Crisis

Starting with the first quarter of FY 2002 (July through September 2001), however, budget shortfalls in a few states developed into a full-blown crisis. That quarter was the first of what is now a string of four in which overall state tax revenue fell compared to the previous quarter (see Figure 2).¹⁶ In FY 2002, the last quarter (April through June 2002), which usually provides states with the greatest amount of revenue, thanks to income tax returns, saw a huge decline of 11 percent. This series of declines had an immediate impact.

FIGURE 2

Changes in Quarterly State Tax Revenue, 2000–2002 (in percent). Source: Nelson A. Rockefeller Institute of Government Revenue Report Database.

By April 2002, according to the National Conference of State Legislatures (NCSL), 43 states reported budgetary shortfalls that totaled $27 billion.¹⁷ Just three months later, the shortfalls rose to $37 billion. To put this gap into perspective, the $37 billion would equal roughly 7.7 percent of all state general revenues, or 3.7 percent of total state spending, including federal revenue to states.¹⁸ In a little over one year, the fiscal environment for the nation’s states had changed dramatically from comfortable surpluses to constrictive shortfalls.

State Responses

Cutting Programs — The first step in covering the FY 2002 budget shortfall was to cut spending. Least painful were administrative steps, such as restricting state employee travel (11 states) and placing a freeze on new hires (approximately 20 states).¹⁹ Another popular administrative strategy was to change projects involving capital expenditures. Thirteen states either delayed capital projects or shifted their financing from payas-you-go to debt.²⁰

But administrative cuts were not sufficient to balance the budget: 29 states implemented across-the-board or targeted cuts. These cuts included programs that were exempted from last year’s cuts: higher education (19 states), K–12 education and Medicaid (12), local revenue sharing (6), and Temporary Assistance for Needy Families, or TANF (3).

Tapping Other Funds — A second strategy was to use monies from balances and a variety of other funds. For FY 2002, states saved money by reducing their enacted budget balances from 8.8 percent of the budget to 5 percent, the largest percentage drop since 1980. Nineteen states tapped into their rainy day funds.²¹ In one year, the balances for rainy day funds fell by one third (from $16.5 billion to $10.8 billion).

In addition to drawing from rainy day funds, states tapped a variety of other funds. Twenty states reallocated monies from various special or dedicated funds, such as those earmarked for education and capital facilities construction, and 12 states used some of their tobacco settlement money for shortfalls in their state general revenues. For the most part, tax increases were not part of a state strategy for balancing the FY 2002 budget.

States proposed the smallest increase in general revenue since 1983.

All in all, governors, state legislators, and agency directors who had grown accustomed to relatively easy fiscal decision making during great economic times found FY 2002 a difficult year. Yet, state fiscal experts claim the first full year of a sustained budget crisis is when the easy decisions are made.²² It is the following two fiscal years (FY 2003 and FY 2004), they say, that are going to be traumatic.

Continued Troubles, Borrowing, and Cutting

While governors and legislators were busy patching and balancing their tattered FY 2002 budgets that ended June 30, 2002, they were also busy enacting the FY 2003 budgets that began July 1, 2002. In comparison to the previous year, states became more conservative in forecasting economic and revenue growth.²³ The result was the smallest increase in proposed state general revenue since 1983.²⁴ With less revenue, states had to find ways to cover gaps in the budget.

A preliminary NCSL report that included responses from 40 states found many were using budget-balancing strategies in FY 2003 that were similar to those employed for FY 2002. States again reduced the amount for balances, from last year’s 5 percent to 3.7 percent, thereby providing the smallest cushion since 1992.²⁵ Twenty-three states again tapped special, dedicated funds (such as those for transportation and state parks) and 12 tapped into the diminishing rainy day funds.²⁶

In a new development, 16 states used some of their tobacco settlement funds. And two states, California and Wisconsin, used their entire tobacco settlement allotments to help balance their FY 2003 budgets.²⁷

Twenty-six states found that tapping into the various funds was still not sufficient to balance the budget, so they cut programs. The most frequent target was higher education, where funds were cut by 16 states.²⁸ Other programs cut included corrections (14 states), Medicaid (12), K–12 education and local revenue sharing (11), and TANF (5). Despite these far-reaching efforts, many states needed to find additional ways to enact a balanced FY 2003 budget.

Tax Increases: No Longer a Sin

In contrast to FY 2002, when states were caught short because the budget gap appeared after the fiscal year began, in preparing for FY 2003 they were able to compensate for falling revenues by increasing taxes for the entire fiscal year. Consequently, for the first time in eight years, states as a whole saw an overall net tax increase of $6.7 billion.²⁹ A variety of taxes, including personal income, business, and sales taxes were raised.

The single biggest revenue increase, and tax revenue story of the year, was the sudden popularity of increasing the tax rate on tobacco products. For FY 2003, 19 states raised their tobacco taxes and 2 others placed cigarette tax increases before their voters.³⁰ The other two “sin taxes”—those levied on alcohol and gambling—did not get as much attention, with only two states increasing their taxes on alcohol.

The proportion of state tax revenue raised by the new cigarette taxes far exceeds anything brought in by the old. Over 40 percent, or $2.9 billion, of the states’ new tax revenue came from higher taxes on cigarette and tobacco products. In contrast, a peak year during the last state fiscal crisis (FY 1992) saw only 2 percent of the net tax increase derived from tobacco taxes.

In addition to enhancing their revenues, states continued to cut spending as they enacted their FY 2003 budgets, although the overall magnitude of the cuts is as yet unclear. However, the fiscal situation appears to be deteriorating so rapidly that the FY 2003 cuts are almost certain to be more drastic than those made to balance the budgets for FY 2002.

Despite incomplete data on the magnitude of state budget cuts, NCSL reports seem to indicate that state policymakers have been making some difficult choices. For example, they have adopted cuts in education, which has long been a priority of governors and legislators. But the states had little choice: K–12 education and higher education are, respectively, the first- and third-most-expensive state programs (Figure 3). States are now focusing more of their attention on controlling the second-largest but fastest-growing program, Medicaid.

FIGURE 3

State General Fund Expenditures, FY 2002. Source: National Association of State Budget Officers

Changes in State Medicaid Programs

The Medicaid program has wide support among safety-net providers and the low-income mothers and children, disabled, and elderly persons the providers serve. Among the program’s advocates are physicians and other practitioners, community health centers, hospitals, nursing homes, and other providers that rely on some level of Medicaid payment. Beneficiary advocates, whether for eligible low-income children and youth under 21, persons with physical and mental disabilities, or people 65 and older, also provide considerable backing for the federal-state program, both in Washington, D.C., and in state capitals across the nation.

When states want to increase dollar flows from the federal government and cut their own budgets, it is inevitable that they focus on Medicaid.

Despite this combined clout, states will be forced to look at their Medicaid programs for fiscal relief. In addition to being the largest source of federal dollars to states, Medicaid is already the second-largest consumer of state general revenue funds and the primary cause of new state spending increases. Therefore, when states want to increase dollar flows from the federal government and cut their own budgets, it is inevitable that they focus on Medicaid.

States are eyeing various changes. One approach would be for the federal government to increase the percentage of funds it provides relative to state matching payments. The current federal formula, generally expressed in percentages (for example, 50 percent federal/50 percent state), matches federal to state dollars, with poorer states receiving more generous matching than richer states. Another strategy, used in various ways in the past through creative financing mechanisms, would be to draw a higher federal match without spending additional state monies.⁴⁸ For example, states have used the Medicaid disproportionate-share hospital (DSH) adjustment to avoid upper payment limit (UPL) restrictions in the Medicaid program and thereby to gain more federal dollars. This strategy proved particularly lucrative for some states during the fiscal crisis of the early 1990s. After Congress tightened the rules around DSH, states began drawing down additional federal funds using other loopholes in the UPL law.

However, it is uncertain whether states will have the same level of success this time around. The Centers for Medicare and Medicaid Services (CMS) has worked to restrict state use of UPL but in the process has created controversy with states and Congress. With Medicaid serving as the largest source of federal funds sent to states, maximization efforts will continue to be an attractive target for state budget makers.

Moreover, states have the option of making incremental changes in their programs by addressing benefits (other than those mandated by the federal government), eligibility, and payment levels. It is likely that many states will be submitting waivers that may end up restructuring their health programs. One type of restructuring would involve state pharmacy assistance programs. Thirty-four states that have a program of this type; 18 are looking to finance some Medicaid beneficiaries’ drug costs through a waiver under the “Pharmacy Plus” guidelines issued by CMS in January 2002.⁴⁹

Other states are looking at fundamental changes that may have an even more significant impact on their Medicaid programs. The Health Insurance Flexibility and Accountability (HIFA) initiative was created to provide states with eligibility and benefit flexibility, but since its announcement in August 2001, the state budget environment has worsened. This new budget context may result in proposed changes in the way states use the greater flexibility. There may be less expansion in eligibility, greater trimming of benefits, more reduction in provider payments, and less state money for the Medicaid match. In June 2002, 17 states indicated that they were developing or considering HIFA waivers.⁵⁰

States will be hard pressed to find the revenues both to provide the required Medicaid match and keep up with the resurgence in health care inflation.

In summary, Medicaid appears to be entering a new era. After an explosion in Medicaid enrollment of low-income people that began in the late 1980s and was complemented by an influx of enrollees from the State Child Health Insurance Program (SCHIP) after it was created in 1997, future enrollment is not likely to increase at the earlier rates. States will be hard pressed to find the revenues both to provide the required match and keep up with the resurgence in health care inflation.

State Requests for Assistance under Medicaid

The states have gone directly to the federal government to seek short-term financial assistance in Medicaid. The governors have been active in supporting a temporary increase in Medicaid’s federal match rate, and the Senate has included such a provision in its recent revisions in legislation overseeing generic drugs.⁵¹ Also included is a temporary increase in the Social Services Block Grant. The future of this proposal in the 107^th Congress is uncertain. The House has not voted on it and the administration has opposed such assistance in the recent past.⁵²

Unknown Effects on Other Health Programs

While relatively systematic and timely information is available regarding changes in Medicaid (and, to a lesser extent, SCHIP and state pharmaceutical assistance programs) during the states’ fiscal crisis, similar information on other state health programs (such as those providing mental health, maternal and child health, substance abuse, and public health services) is not as forthcoming. There is anecdotal evidence that these programs are suffering, perhaps more than Medicaid. One potential indicator is a series of state surveys conducted by the Maternal and Child Health Policy Research Center. The center found that about half of the states were cutting state FY 2002 Title V Maternal and Child Health Block Grant funds for children with special health care needs and that 58 percent of the survey respondents expected reductions in state FY 2002 funds for children’s mental health services.⁵³ A report tracking tobacco prevention programs found 15 states recently cutting their programs, with some cutting them by 35 percent to 45 percent.⁵⁴ Given the depth and breadth of state cuts in priority programs such as education, it would seem that these other health programs would be vulnerable to major cuts. To more accurately assess the effects of budget cuts on these and other similar programs, however, more systematic reporting is needed.

A Weakened Partner in Federalism: Now and in the Future?

The short-term fiscal outlook for states is not good. State budget analysts hope that improvements in forecasting future revenue and an economic rebound will end the recent series of surprising shortfalls. Even if states’ ability to project revenues improves and the economy rebounds, however, the next three to four years will be difficult, for history suggests that there is a 12- to 18-month lag between an economic recovery and a return to former levels in state revenues.⁵⁵ And, for a time, states will have to spend new revenues replenishing their rainy day funds and repaying monies borrowed from the numerous dedicated funds.

“State finances will be constrained quite tightly over the next several years.”

Even an improvement in the state’s economy and budget does not guarantee a return to the boom days of the late 1990s, in which states were cutting taxes, increasing spending and showing comfortable balances in their budgets. Donald J. Boyd of the Nelson A. Rockefeller Institute of Government argues that a series of unusual events, including the following, aided states during that period:

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The tobacco settlement for states provided an unexpected windfall.

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The stock market grew tremendously, raising state income tax revenue.

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States benefitted from the TANF block grant, since the state funding levels were determined by data gathered in poor economic times but were applied during times of low unemployment.

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Inflation in both health care and Medicaid costs fell to single-digit levels.⁵⁶

Given the unlikelihood that such one-time events will again bail the states out of fiscal difficulties, Boyd concludes that, even with a good economic recovery, “state finances will be constrained quite tightly over the next several years.” In reference to the windfalls and trends that negated past predictions of state fiscal stress, he acknowledges, “It could happen again. But of course unforseen events need not be beneficial and it is best not to plan on that.” One worry that economists have is that the nation could slip into another recession that would prolong the states’ fiscal woes.

Even with a quick recovery, however, some states may struggle to find sufficient revenues to balance their budgets. The mainstays of state revenues, personal income taxes and the sales tax, both present challenges to state lawmakers. Clearly, much of the sudden and dramatic loss of income tax revenue can be attributed to the overall market downturn and the resulting loss of stockholders’ income and capital gains. At the same time, the revenue from state sales taxes seems to be declining. In many jurisdictions, an increasing number of items have been exempted from the sales tax; these include food, clothing, and services—the last of which constitutes a growing proportion of consumer spending. Difficulties in collection persist (especially for items purchased via catalogue and the Internet).⁵⁷

Finding the dollars for the projected health care costs will be difficult. Medicaid will continue to be a challenge to state budgets because of the resurgence in health care inflation. And with each passing year, the aging population looms as a growing threat to state Medicaid programs, a primary payer of long-term care services.

Probable Shift in State-Federal Health Care Relationship

The decisions states make in the midst of this fiscal crisis will have major impacts on the programs they jointly fund with the federal government. The likelihood is that states will seek to rely even more heavily on federal financing.

In turn, the federal government will feel increasing pressure to reexamine its role in financing the state-federal programs, especially the 35-year-old Medicaid partnership. The first step in this process may be consideration of a proposal by the governors to create a national commission on restructuring Medicaid.⁵⁸ The policy, adopted by the governors at their winter 2002 meeting, suggests the formation of a bipartisan commission.

The idea of reviewing the basic tenets of the Medicaid program and the federal-state relationship upon which it is built is not a new one. Almost since the program’s inception in 1965, individuals and groups representing federal or state interests have periodically called for redefining roles, restructuring the program, rethinking the allocation of funding and programmatic responsibility, or considering a variety of cost-containment schemes.

Among the questions any reexamination of state and federal roles in Medicaid will raise are the following:

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How much should states be expected to contribute to the support of the Medicaid program? Is the federal government able or willing to define a basic required level of support across the country? If so, is it appropriate for the federal government to assume some greater portion of Medicaid funding?

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Is there a way to reconcile differences in states’ willingness and capacity to support a basic program of benefits to needy people under Medicaid and related programs?

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If the federal government assumes additional financial responsibility for Medicaid, what does that imply in terms of additional national goals or mandates that would be required of participating states?

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How will state and federal government sort out the growing demand for long-term care and pharmaceuticals? Should these questions not be an integral part of the dialogue around the federal-state Medicaid partnership?

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Medicare and Medicaid, two programs of critical concern to many of the most vulnerable of our citizens, are grounded in markedly different federal-state paradigms. What can be done to better coordinate both funding streams and care for those who are dually eligible for the two programs?

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Is the notion of “swapping” some current state responsibilities for increased (or even total) federal funding of other responsibilities likely to gain more currency in the future?

The press of business this fall makes it unlikely that Congress will spend much time debating these questions in the short term. However, given the current pressures on state budgets, it does seem certain that considerable attention will be given to discussion of matching rates and state flexibility under HIFA. With the likelihood that state budget pressures will continue over the longer term, it appears that discussion of more fundamental Medicaid restructuring will remain a significant concern in the years ahead.