audits provider taxes to ensure that they are levied evenly across a group of similar institutions in a region, such as nursing homes or hospitals, and are not directly tied to increases in Medicaid payments to any particular institution. When they work according to federal rules, some hospitals are winners and some are losers. Every hospital pays the tax, but only those with the greatest need get higher Medicaid payments in return.

Do all states impose provider taxes?  Not quite all of them. Six states have no provider taxes at all. Among those that do, there are big differences in how much each state benefits from provider tax schemes. Louisiana and New Hampshire, for example, have historically been allocated a disproportionately large share of federal supplemental payments for hospitals that serve uninsured patients. Because of that, provider taxes have been a major source of Medicaid revenue in those states. Pennsylvania is another state that has benefited more than most from taxes levied on nursing homes.

What is the administration’s plan?  In its overall Medicaid proposal, the administration is calling for a $72 billion reduction in federal payments to states over a 10-year period starting in 2014. That’s $28 billion less than the administration proposed to cut earlier this year during debt ceiling negotiations. In the current proposal, an estimated $26.3 billion of the reduction would come from lowering an existing cap on state provider taxes. Currently, these taxes cannot exceed 5.5 percent of a health care organization’s revenues. The administration’s proposal would gradually lower that ceiling to 3.5 percent over a ten year period starting in 2014.

How have the nation’s governors responded to the administration’s proposal? Governors have said very little about it. In general, however, they have complained that proposed deficit reduction measures simply pass more costs onto states. “Make no mistake: these reductions are significant and cannot be absorbed into state budgets,” wrote Governor Christine Gregoire of Washington for the National Governors Association.

When the federal government proposed limits to provider tax schemes at various times in the past, governors argued that states had full rights to tax business entities to raise the revenues needed to run their governments. Since Medicaid is currently the biggest single expenditure in state budgets, governors say they need full latitude to raise the funds needed to meet their matching obligation. Some point out that they’ve relied on the practice so long that limiting it would be tantamount to shifting costs back to the states.