Medicaid’s Flawed Response to Economic Downturns

When recessions hit, Medicaid is supposed to help stabilize state economies. But its structural flaws prevent meaningful aid from being distributed quickly.

Medicaid is usually regarded as a health insurance program for low-income people. That view isn’t wrong, of course, but it is incomplete. Another, less often noted, objective of Medicaid is to provide macroeconomic stability by automatically injecting money into the economy when aggregate demand slackens. The trouble is, it’s pretty bad at it.

Before getting into the details of how Medicaid reacts to economic downturns, it’s important to appreciate the sheer size of the program. Medicaid spending accounts for more than 3 percent of U.S. GDP and represents — by a very wide margin — the single largest intergovernmental subsidy in the country. Each year, the program transfers about $500 billion from the U.S. Treasury to state coffers. In 2019, Medicaid accounted for 65 percent of all funding flowing from the federal government to the states. (As a point of comparison, only 8 percent of federal grants that year were targeted to transportation projects.)

Consequently, even small shifts in federal Medicaid funding can have a large impact on state budgets and the macroeconomy. In 2016, Medicaid accounted for more than one-quarter of all state spending. In most states, the only budget category more costly than Medicaid is K-12 public education.

Medicaid enrollment and spending are counter-cyclical, increasing during times of economic distress when employment-sponsored health coverage shrinks as jobs are lost and the number of low-income Americans grows. On top of that, economic downturns usually cause state revenues to stagnate or decline, reducing states’ fiscal capacities precisely when more people are reliant on the social safety net. And since nearly all states face balanced budget requirements, barring them from running deficits to accommodate higher Medicaid spending during recessions, the infusion of federal Medicaid cash helps states stay afloat.

On the surface, Medicaid’s funding rules seem reasonably responsive to changing economic conditions. Each state’s share of Medicaid spending is primarily determined by the Federal Medical Assistance Percentage (FMAP), derived from a formula that shifts a larger proportion of Medicaid expenditures to the federal government in states with lower per capita personal income relative to the national average. Conversely, states with higher per capita personal income are responsible for a larger share of their Medicaid expenditures. So if a state enters a recession, its personal income per capita should fall and automatically trigger larger federal Medicaid payments, right?

In practice, it’s not so simple.

First, the FMAP formula is based on the ratio of state and national per capita personal incomes. When a single state or region experiences a dip in personal income, the FMAP formula ensures that these states receive more federal aid. But if the country enters a recession that affects all states similarly – by reducing personal income fairly evenly across the country – each state’s FMAP doesn’t change much, since the ratio of each state’s per capita personal income to national per capita personal income stays about the same.

Second, there’s a substantial time lag in the collection and calculation of the personal income data used to determine FMAP rates. It takes years for statisticians to generate state-level estimates of personal income, and the problem is compounded by the fact that the figures used in the FMAP formula are based on a rolling three-year average. As a result, FMAP rates in effect at any given time are based on data from three to six years earlier. In setting FMAP rates for fiscal year 2021, for example, the federal government used personal income data from 2016, 2017, and 2018. In other words, while the country was still recovering from a deep recession, federal Medicaid payments to states were still being calculated based on pre-COVID data.

The FMAP formula’s sluggish response to recessions has led federal lawmakers to repeatedly intervene, passing legislation to temporarily increase the FMAP rate during recent economic crises (including the recessions of 2001, 2007-09, and 2020). These post hoc revisions to the FMAP rate have several limitations. They are prone to political squabbles, are often enacted months after crises hit, and create significant uncertainty for states.

For example, the Families First Coronavirus Response Act — the first major pandemic-related legislation, signed into law on March 18, 2020 — provided states with a temporary 6.2 percentage point increase in their regular FMAP rate. There’s no reason to think that the 6.2 percentage point figure was the result of any careful analysis. In fact, we know it wasn’t: Congress just recycled the exact same figure that it had approved in the American Recovery and Reinvestment Act of 2009. Despite starkly different circumstances — it was obvious that the COVID-19 pandemic would impact Medicaid differently than the Great Recession had — Congress didn’t make any effort to tailor its response.

Instead of relying on a chaotic federal policymaking process to pass FMAP rate increases during recessions, a better solution would be to modify the FMAP formula to automatically deliver additional federal Medicaid funds to a state if the health of its economy falls below some threshold.

Concrete proposals along these lines have been put forward by the Government Accountability Office (GAO) and the Brookings Institution. The details differ — the GAO favors using the employment-to-population ratio to gauge the economy’s health, while the Brookings plan focuses on the unemployment rate — but the main idea is the same: Create an automatic trigger mechanism based on high-frequency data that sidesteps the political dysfunction of Washington and turns Medicaid into a macroeconomic stabilizer worthy of the name.