The 2024‑25 Budget

The MCO Tax Package at May Revision

Summary

This post provides our initial assessment of the Governor’s proposed managed care organization (MCO) tax package in the May Revision. It first provides background on the MCO tax and the package that was in place at Governor’s budget. (The Governor’s budget included a plan to implement a multiyear spending framework that was adopted in last year’s budget.) Next, it summarizes the proposed changes at May Revision. It then provides our initial assessment and recommendations.

Bottom Line. We find the proposed increase to the MCO tax to be reasonable in concept. To fully assess the proposed increase, we recommend the Legislature direct the administration to provide (1) more information on the new tax rates and (2) analysis demonstrating the increase meets federal rules. Also, revisiting the MCO tax-funded augmentations in light of the substantial budget problem facing the state is reasonable. To the extent the Legislature still wishes to pursue certain augmentations, we recommend it (1) focus on augmentations that are relatively simple to implement and have relatively predictable positive effects on access to quality health care, (2) focus on rates that are relatively low, and (3) keep in mind the state’s budget problem. To the extent the Legislature pursues certain rate augmentations, dollar-for-dollar reductions in other areas of the budget would be required.

Background

MCO Tax

State Has Renewed and Increased the MCO Tax. The 2023-24 budget renewed the MCO tax through the end of 2026. Like the recent past versions, the tax is based on MCOs’ enrollment in Medi-Cal and private insurance. The tax is much larger than previous versions, raising more than three times the amount of revenue. This year’s early action package further increased the tax. As a result of these actions, the tax is raising $5.7 billion annually in net revenue.

Tax Was Estimated to Be at Federal Limit. The federal government must approve the MCO tax before it can go into effect. Federal approval is conditioned on a number of rules. For example, one rule limits the total amount of revenue the MCO tax can generate to 6 percent of the total revenue earned by MCOs. The federal government generally has approved the MCO tax, but has not released its decision on the early action to further increase the tax. In its analysis to the federal government of the early action increase, however, the Department of Health Care Services (DHCS) determined that the increase meets federal rules. It also estimated that the tax revenue was nearly at the 6 percent federal limit—meaning that the tax could not be increased any further.

Federal Government Signaled Intent to Change Rules for Approving Tax in the Future. As we noted in our February analysis, the federal government has signaled that it intends to change rules around approving the MCO tax. It intends to change these rules so that the tax is more equal between Medi-Cal and private insurance in the future. This is of concern to the federal government because nearly all of the cost of the tax currently falls on the Medi-Cal program—which is partly supported by federal funds—rather than more proportionately between Medi-Cal and private insurance. That said, no proposed rule changes have been released to date. For this reason, the scope of the rule changes or the time line to enact them is not known.

MCO Tax Package at Governor’s Budget

Last Year’s Budget Committed Portion of MCO Tax Funds for Augmentations. Historically, the state has used the MCO tax to help pay for existing services in Medi-Cal. Using the tax in this way allowed the state to spend less money from the General Fund on Medi-Cal. When the Legislature notably increased the tax in 2023, however, it designated some of the associated revenue to increase funding for Medi-Cal and other health programs. These augmentations were expected to cost $2.7 billion MCO tax funds at full implementation (when the tax was estimated at the time to raise between $5 billion and $5.4 billion annually in net revenue). The remaining funds were designated to offset General Fund spending in Medi-Cal.

Most Augmentations Were Proposed to Begin in 2025. The MCO tax package was to increase rates for a broad array of Medi-Cal providers, such as physicians, hospitals, clinics, and ground emergency transport providers. Some rate increases began in 2024 (focused on primary care, maternity care, and mental health services), but most were to begin in 2025. The Governor’s budget included a more detailed plan for the 2025 rate increases. The package also supported certain other health program augmentations, such as grants for graduate medical education programs (administered by the University of California) and one-time hospital relief programs (administered by the Department of Health Care Access and Information).

Package Included Reserve for Augmentations. According to DHCS, the next version of the MCO tax may be notably smaller than the current version. This is because of potential federal rule changes in the future. Recognizing this risk, last year’s budget placed funds for health program augmentations in a reserve. Some money would remain in the reserve after this version of the MCO tax ends in 2026 to help sustain the augmentations in the future. This year’s early action shifted $3.1 billion out of the reserve to help address the budget problem. As a result of that action, DHCS projected that $841 million would remain in the reserve when the tax ends in 2026.

Proposal

Further Increases MCO Tax. As part of the May Revision, the Governor proposes to increase the MCO tax rates further. According to the administration, there is more room under the federal limit than originally estimated. This is because DHCS did not include revenue MCOs earn from the federal Medicare program in its calculation of the limit. DHCS says it recently learned in discussions with federal administrators that including Medicare revenue in the calculation is allowable. The administration has publicly stated that it is only proposing to increase the tax on Medi-Cal enrollment. To date, however, the administration has not released the proposed new MCO tax rates. Across all of the years of the term of the MCO tax, the administration projects the increase to generate an additional $3.4 billion in net revenue.

Rescinds Most Augmentations in MCO Tax Package. The May Revision rescinds most ($881 million in 2024-25) of the augmentations in the MCO tax package at Governor’s budget. Only the Medi-Cal rate increases that began in 2024 would remain ($291 million in 2024-25). The proposal also generally sweeps the reserve that was projected at the end of 2026 ($841 million).

Supports New Directed Payment for Children’s Hospitals. The Governor proposes to create a new directed payment for children’s hospitals. (A “directed payment” is a supplemental payment to providers that the state directs through the Medi-Cal managed care system.) It would cost $115 million annually in MCO tax funds ($230 million annually total funds). The administration has not provided further detail on how the proposed payment would work.

Backfills Declining Proposition 56 Funds. Proposition 56 (2016) increased taxes on tobacco products. The state uses most of the associated revenue to fund supplemental payments to certain Medi-Cal providers. In recent years, Proposition 56 funds have fallen below the cost of the supplemental payments, requiring a General Fund backfill. In 2024-25, the Governor proposes to support some of the backfill using MCO tax funds instead of General Fund. This results in one-time General Fund savings of $145 million. The administration’s plan does not assume using the MCO tax funds in this way in later years.

Provides Substantial Budget Solution to State. As Figure 1 shows, the Governor’s proposals provide $9.8 billion through 2026-27 as a budget solution (including the Proposition 56 backfill). Of this amount, $1.8 billion would be in the budget window (through 2024-25). The remainder would be realized in the out-years.

Assessment

MCO Tax Increase Could Be Reasonable—but More Information Is Needed. Maximizing the size of the MCO tax is reasonable, particularly in the context of the state’s budget problem. This is because the MCO tax results in the state drawing down more federal funding, while imposing a relatively small cost on MCOs or private insurance consumers. The administration’s proposal to further increase the tax appears to align with this objective. However, key information remains outstanding. Most importantly, the administration has not released the proposed new tax rates, the associated trailer legislation, or its analysis showing that the tax increase meets federal rules. Without this information, the Legislature cannot assess whether the proposed increase stands a reasonable chance of being approved by the federal government.

Revisiting MCO Tax Package Is Warranted for Two Reasons. In our view, it is warranted for the Legislature to revisit the planned augmentations in the MCO tax package for two reasons.

• Helps Address Sizable Budget Problem. The state currently is facing a sizable budget problem that requires significant reductions to state programs. Given the substantial change in the state’s fiscal condition—and the likelihood that deficits will persist—revisiting last year’s plan is reasonable.

• Helps Manage Fiscal Uncertainty in Package. Because there is a risk the next MCO tax is much smaller than the current version, MCO tax revenues could be insufficient to sustain the originally proposed augmentations in the future. This shortfall would need to be backfilled by another funding source, such as the General Fund. However, whether the General Fund will have capacity to backfill this shortfall is uncertain. Adopting a narrower set of augmentations makes it likelier the state could manage this shortfall in the future.

But Legislature May Still Have Interest in Pursuing Certain Augmentations. While revisiting plans for the MCO tax is warranted, the Legislature may still wish to pursue certain augmentations given the existing provider rate structure. In particular, Medi-Cal has an inconsistent approach to adjusting rates over time for certain kinds of providers. As a result, some Medi-Cal rates can lag behind inflation and what is paid in other programs, such as Medicare. This inconsistent approach could impact access to quality health care for Medi-Cal beneficiaries. Also, Medi-Cal beneficiaries face greater barriers to access to health care than people enrolled in private insurance. Research suggests that rate increases are associated with improved access to services.

Proposed Augmentation for Children’s Hospitals Raises Key Questions. According to the administration, the proposed directed payment for children’s hospitals is intended to improve access to quality health care for children with serious diseases. Also, children’s hospitals can face unique cost pressures and financing issues because of their focus on serving children. There are many kinds of vulnerable populations and providers in Medi-Cal. How the administration determined to prioritize limited funding in this area of the Medi-Cal program—given it was not included in the original plan—is unclear. Also, the administration has not released more information on the proposed directed payment or clarified how it will impact access to quality health care for children.

Proposal Faces Fiscal Risks From Potential Ballot Measure. In fall 2023, proponents began circulating an initiative measure on the MCO tax. The measure would permanently extend the MCO tax and create rules around how to spend the associated revenue. The Secretary of State currently is reviewing whether enough signatures have been collected for the measure to qualify for the November 2024 election. If the measure were to qualify for the ballot and were voters to enact it, the state might need to change how it spends MCO tax revenue beginning in 2025. For example, the state might need to use more revenue than proposed in the May Revision for health program augmentations. In this case, less money could be available to address the budget problem, requiring the Legislature to look elsewhere for budget solutions next year.

Recommendations

Adopt Tax Increase, Conditioned on Administration Providing More Information. Given the issues raised earlier, we recommend the Legislature direct the administration to provide more information on the proposed MCO tax increase. This information should include, at a minimum, (1) the proposed tax rates, (2) the proposed trailer bill legislation, and (3) analysis demonstrating the revised tax meets federal rules. Given the limited time frame available to the Legislature to assess proposals and adopt the budget, the administration will want to provide this information as soon as possible. If the administration satisfactorily provides this information, we recommend adopting the tax increase.

Consider Three Key Principles in Crafting MCO Tax Package. Given the Legislature’s interest in using the MCO tax to support augmentations, it may wish to weigh alternatives to the proposed package in the May Revision. To guide decisions, we recommend keeping three key principles in mind.

• Focus on Simple and Predictable Augmentations. Given the fiscal constraints facing the state, we recommend the Legislature focus on augmentations that are relatively simple or that expand existing programs. For example, the Legislature could consider setting Medi-Cal rates to a percent of what is paid in the federal Medicare program, adopting an inflationary adjustment to certain rates, or temporarily increasing funding for existing health programs. We recommend against more complex changes or establishing new programs. This is because such actions tend to have less certain or predictable effects. With the state facing limited resources this year, it likely will want to focus on areas where the effects are relatively certain. To this end, we recommend the Legislature direct the administration to provide more information on the proposed children’s hospital directed payment. If more information is not forthcoming, the Legislature could use the funds to support other augmentations or to help address the budget problem.

• Focus on Relatively Low Rates. To the extent the Legislature wishes to increase Medi-Cal rates, we recommend that it focus on rates that are known to be particularly low relative to Medicare or the cost of care. This is because focusing on these rates could yield the largest improvements to access to health care. We recommend against focusing on rates that are relatively high.

• Keep in Mind Budget Problem. Given the fiscal challenges facing the state, we recommend the Legislature treat the proposed budget solution as a starting point. If the Legislature rejects some of the proposed reductions to planned augmentations, dollar-for-dollar reductions in other areas of the budget would be required. The current fiscal situation requires weighing difficult trade-offs between programs.

Develop Plan for Ballot Measure. We recommend the Legislature keep in mind the possibility that the voter initiative qualifies for the ballot and is enacted by voters as it crafts its MCO tax package. For example, the Legislature could consider the risk that less funding is available than assumed in the May Revision to address the budget problem as a result of the measure, potentially requiring solutions elsewhere in the budget.