The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

Primary Credit Analyst: Gabriel J Petek, CFA, San Francisco (1) 415-371-5042; gabriel.petek@standardandpoors.com

Table Of Contents
States As Agents Of Macroeconomic Policy Extraordinary Times May Not Always Call For Extraordinary Measures Secular Stagnation Medicaid's Part In the Federal Fiscal Outlook As A Driver Of Potential Reform Medicaid's Growth Has Resulted From Policy Changes And Health Care Inflation What To Watch For

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States
By almost any measure, Medicaid is a massive program. The Congressional Budget Office (CBO) estimates that each month in 2013 an average of 57 million, or more than 18%, of Americans will have obtained their health insurance coverage under Medicaid. For the states, Medicaid is also a fiscal behemoth, consuming more of their total budgets than any other program. And although when pressed, states can engage in a variety of cost containment measures, Medicaid spending trends mostly lie outside of the states' control. Furthermore, the program's enrollments and costs are countercyclical, spiraling upward when the economy slumps, exacerbating budgetary strain during recessions. Yet, despite what conventional wisdom might suggest given its prominence and countercyclical cost pressures, Medicaid has played an understated role in state credit quality through the years. Standard & Poor's Ratings Services has rarely, if ever, linked a change in a state's credit ratingup or downspecifically to Medicaid. Overview Medicaid is the biggest single expense item in state budgets. While rarely if ever has a state rating been linked to Medicaid, this might change, as its effect on state budgets and economies increases. It'll probably take another recession for the effect of Medicaid expansion on states' credit profiles to become clear.

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

Chart 1

There is reason to wonder whether this could change, however, because with the arrival of 2014, Medicaid is set to undergo an unprecedented enlargement. As part of the Patient Protection and Affordable Care Act (ACA), and following the U.S. Supreme Court's June 2012 ruling on its constitutionality, states have the option to significantly expand their Medicaid programs. As the expansion process begins, market participants may wonder whether we expect to differentiate state credit quality based on whether states adopt or reject the expansion option. The answer to this and other questions depends on how an expanded Medicaid program will function once it's in place. For example, will Medicaid expansion under the ACA make the program a more efficient vehicle for the delivery of fiscal stimulus during economic downturns? If yes, then the expansion states may bounce back from recession faster than non-expansion states. But if not, then the additional fiscal burden associated with expansion, despite being a small part of the overall costs, may outweigh its economic benefits from a credit standpoint. As the nation's health care insurance model undergoes an unprecedented reform, we believe there are some risks, as well as potential upsides, to state credit quality. And while we believe it's premature to say whether the net effect of the ACA and Medicaid expansion on state credit quality will be positive or negative, we have begun to analyze the tradeoffs involved.

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

First, a bit of background is warranted. Since Medicaid's inception in 1965, states opting to participate in the program have been eligible to receive federal matching funds for providing Medicaid coverage to certain covered populations. By virtue of Medicaid's status as a federal entitlement, states can be assured they will be reimbursed for eligible expenditures. The federal government matches state expenditures according to a formula that provides a higher subsidy to states with lower per capita incomes relative to the national average, and vice versa. On average across all the states, the federal matching rate is 57% (the subsidy rates across the states currently range from 50% to 74%). States have considerable latitude in the design of their Medicaid programs but they are required to cover certain mandatory populations and core services. The federally required populations that state Medicaid programs must cover include children, pregnant women, the disabled, seniors, and parents, all subject to various income test thresholds relative to the federal poverty level (FPL). Under the ACA, states have the option to extend coverage to childless adultsa group that has traditionally not been eligible for Medicaidwith incomes of up to 138% of FPL. Unlike for the previously eligible populations, under the ACA the federal government will initially provide a 100% match for state spending on the newly eligible population. In 2016, the federal subsidy rate for the newly eligible population will begin to taper, eventually reaching 90% in 2020, where it will remain thereafter. Currently, about half the states are planning to expand their Medicaid programs as envisioned under the ACA. Beginning in March 2014, most individuals are required to have obtained health insurance coverage under the ACA's "individual mandate." And although the ACA's effects on the private health insurance market have received much of the attention to date, Medicaid is likely to provide a majority of the new health insurance coverage. The CBO forecasts that the number of uninsured will decline by 14 million in 2014 as a result of the ACA, with as many as nine million becoming covered under Medicaid. A significant portion of the newly insured people, however, is from among the population of those that are currently eligible but not enrolled in Medicaid. Due to the ACA's individual mandate provision, enrollments from this population are likely to increase even in the states that do not adopt the Medicaid expansion option. But unlike for the newly eligible population, states will only receive federal funds at their traditional match rates (57% on average) for the new enrollees that were previously eligible.

States As Agents Of Macroeconomic Policy

So far, we have focused on Medicaid's attributes as a health insurance program, but given its magnitude, it also plays an important role in the macro economy. The federal government, acting through the states and using Medicaid as a ready-made platform, is able to inject billions of federal dollars into the economy. In 2011, for example, of the $607 billion in federal grants to state and local governments, 45% was for Medicaid, far more than for any other individual program. During recessions, when unemployment rises and income levels fall, more people become eligible for Medicaid. At these times, Medicaid is a safety net program that also performs an economic function. This is because the increased spending that accompanies the growing Medicaid caseloads serves as a source of income for health care providers. Once it is spent to purchase Medicaid services, each dollar continues to circulate and, through a multiplier effect, raises the overall level of economic activity in a state. Federal matching funds further magnify the economic impact of a state's Medicaid spending. For a state at the average federal matching rate of 57%, each dollar it spends is met with

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

another $1.33 in federal funds. And unlike large infrastructure programs, which can take years of planning and multiple layers of regulatory and governmental approvals, Medicaid can deliver billions in federal funds within weeks or months. Furthermore, because of its status as a federal entitlement, the increased federal outlays that occur during recessions don't require Congressional action. For the states that adopt expansion, there is potential that Medicaid will pack an even more potent economic punch than it does for the states that reject the expansion option. Under the expansion option, Medicaid coverage is available to the low-income childless adult population. As a group, the personal situations of the working age adult population tend to be more sensitive to economic conditions than the traditional Medicaid populations. Therefore when the economy softens, the declining employment and income levels in the economy will have a relatively greater impact on the childless adult population. Correspondingly, states that adopt Medicaid expansion to include the childless adult population are likely to experience a proportionately larger increase in enrollments. And since the federal government will pick up almost all the cost of covering this population, the receipt of federal funds under the expansion option amounts to pure fiscal stimulus for the states that adopt it. Enrollment data from the Kaiser Commission on Medicaid and the Uninsured (KCMU) during the Great Recession support our view. Enrollments from among the elderly and disabled populations grew at an annual rate of 3.3% from 2007 through 2009, similar to Medicaid's overall long-term enrollment growth rate. However, the non-disabled children and adult enrollmentsgroups that are more similar to the expansion populationgrew at 6.5% per year during the same period. On the other hand, the states opting against Medicaid are likely to continue to exhibit the enrollment and spending patterns that were in place prior to expansion. In 2011 and prior to expansion, for example, the elderly and disabledwhose health care spending is less tied to cyclical economic conditionsaccounted for 65% of total Medicaid spending despite representing just 26% of enrollments. Although Medicaid expenditures have always been countercyclical, the programs in the non-expansion states may prove to be less so over time than those in the expansion states.

Extraordinary Times May Not Always Call For Extraordinary Measures

Besides being an instrument of macroeconomic policy, Medicaid is also a major budgetary cost for the states, consuming 19% of their general fund budgets in fiscal 2013 according to the National Association of State Budget Officers (NASBO). And whereas Medicaid's countercyclical expenditure patterns may be helpful from an economic standpoint, they may contribute to fiscal stress for the states during downturns. In effect, by participating in Medicaid, the states are charged with engaging in countercyclical fiscal policy despite being institutionally ill-equipped to do so because of their balanced-budget requirements. In an apparent recognition of this inherent tension, during the past two recessions, Congress has stepped in with extraordinary federal fiscal assistance for the states' Medicaid programs. When the states were collectively facing fiscal emergency in 2009, Congress provided an estimated $89 billion in enhanced Medicaid funding as part of the American Recovery and Reinvestment Act (ARRA). Initially set to expire at the end of 2010, Congress subsequently supplemented it and extended the enhanced levels of Medicaid funding by $16.1 billion through June 2011. In total the states would receive an estimated $105.1 billion in enhanced federal Medicaid funding over 32 months. The extraordinary federal funds reduced the fiscal burden on the states, whose

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

share of total Medicaid expenditures declined to about 34% under ARRA from the regular 43%. The federal funds were a critical fiscal lifeline for the states as they struggled to balance their budgets in the face of more than $400 billion in cumulative budget deficits for the three years through fiscal 2011. In fact, because of the additional federal funds, the states' own-source general fund spending on Medicaid declined by 10.9% and 7.1% in fiscal years 2009 and 2010, the only such declines in the program's history. But given the differentand more stridently partisanpolitical landscape in Washington, we believe it's unlikely now that another round of extraordinary federal fiscal support would be made available to the states. We assume that in a recessionary scenario, the states would be left to bear their full share of total Medicaid costs without any special federal fiscal aid. (Although we note that because of the higher matching rate for the expansion population, the overall share financed by the states will decline somewhat to about 39% or 40%). So although Medicaid may serve a helpful economic function for the states during recessions, it may be outweighed from a credit perspective by their fiscal responsibilities related to the program at these times. The increased enrollments and costs could be enough to weaken states' finances to a point that it would undermine their credit quality. And the threat to credit quality as a result of the fiscal burden from Medicaid could potentially be greater among the states that adopt Medicaid expansion. Starting in 2020, the expansion states are scheduled to cover 10% of Medicaid costs for the newly eligible population. Keeping in mind that this population is likely to be more sensitive to economic cycles, we believe that the obligation to fund even a small share of their Medicaid costs could result in budget pressure during a severe downturn.

Reshaping the federal-state fiscal relationship via Medicaid expansion

Having the option to adopt or reject the Medicaid expansion represents a major policy decision. And the amount of federal funding at stake is enough to begin reshaping the federal-state fiscal relationship. But although the Supreme Court ruled that the states are free to opt out of Medicaid expansion, they cannot opt out of the taxes that were imposed to help finance Medicaid expansion. In effect, by paying the ACA-related taxes, the taxpayers in states not expanding their Medicaid programs will be subsidizing those in states that are expanding their programs. The KCMU commissioned a study by the Urban Institute which found that in 2016 alone, there is about $81 billion in incremental new federal funding available if all states were to expand. The 25 states (plus D.C.) that are moving toward expansion are poised to collect a $37.5 billion increase in federal Medicaid funds in 2016. Conversely, the non-expansion states are foregoing $43.1 billion in potential federal Medicaid funds. Under the traditional federal Medicaid funding formula higher subsidy rates go to the states with lower per capita incomes. But because the richer states are opting for expansion while the lower income states are rejecting it, the Medicaid expansion is beginning to reverse the historic direction of federal flows. We have calculated that the expansion states have per capita incomes equal to 112% of the non-expansion states. Similarly, using KCMU's estimates, we calculate that the amount of new federal funding the expansion states can expect to collect from 2013 through 2022 will equal 4.07% of their 2012 GDPs. But for the non-expansion states, the foregone federal funding would equal a larger 6.01% of their 2012 annual GDPs (see table). In short, based on the current status of each state relative to the expansion option, the new additional federal funding made available under the ACA will be going to the richer states with larger economies. Whether this matters from a credit perspective really depends upon which effect from Medicaid expansionthe potential economic boost or the

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

additional fiscal obligationwinds up having the most influence. It may not be until the next recession hits that the implications of Medicaid expansion in state credit profiles is more fully understood.

Secular Stagnation
Apart from the risk of another recession, some economists have begun to posit that the economy has entered secular stagnation, implying that it is in the midst of a prolonged slump rather than just cyclically soft. If that is true, demand for a range of social services could remain elevated. For states, especially those that opt for expansion, this would translate to sustained pressure on budgets as a result of higher rates of Medicaid enrollment and utilization. In its February 2013 long-term budget outlook, the CBO revised its estimate of the natural rate of unemployment to 6.0% from 5.0%. The CBO pointed to a mismatch between the skills and locations of workers relative to employer needs as the reason for the change. The adjustment reflected the CBO's view of the economy's structure more than its cyclical performance. Prior research suggests that for every one percent rise in unemployment, Medicaid enrollment increases by around one million, or almost two percent. The CBO's revised economic outlook was accompanied by an upward revision to its Medicaid enrollment projections. Compared with its July 2012 forecast, the CBO's updated May 2013 projections anticipate enrollments will be two million and three million higher in 2014 and 2015, respectively (see table). The CBO's forecast captures Medicaid enrollments driven by both cyclical and structural forces behind its unemployment projections. The forecast demonstrates that beyond the effects of a cyclical downturn, if the structural unemployment rate has risen, states could face a persistent source of Medicaid-related fiscal pressure. Economic Impacts Of Medicaid Expansion
Per capita income as a % of the U.S. States not expanding Medicaid at this time Alabama Alaska Florida Georgia Idaho Indiana Kansas Louisiana Maine Mississippi Missouri Montana Nebraska New Hampshire North Carolina Oklahoma 82.1 113.0 93.8 85.6 78.8 87.2 98.4 91.6 91.7 77.0 89.5 88.2 102.9 112.3 86.7 92.9 7.8 2.8 8.5 7.8 5.6 5.8 3.8 6.5 5.8 14.3 6.9 5.2 3.1 3.7 8.7 5.3 Estimated additional funds from Medicaid expansion, 2013-2022, as share of 2012 state GDP (%)

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

Economic Impacts Of Medicaid Expansion (cont.)

Pennsylvania South Carolina South Dakota Tennessee Texas Utah Virginia Wisconsin Wyoming Average of non-expanding states States expanding Medicaid Arkansas Arizona California Colorado Connecticut Delaware District of Columbia Hawaii Illinois Iowa Kentucky Maryland Massachusetts Michigan Minnesota Nevada New Jersey New Mexico New York State North Dakota Ohio Oregon Rhode Island Vermont Washington West Virginia Average of expanding states 81.0 82.9 106.3 104.7 136.5 101.1 171.0 102.4 104.8 100.5 81.5 123.1 128.0 87.6 107.3 87.4 125.7 81.6 121.7 125.5 91.6 89.6 104.9 101.9 105.3 80.2 105.1 6.8 4.0 3.4 3.8 3.6 2.9 0.8 4.5 3.1 2.6 10.3 3.9 1.8 4.4 1.9 4.2 3.0 6.1 4.7 5.1 10.5 6.5 5.8 3.8 2.2 12.6 4.7 103.1 80.2 103.8 88.6 97.5 81.0 110.6 96.3 115.6 93.9 6.3 9.0 5.0 8.1 4.7 4.0 3.3 4.7 3.5 6.0

Source: Urban Institute Analysis, Status of State Action on the Medcaid Expansion Decision as of Oct. 22, 2013. Income and gross state product data is from U.S. Bureau of Economic Analysis.

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

Medicaid's Part In the Federal Fiscal Outlook As A Driver Of Potential Reform

A rise in the concern among lawmakers in Washington about the federal deficit has brought the federal government's rate of Medicaid spending growth into sharper focus. CBO recently reported that from 2004 through 2013, federal Medicaid spending growth increased at an average rate of 8%, which is faster than the overall rate of spending growth on federal mandatory programs of 5.6. Federal Medicaid spending has also grown faster than real U.S. GDP, which expanded at an average annual rate of 3.86% from 2003 through 2012. Over the next 10 years and once the ACA is fully implemented, the CBO expects federal Medicaid spending will have increased to 11% of non-interest federal expenditures from around 8% in 2013. In the context of the debate around federal deficits, Medicaid's open-ended federal funding model has come under intensifying scrutiny in recent years. Although at this point they have not had bipartisan traction, the most significant reform proposals developed to date would convert Medicaid to a block grant or establish some kind of federal spending caps.

Federal spending cap or block grant

In its November 2013 report presenting options for reducing the federal deficit from 2014 through 2023, the CBO put forward the concept of capping federal Medicaid outlays. In our view, capping federal Medicaid outlays would function similarly to a block grant, which the House of Representatives passed in its budget proposal for fiscal year 2014. Although the details would differ, the two models have one important implication for the states. Once a state's Medicaid costs exceeded the funding caps or block grant amounts, any residual fiscal burden would fall to the states. Most of the proposals to establish federal caps or block grants provide states with increased flexibility, allowing them to conceivably find areas of savings within their existing Medicaid programs. However, besides the option of simply curtailing the level of benefits offered, we are skeptical that there are a plethora of efficiencies to be exploited in the Medicaid programs. For despite the program's overall spending growth, on a per-enrollee basis, Medicaid spending has increased at a slower rate (4.6%) than have private insurance premiums (7.7%), according to the KCMU. Furthermore, administrative expenses only made up about 5% of state Medicaid spending in 2012, leaving relatively little room for material savings (also based on reports from KCMU). CBO reports that capping federal spending could generate federal savings of between $105 billion and $450 billion from 2016 through 2023, depending on how it is structured. And we believe that federal spending caps or block grants would diminish Medicaid's role as an automatic stabilizer. The states would be more exposed to the full brunt of economic recessions if federal Medicaid funding to the states were lessif at allcountercyclical under a block grant scenario. Thus one of the program's strongest attributes--its countercyclical fiscal support function--could be lost to the states in a block grant type program. Under such a funding model, the states could be exposed to greater recessionary variability and potentially greater ratings volatility. By having leveraged greater amounts of federal funding, the expansion states would be subject to even more economic dislocation if federal funds were capped than would the non-expansion states.

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

Medicaid's Growth Has Resulted From Policy Changes And Health Care Inflation
At slightly more than 18% of the U.S. population the average monthly rate of Medicaid enrollment in 2013 was roughly twice the level of the 1980s. The rising rates of Medicaid enrollment have been the result of both policy and economic changes. Throughout the latter part of the 1980s, Congress liberalized eligibility. The persistently weaker economic conditions in recent years have also left more people eligible for Medicaid. According to the Office of the Actuary of the Centers for Medicare and Medicaid, Medicaid enrollment could reach 77.9 million by 2021, topping 23% of the U.S. population. Increasingly, we see the states' finances and credit quality as sharing linkages with the nation's health care system. For one thing, health care simply accounts for more of what states do. Medicaid spending by the states has already increased to 19% of general funds in 2013 from 8.1% in 1987, according to data collected by NASBO. Similarly, the program has increased to 24.5% of total state budgets in 2013 from 10.2% in 1987, also according to NASBO. And these increases are before the expansion initiative.
Chart 2

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The Big Rollout: Medicaid Expansion Marks A Major Policy Change For States

For this reason, all the states, whether or not they are adopting Medicaid expansion, have a stake in the success of the ACA insofar as one of its objectives is to reduce the rate of health care inflation. For the past several years, the rate of national health spending has been lower than at any point since 1960, when the federal government began tracking it. It's unclear, however, how much of the reduced rate of health care inflation is the result of a slower economy and low inflation generally versus changes to the national health care system. Most likely, it is the effect of some combination of the two. Sorting out the underlying driver of the health care spending slowdown is important. If most of it is just the result of a weaker economy, then the inflationary bias will likely accelerate again if growth picks up to something approaching historic norms. But if a significant portion of the slowdown is the result of policy changes, then the fiscal implications to states of the ACA could be more favorable over the longer term. In February 2013, the CBO incorporated the recent slower rate of health care spending growth into its forecast by revising its projection of total Medicaid spending growth down by 5.6% through 2022. In our view, if the CBO's forecast proves accurate, total spending by the states on Medicaid through the same timeframe could be commensurately lower than previously projected as well.

What To Watch For

At this point, the credit implications to states from the ACA, Medicaid expansion, and the likelihood of a less supportive federal government are not fully understood. While we acknowledge the potential additional economic boost Medicaid could offer to the states during downturns, it also involves a substantial fiscal commitment on their part. If health care inflation picks up again, even the incremental additional costs to the states under expansion could add material fiscal strain. Moreover, in a number of early expansion trial programs, some states have found that adding the expansion population has proven more costly than they had forecast. This suggests that the fiscal burden to the states from expansion could be greater than what they currently project. In a different vein, and somewhat counterintuitively, federal Medicaid funding (as a mandatory federal expenditure and an entitlement) has emerged as a relatively reliable source of funding for states in recent years. This has remained true even as federal fiscal policy more broadly has become less certain. Again, the expansion states have the advantage to the extent this remains true. But should the federal deficit hawks prevail in capping federal Medicaid expenditures, the expansion states would be more economically and fiscally vulnerable to the effects of a curtailment of federal funds. It's too soon to know the outcomes of these and other unknowns that make up the health care reform initiative. For example, it currently appears that in 2016, governments and hospitals in the non-expansion states will also face greater exposure to costs related to providing uncompensated care to indigent patients. When it was passed, the ACA included a phasing out of federal funding that was used to reimburse hospitals and local governments for the cost of providing care to indigent patients. Planners expected costs related to the indigent population to decline and be absorbed under Medicaid as the program expanded. But now that expansion is a state option as opposed to a requirement, the ACA appears poised to simply shift the cost of care for the indigent patients from the federal government to some combination of the states, local governments, or providers themselves. The recent budget agreement in Congress may be angling to defer these cutbacks until 2016, however. With a myriad of uncertainties like these, the only thing we can be sure about is that Medicaid's role in state finances is on the rise.

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