The Centers for Medicare & Medicaid Services (CMS) issued a proposed rule that would close a Medicaid tax loophole exploited by states to inflate federal payments to states, and free up state funds for non-Medicaid purposes. Some states have exploited these tax loopholes to take money from federal taxpayers and then simultaneously spent "state" money on new benefits for illegal immigrants. This regulatory move is projected to save taxpayers more than $30 billion over five years and continues CMS' work in ensuring this vital safety net continues to be available for the country's most vulnerable populations in the future.
"States are gaming the system—creating complex tax schemes that shift their responsibility to invest in Medicaid and rob federal taxpayers," said CMS Administrator Dr. Mehmet Oz. "This proposed rule stops the shell game and ensures federal Medicaid dollars go where they're needed most—to pay for health care for vulnerable Americans who rely on this program, not to plug state budget holes or bankroll benefits for noncitizens."
Here's how it works: Under the law, states can tax stakeholders and use that as part of their state share for Medicaid, as long as those taxes are uniform and broad based, or they can pass certain regulatory tests. Taxes are not permitted when they are not generally redistributive – and these loophole taxes are solely designed to game the higher federal match by taxing a type of entity, drawing down a high federal match (ranging up to 77% for traditional Medicaid populations), and then redistributing those federal dollars back to the very same entities that were taxed – that's what most Americans call money laundering. Specifically, certain states are imposing taxes on all managed care organizations (MCOs), yet structuring the tax so that it only affects Medicaid business within those MCOs – the ones who will benefit from the federal match in the form of payments from the state back. In California, Medicaid business in certain cases is taxed at $274 per member/per month, while non-Medicaid business is taxed at just $2 per member / per month.
These arrangements allow states to benefit from a budget surplus to reinvest in unrelated programs—including the $8.5 billion program in California to cover more than 1.6 million illegal immigrants and other non-citizens.
"This isn't just wasteful—it's wrong," said Drew Snyder, CMS Deputy Administrator and Director of Medicaid & Children's Health Insurance Program (CHIP) Services. "Medicaid was designed to protect low-income seniors, pregnant women, children, and people with disabilities—not subsidize coverage schemes that displace our most vulnerable. We are restoring Medicaid to its original purpose and ensuring the intent of the law is followed."
In its final year, the last Administration approved four waivers that exploit this tax loophole, submitted by California, Michigan, Massachusetts, and New York. Together, these four states are responsible for more than 95% of projected federal taxpayer losses under the loophole. If CMS had not taken decisive action, more states could have exploited this tax loophole. A CMS estimate shows that if just two more states adopt these schemes each year, excess federal costs could balloon more than $74 billion over 5 years.
The CMS proposed rule would:
- Prohibit states from taxing Medicaid business at higher rates than non-Medicaid business;
- Bar the use of vague language to disguise Medicaid-specific taxes;
- Maintain statistical testing while adding safeguards to prevent system gaming; and
- Provide a transition timeline based on the age of existing waivers.
Medicaid is a shared federal-state responsibility. CMS' proposal reaffirms that partnership, while ensuring states cannot manipulate the system at the expense of federal taxpayers.
The proposed rule can be viewed at the Federal Register and will be open for public comment until July 14, 2025.
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