New York’s budget has sprung its first major leak just five days after being finalized by Governor Hochul and the Legislature.

On Tuesday, federal officials announced a policy change that would effectively cancel the state’s newly enacted MCO tax, which was designed to generate billions in extra federal aid by exploiting a loophole in the Medicaid financing system.

The budget approved last week used most of that revenue to increase Medicaid spending, including rate hikes for hospitals, nursing homes, physicians and clinics worth more than $2 billion per year.

Under a rule change proposed by the Centers for Medicare & Medicaid Services, however, New York would collect only a fraction of what it was expecting – meaning those rate hikes cannot go forward as budgeted.

New York had expected that it could exploit the loophole for two years, from Jan. 1, 2025, when its MCO tax went into effect, through the end of 2026 – during which time it anticipated netting $3.7 billion in extra federal aid. Now it appears it will collect less than half that amount, leaving a potential hole of $2 billion or more in its financial plans.

This turn of events should not come as a complete surprise. In granting permission for New York and other states to levy MCO taxes, CMS officials warned that such taxes violate the spirit of federal law – and that the agency would be tightening its rules going forward.

“Please be advised that any future changes to the federal requirements concerning health care-related taxes may require the state of New York to come into compliance by modifying its tax structure,” CMS wrote to state Medicaid director Amir Bassiri in December. 

CMS’s effort to close its regulatory loophole appears to have accelerated after the Trump administration took over in January.

The tax on managed care organizations, or MCOs, is a tactic for exploiting Medicaid’s financing system, under which the federal government pays half or more of the expenses incurred by each state’s program.

New York’s plan – inspired by a similar scheme in California – was to impose a tax that primarily targeted MCOs serving Medicaid recipients (see table).

Under existing CMS rules, Medicaid would reimburse MCOs for the expense of this tax, with the state and federal governments each paying half. The state would pay itself back out of the tax proceeds – and keep the federal matching aid as net revenue. In effect, the state would be taxing the federal government.

The federal government has long tried to limit these maneuvers, including by requiring that health care-related taxes must be “broad-based” and “uniform.” However, CMS can waive those requirements if a tax is shown to be “generally redistributive in nature” – meaning it shifts resources from non-Medicaid providers to Medicaid providers – based on a statistical test written into the agency’s regulations.

In recent years, California, New York and other states found ways to tailor their taxes that would pass the so-called B1/B2 test while flouting the “broad-based” and “uniform” standards – and maximizing how much federal aid they would generate.

CMS discussed this trend in the preamble to the regulatory proposal released on Tuesday:

[O]ver the last decade, CMS became aware that some States are manipulating their health care-related taxes to impose tax structures that the State intends not to be generally redistributive, but that were still able to pass the B1/B2 test. In these cases, the State does not impose taxes on non-Medicaid services in a class to then use the tax revenue as the State’s share of Medicaid payments. Instead, the States derive the vast majority of their tax revenue from Medicaid services, which they then use to fund the non-Federal share of Medicaid payments. In essence, this process results in a simple recycling of Federal funds to unlock additional Federal funds.

CMS said it would continue using the B1/B2 but add “safeguards” to prevent what it views as abuse – estimating that this will save the federal government $33 billion over the next five years.

For existing taxes that have been in place for more than two years, the agency is allowing a one-year “transition period” during which states can continue receiving federal aid as before while they revise their tax structure.

For taxes approved more recently – including New York’s – CMS is not proposing a transition. Instead, it said it will start withholding federal matching funds for those taxes as soon as the regulation takes effect, which could be as soon as this summer.

Although the revenue from the MCO tax was always expected to be temporary, state lawmakers nevertheless chose to use it to finance ongoing expenses, such as reimbursement hikes for providers that are typically considered permanent unless the state acts to revoke them. Fiscal watchdogs had warned that this would put Medicaid on the path to a fiscal cliff, when it predictably run out of revenue to keep its spending commitments.

With yesterday’s action by CMS, that fiscal cliff appears to be just two or three months away.