March 7, 2016

California's Illegal Medicaid Tax

Brian Blase

Former Senior Research Fellow

State schemes to maximize money coming through the federal Medicaid reimbursement are not new. However, they have exploded in recent years—evidenced by a sharp increase in provider taxes and other gimmicks that artificially inflate state Medicaid expenditures in order to draw down federal funds.

Contact us
To speak with a scholar or learn more on this topic, visit our contact page.

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.

The letter was motivated, in part, by a 2014 report that identified Pennsylvania as in violation of this law since October 2009. Pennsylvania raised $1.76 billion with an illegal Medicaid MCO tax for the first three years it was in place. Through supplemental payments to the Medicaid MCOs, Pennsylvania returned $1.60 billion of that money. The federal share was nearly $1 billion—a huge windfall for Pennsylvania from its tax. According to Kaiser Health News, Ohio, Michigan and California also have taxes out of compliance with federal law.

CMS gave California until the end of June 2016 to implement a tax that complied with the 2005 federal law. Since California had been receiving more than $1 billion annually from federal reimbursements stemming from the illegal tax, the state and California insurers have been hard at work for the past year developing a new scheme so not to lose that money.

Charles Bacchi, president and CEO of the California Association of Health Plans commented that the proposal is “mind-bending and hard to explain. … We can’t say it enough; it’s highly complicated.” It’s unsurprising that neither Governor Brown, nor likely anyone in the California state legislature, understands the revamped tax. Since the federal rules governing provider taxes are complicated and contain loopholes, the insurers are the ones with the largest incentive to figure out how to create a tax scheme that benefits them. Apparently, they were successful.

According to the Orange County Register, “Health insurers would be taxed according to a[n] elaborately tiered system, based on the number of Medi-Cal [California’s Medicaid program] and non-Medi-Cal patients each plan serves. Kaiser Permanente, a large nonprofit, has its own designated tax rate. Certain small local plans in Sacramento and San Diego counties are exempted entirely.”

According to the Los Angeles Times, “Most health insurers, including major players such as Blue Shield, Anthem and a trade group—the California Assn. of Health Plans—are in support and have said the new proposal will not affect consumers.”  

According to the state, the plan will generate around $1.35 billion for the state each year—with health plans coming out ahead by about $100 million. Since there are three sets of actors principally involved with how this complicated scheme works—insurers, California taxpayers and federal taxpayers—if insurers and California taxpayers are both much better off from the scheme, then federal taxpayers are much worse off. 

The plan, which passed the legislature and was signed by Governor Brown, still needs federal approval. Congress should make sure that CMS as well as the Inspector General at the Department of Health and Human Services completely vet this “highly complicated,” “elaborately tiered tax” that exempts certain insurers, was largely written by insurers and their lobbyists, and that the governor cannot explain.

Obama Administration Failure and Role for Congressional Oversight

State schemes to maximize money coming through the federal Medicaid reimbursement are not new. However, they have exploded in recent years—evidenced by a sharp increase in provider taxes and other gimmicks that artificially inflate state Medicaid expenditures in order to draw down federal funds.

The Obama administration’s central focus on maximizing enrollment in Medicaid and exchange plans since the passage of the Affordable Care Act has harmed program integrity—by, for example, allowing hundreds of thousands of people who lacked evidence of legal residency to enroll in exchange plans and receive large subsidies. The administration’s misplaced focus neglects important oversight efforts from the executive branch.

Congress must step up and conduct rigorous oversight of these illegal Medicaid MCO taxes and state efforts to implement new taxes that comply with federal law. Key Congressional committees can start by requesting documents and communications between both states and CMS as well as from the insurance companies that wrote, or at least heavily influenced, the revised tax plans. They can also hold hearings on why it took the federal government years to do anything about the illegal taxes, the amount of federal money misspent, and the process for resolving them.

Medicaid spending is the fastest growing program at both the federal and state levels. The large spending growth, the lack of program transparency, and the recent evidence that Medicaid delivers relatively low value to enrollees demonstrate the need for large scale policy change in this area—change that can be abetted by aggressive Congressional oversight.