Revenues

Programmatic decisions regarding Medicaid and other state spending are often driven by the strength of state revenues. State budgeters undoubtedly wish they could know exactly how much revenue their state will collect each year, but projecting revenues is complicated by the many factors that can affect revenue flow. The effectiveness of tax collections, employment rates, consumer spending, fluctuations in the real estate market, and changes in federal legislation are just some of the factors that state budgeters must consider when making revenue projections.

States revenues come from two major sources. The first is state-levied—personal income, corporate income, and sales taxes; fees and licenses; and other taxes, such as property, inheritance, or cigarette taxes (see Figure 1). The second and single largest source is intergovernmental revenue. Nearly 40 percent of intergovernmental revenue comes from federal matching payments for the Medicaid program.³ Matching rates (called the federal medical assistance percentage, or FMAP) range from 50 percent to 83 percent and are calculated based on each state’s per capita income.⁴ Even states with the lowest matching rate still receive one federal dollar for every state dollar they spend on Medicaid, making the program a true partnership. In fact, the federal matching relationship in Medicaid is significant enough that many states have been reluctant to cut their programs because they do not want to forgo the opportunity to draw down federal funds.

FIGURE 1

Sources of State Revenue, First Quarter 2007 . †Fuel, tobacco, and alcohol taxes and motor vehicle and operator’s licence fees. Source: U.S. Census Bureau, Quarterly Summary of State and Local Government Tax Revenue, table 2; available (more...)

Despite the availability of federal support, however, many argue that Medicaid’s financing structure is not sufficiently responsive to changing economic conditions, making it difficult for states to budget effectively. During economic slowdowns, unemployment rates tend to increase, causing individuals to lose access to employer-sponsored health coverage. The FMAP is calculated each year based on the average of the past three years of states’ per capita income data. As a result, the federal matching rate often does not respond to current state economic circumstances, and states are therefore faced with making program cuts during times of greater need. Many experts have suggested that the financing formula be modified to be more “counter-cyclical,” that is, more appropriately tied to immediate economic indicators, in order to provide more timely federal support to states.⁵

States vary significantly in revenue sources, and these variations often result in disparate effects when economic changes occur. Seven states do not collect any income tax, and two tax only dividend and interest income.⁶ Even among states with similar sources of tax revenue there is variation. For instance, states with income taxes can have as many as ten brackets—or as few as one. States without income taxes tend to rely heavily on other revenue sources, such as sales taxes or fees. In general, southern states rely more on sales taxes,⁷ while many states in the Northeast depend more on personal income taxes. There are exceptions; for example, New Hampshire has no personal income tax, and North Carolina receives less than 15 percent of its revenue from the sales tax.⁸ Using fees to pay for new programs or program expansions is one way states can raise revenues without increasing broad-based taxes. Many types of fees tend to be dedicated to one program area, such as motor vehicle fees that are dedicated to transportation projects and are therefore more transparent than general taxes that are used for various purposes. Fees may also be easier to institute because they encounter a lesser degree of public resistance to passage than broad-based tax increases.

Correctly estimating revenues is important, not only because it helps states determine what is available to spend on their programs, but also because of the constitutional requirement in most states to have balanced budgets. Since matching estimated revenues with actual spending is difficult, states set aside extra revenues in reserves or fund balances, sometimes referred to as “rainy day funds,” to use when spending exceeds collections. Rainy day funds are then saved for use when states experience fiscal downturns.

Expenditures

Sources of state expenditures include state funds (which come from broad-based taxes), bonds, and federal funds (which include the federal share of funding for programs like Medicaid).⁹ There can be large differences in program spending between states, although most states spend the largest portion of state funds (not including federal funds) on kindergarten through grade 12 (K–12) education and Medicaid. These two areas comprise nearly half of all state spending.¹⁰ In FY 2004, Medicaid’s double-digit growth rates, combined with the slowing economy, caused Medicaid spending to surpass spending on K–12 education—making it the largest component of state budgets, if all funds are considered.¹¹ (Figure 2 shows the continuation of this situation in FY 2005.)

FIGURE 2

Major State Expenditure Categories, 2005. Source: National Association of State Budget Officers, 2005 State Expenditure Report, figure 4, Fall 2006, p. 4; available at www.nasbo.org/Publications/PDFs/2005%20State%20Expenditure%20Report.pdf.

States’ programmatic expenditures can also be difficult to predict because of market changes such as recessions, inflation, new legislative requirements, or unforeseen crises, such as natural disasters. For example, at the dawn of this century, state budgeters could not have predicted the terrorist attacks of September 11, 2001; Hurricane Katrina; or the recession that drove large enrollment increases in Medicaid.

The Fiscal Storm: FY 2001 to FY 2003

Before the fiscal downturn of 2001, state expenditures had been growing substantially for a number of years.¹² Several decades of large per capita state expenditure increases, coupled with a sudden and dramatic drop in state revenues, caused the economic slowdown to last multiple years in many states. Initially, this slowdown was most severe in those states where revenue generation was most directly tied to stock market fluctuations. Market losses significantly affected the Northeast, including New York State, where the financial services industry is important to state revenues. Eventually, the economic slowdown spread to every region of the country, so that in fiscal year (FY) 2003, 36 states had mid-year budget gaps.¹³ A significant contributing factor to states’ budget difficulties was Medicaid’s expenditure growth rate.¹⁴ The combination of the revenue crisis and increases in Medicaid spending led the National Governors Association to characterize the state fiscal situation as the worst since World War II.

Recovery: FY 2003 to FY 2006

Many states initially reacted to the fiscal crisis by using one-time measures to fill budget gaps, for example, using rainy day funds, selling state assets, or drawing down all their tobacco settlement money at one time.¹⁵ However, as the crisis persisted, some states made across-the-board cuts, enacted program cost controls, or raised taxes. These cutbacks caused negative percentage increases in annual state budgets from FY 2002 through FY 2004.¹⁶ In the last quarter of 2003, lower growth, combined with an improving stock market and increased revenues, allowed states to experience their first positive adjusted real change in revenue collections. Since then, state revenue growth has remained positive, with the most notable gains occurring in FY 2004 and FY 2005, as shown in Figure 3 (next page).¹⁷

FIGURE 3

Real Adjusted State Tax Revenue, Year-Over-Year Percent Change, 1991–2006. Source: Rockefeller Institute of Government Revenue Report 68, adjusted real changes account for legislated tax changes and inflation.

A significant slowdown in Medicaid expenditures in 2006 allowed the states to shore up their finances. The slower growth was due in part to changes in states’ policies designed specifically to contain costs, such as freezing provider rates¹⁸ or enacting prescription drug cost controls. Another factor that influenced the decrease in Medicaid expenditures was the implementation of Medicare Part D, the prescription drug benefit.¹⁹ However, it should be noted that the shift in costs from the Medicaid to the Medicare program does not necessarily benefit the states because of the requirement, known as the “clawback,” that states make payments back to the federal government in return for Medicare’s takeover of prescription drugs for dually eligible beneficiaries. Hospital and nursing facility spending also slowed during this period. The slowdown in Medicaid spending was also encouraged by federal administrative actions, such as providing states greater flexibility in structuring their program benefits to control costs and limiting states’ use of techniques to maximize their federal match.²⁰

By FY 2006, most states’ fiscal situations were very different than in FY 2003, with ending balances as a percentage of expenditures the highest since FY 2000, and with only two states requiring mid-year budget cuts.²¹

Future Indicators

How long will state budgets remain healthy? What do long-term trends mean for the future of the Medicaid program? Four indicators suggest that the current stability of state budgets may not last.

State revenues slowing—Revenue increases in 2006 were modest compared to 2004 and 2005. The first quarter of FY 2007 showed a nominal growth rate of 4.3 percent compared to the same quarter from a year earlier, which was slightly below the previous quarter’s growth of 4.6 percent. This growth was characterized as “stable” but it was the weakest growth since the April–June quarter of 2003.²⁴ The second quarter of FY 2007 (January–March 2007) showed that state tax revenue increased 4.9 percent compared to the same quarter the year before. The nominal growth rate was stronger than the previous two quarters but not as strong as the first two quarters of FY 2006.²⁵ Of most concern is the fact that state sales tax collection slowed considerably. Looking ahead, many states believe that the modest slowdown in revenue growth will continue in the year ahead. A survey by the National Conference of State Legislatures (NCSL) in November 2006 indicated that many states were experiencing slower sales tax revenue and were not as optimistic as they had been in the previous year.²⁶

The “steadying” of revenue growth that states are experiencing differs from the recession that began in 2001, in which the drop in revenues was abrupt and severe. However, with the state fiscal crisis of 2001 to 2003 still a recent memory, some states are being cautious with their revenue estimates and spending proposals as they enter FY 2008. The NCSL’s preliminary report on state budget and tax actions for 2007 shows that year-end balances of more than half of the states were lower in FY 2007 than they had been in FY 2006.²⁷

Local governments are not as large as state governments, but their financial health is still a consideration for the states. If local governments are strapped for cash, they look to state government for assistance. Property taxes are the major source of income for local governments—an estimated 73 percent of total revenues. Property taxes have performed well in recent years, as they are linked to the real estate market and can be updated yearly, unlike other taxes, which are more statutorily rigid.²⁸ This year, however, many governments are considering property tax cuts,²⁹ and the real estate market has softened, which will further decrease revenues from this source.

Federal funding levels and national economic trends—Notable changes have taken place with federal revenues since the last fiscal crisis. The first of these is the end of extra federal revenue, $20 billion of which the federal government provided to states during the fiscal crisis through the Jobs and Growth Tax Relief Reconciliation Act of 2003. Half of this money was used to relieve states of the growing cost of Medicaid through a temporary increase in the amount of Medicaid matching dollars states received from the federal government, and half was used for general fiscal relief. This one-time measure helped states but has now ended.

More significant to the future of state budgets are decreasing amounts of federal grants-in-aid. This trend began in 2006, and the president’s proposed FY 2008 budget would further cut discretionary and mandatory grants to state and local governments (excluding Medicaid).³⁰ States will experience revenue losses because of other changes at the federal level, such as implementation of the federal “domestic production deduction.” The domestic production deduction is a corporate tax break created by the federal government that allows corporations to claim a tax deduction for certain “qualified production activities.” The tax break also affects corporate income tax collections at the state level.³¹ Not all states will be affected by this deduction but, for those that are, losses are expected to double in 2007. With the wars in Iraq and Afghanistan still surging and the first members of the baby boom generation nearing age 65, federal entitlement spending is expected to continue to increase, so it is unlikely that federal grants-in-aid to state and local governments will increase any time soon.

Significant to the future of state budgets are decreasing amounts of federal grants-in-aid.

Projections based on the most current national economic data are mixed. According to the Bureau of Labor Statistics, unemployment trends vary considerably from state to state, but the overall U.S. unemployment rate has been steady since the fall of 2006.³² The Bureau of Economic Analysis indicates that there was a small acceleration in the gross domestic product (GDP) in the fourth quarter of 2006.³³ The Congressional Budget Office’s economic outlook for FY 2008 through FY 2017 indicates that revenues will be less than required outlays from FY 2007 until FY 2012.³⁴ The federal government has considerable financial liabilities of its own to address.

Increasing state spending rates—States’ reliance on one-time measures such as rate freezes and temporary spending controls to close gaps during the last fiscal crisis meant that not all states enacted structural changes to control long-term spending trends. Within health care, several states attempted to control costs by implementing disease management programs, expanding managed care, or placing utilization limits on certain services. Many of these measures helped slow Medicaid spending. In FY 2007, state general fund spending as a percent of GDP was still lower than prerecession levels, but it is unclear how long this will continue.³⁵

In 2007, many states have been proposing programmatic changes that would increase short- and long-term spending levels. These changes include universal prekindergarten, universal health care, and substantial increases in other education funding. For instance, at least nine states are proposing health care coverage expansions, while seven others have established commissions to examine reform and coverage expansion options. California has proposed universal health care estimated to cost $12 billion yearly, while New York took the first steps to increase K-12 education spending by $7 billion over four years, and, for FY 2008, 34 governors introduced plans to reduce the number of uninsured.³⁶ A recent NCSL paper indicates that projected spending increases may be higher than revenue growth.³⁷

Trends also suggest that the slowdown in Medicaid spending will reverse and that significant eligibility expansions, such as those proposed by California and Pennsylvania and recently passed in New York,³⁸ may increase Medicaid enrollment and corresponding expenditures even more in future years. However, the exact amount that these projected program expansions will increase states’ spending obligations is unclear.

The Centers for Medicare & Medicaid Services, which predicted less than a 1 percent growth rate in Medicaid in 2006, expects Medicaid to grow between 7.3 percent and 8.3 percent over the next several years.³⁹ This is above the rate of inflation and, in most years, greater than Medicare and private insurance growth. Adding to concern over the potential for Medicaid to grow faster than expected is the fact that these projections were made prior to the changes in eligibility for the Medicaid program mentioned previously. Also uncertain is the level of federal funding for the State Children’s Health Insurance Program (SCHIP), which is due for reauthorization by September 30, 2007. If federal funds are insufficient, states may end up shifting a share of program costs to Medicaid. Finally, the proportion of people over age 65 will increase significantly as the “baby boom” generation retires. Medicaid is the largest public source of funding for long-term care in the United States, representing 49 percent of total national long-term care expenditures in 2004. About one-third of Medicaid spending is for long-term care.⁴⁰ The growth in spending by the federal government and states for long-term care services through Medicaid will likely continue to increase as the population ages.

If federal funds are insufficient, states may end up shifting a share of program costs to Medicaid.

States’ long-term fiscal obligations—A fourth important financial burden for states in the years to come is state employee pension and benefits obligations. Before 2004, states did not account publicly for all of these expenses, but that changed in 2004 when the Governmental Accounting and Standards Board (GASB) issued “Statement No. 45,” (GASB 45), which required governments to report annual “other than pension employee benefits” (OPEB). States must report unfunded actuarial accrued liabilities (the difference between a government’s total obligation for OPEB and any assets it has set aside for financing the benefits).⁴¹ Financing these obligations will be a substantial challenge for many states. For example, Illinois estimates that its unfunded liability in the state pension system is over $40 billion.⁴² In California, Governor Schwarzenegger established a commission to address public employee pensions and other obligations, which must recommend by January 2008 a plan to the legislature for dealing with these liabilities.⁴³ And New Jersey’s pension fund, estimated to be the sixth largest in the country, is also estimated to be $56 billion in deficit.⁴⁴ Some states view the GASB 45 requirement as the top issue for the 2007 legislative session.⁴⁵ The states’ difficulty in meeting the requirements shows how the aging of the baby boom generation will have major implications for state budgets. As baby boomers retire from state jobs, pensions and retiree health care costs for states will be significant.

State Variations Persist

The degree to which states’ budgets and Medicaid programs thrive or lag may vary. Thirty states have made revenue forecasts for FY 2008, 23 for FY 2009, and 14 for FY 2010. The growth estimates range from 0.5 percent to 6.5 percent in FY 2008. For FY 2008 through FY 2010, the revenues of those states that make projections are expected to be lower than nominal GDP changes each year.⁵¹ Contributing to differences in states’ economic conditions are the varied changes in their tax laws and new policy directives.

Tax changes can vary considerably. Oregon is projecting $1.3 billion in refunds, while other states predict much less. Regionally, the Southwest and the Rocky Mountains states saw the biggest changes in tax revenues in the first fiscal quarter of 2007—nearly 12 percent, while the far West experienced growth of less than 2 percent.⁵²

There may also be widening differences in states’ Medicaid programs. Already, states vary significantly in terms of the eligibility levels they use for Medicaid, the services they cover, and their mechanisms for care delivery. The Deficit Reduction Act of 2005 makes it even easier for states to tailor their Medicaid programs to meet both fiscal and political priorities.⁵³ Some states may choose to continue looking for ways to contain costs in their Medicaid programs, while others may choose to expand them. Whether states choose expansion or retraction may depend on their financial health.

In addition to variations in spending, revenue collection, and Medicaid program costs, demographics and long-term debts also are likely to create different situations for state budgets. States that have lower long-term pension obligations and fewer high-needs populations may have an easier time in the coming years. The structure of state economies will also create differences in states’ financial health. States that can adapt their workforces more easily in ways that produce economic growth are likely to do better then those with less adaptable workforces and industries.

Addressing the FMAP

As noted previously, during times of economic slowdown and increased unemployment, more people turn to Medicaid for assistance with medical care needs. However, the nature of the financing structure makes the program inherently more vulnerable during these times of greater need. (And, perhaps a bit ironically, states may receive a higher proportion of federal Medicaid funds during strong economic times because of the lag in the data used for the FMAP calculation.)

Analysts representing a wide range of perspectives (state, federal, and beneficiary groups) have come up with several suggestions for making the federal matching formula more appropriately responsive to the economy:

▪

Increase the FMAP by one percentage point for states with higher unemployment rates (or during times of higher national unemployment rates).

▪

Shorten the time period for calculating the average per capita income for each state (for example, from three years to two years).

▪

Apply the new matching rates in the same year they are cal - culated, rather than delaying them for two years.⁵⁴

While these modifications may seem highly technical, the slight changes that would result could mean the difference in states’ ability to sustain program expansions and other experimentation, regardless of inevitable fluctuations in the economy. Of course, such changes would require a commitment by the federal government to provide a higher level of support to states through a program that has grown exponentially over the past several years.

Policy Questions

Now that states and Medicaid have weathered the storm, policymakers will need to consider a few fundamental questions about the program’s future. The uncertainty of state finances and the dynamic between the federal and state governments raise important policy questions for the Medicaid program.

How sustainable is Medicaid, given state fiscal volatility? As discussed in this paper, states are more likely to expand Medicaid eligibility when revenues are strong. But because Medicaid is countercyclical, the number of enrollees and resulting expenditures grow when state economies are weak. The fact that Medicaid tends to grow at precisely the time states are looking to cut spending makes the program vulnerable.⁵⁵

Should the Medicaid financing relationship between the federal and state governments change? Questions about the state-federal fiscal partnership of Medicaid are often raised when Medicaid expenditures are at issue. Should the federal government change the way it finances Medicaid so that the allocation of funding to states is more responsive to the economy? Should the formula consider factors in addition to per capita personal income levels? Should the FMAP rates continue to be based on three-year averages or should they be updated more frequently? Should certain responsibilities be shifted from states to the federal government, and vice versa, for better cost management? For example, should states bear the fiscal responsibility for caring for low-income children and families, while the federal government bears the fiscal responsibility for the elderly and disabled and those dually eligible for Medicare and Medicaid? How much fiscal responsibility should the federal government assume for state-initiated Medicaid expansions? Given the commencement of the Medicare Part D drug benefit, should states be relieved of the fiscal responsibility of having to pay the federal government for estimated savings to the Medicaid program? Finally, should the funding formula for Medicaid be based, at least in part, on unemployment rates, which—given the country’s overall reliance on the employer-based health insurance system—could provide a fairly reliable indication of anticipated need for assistance with medical costs?

How large a role will Medicaid play in covering the uninsured? Medicaid’s utility as a means for covering the uninsured is being debated by Congress and the 2008 presidential candidates. Some of the candidates and members of Congress view Medicaid/SCHIP expansion, combined with other initiatives, as a means to universal health insurance coverage, while others seek alternate solutions. Regardless of whether politicians at the federal level view Medicaid/SCHIP expansion as part of a solution for covering the uninsured, state governments are already moving forward. In the absence of a federal initiative to expand the Medicaid program, the more pressing question for federal policymakers is the degree to which they will politically and financially support states’ expansion efforts.

How vested is the federal government in sustaining Medicaid in future years? If the fiscal circumstances of states become as precarious as they were from 2001 to 2003, a second question is whether the federal government, given its fiscal obligations, could provide the same type of fiscal relief for states as it did under the Jobs Growth and Tax Relief Reconciliation Act of 2003, which allowed many states to avoid cuts to their Medicaid programs. That last fiscal crisis occurred at a time when federal government had fewer long-term financial obligations (that is, before the wars in Iraq and Afghanistan). How would states avoid significant cuts in Medicaid if the economy were the same as it was during the recent recession but states received no equivalent federal fiscal relief?

What is the appropriate role for Medicaid in financing long-term care? The looming growth in the U.S. elderly population raises questions about Medicaid’s large role in funding long-term care services. Should the federal government assume greater responsibility for paying for care for the elderly? Was the addition of the Medicare Part D drug benefit in 2006 just the first step toward the federal government’s fully covering the health care needs of Medicare beneficiaries? The answers to these questions could affect whether Medicaid will continue to be the major source of funding for a growing number of people in need of long-term care.

How federal and state governments respond to these policy questions may be partially dependent on the fiscal health of states. But these questions also depend on how states and the federal government view their intergovernmental relationship and how they think the responsibilities to Medicaid should be balanced between the two levels. Can the intergovernmental relationship that maintains Medicaid be expected to continue in the future? Only time will tell how the fiscal health of state budgets will affect policy discussions on the future role of Medicaid as a major provider of health insurance coverage.