*Tracy M. Gordon is an Assistant Professor at the School of Public Policy at the University of Maryland and Kim Rueben is a Senior Research Associate, The Urban Institute and Joint Brookings Institution/Urban Institute Tax Policy Center. NEW AMERICA FOUNDATION HEALTH POLICY PROGRAM February 2008 FINANCING HEALTH INSURANCE COVERAGE: CALIFORNIA’S REVENUE STRUCTURE AND OPTIONS By Tracy M. Gordon and Kim S. Rueben EXECUTIVE SUMMARY California’s health care reform effort may have been one of the first casualties of the national economic downturn. Yet the conditions that gave rise to the initiative did not disappear when the plan failed, and other states are pushing ahead with proposals to expand health coverage. So it remains useful to reflect on the California experience. In particular, it will be helpful to understand the proposed funding sources, how they would have interacted with California’s revenue system, and what alternative funding streams might have withstood the politics of reform. In this policy brief, we analyze the options for financing expanded health insurance coverage in California and offer our own preferred solution in light of the state’s fiscal and political constraints. Regardless of what the future holds for California’s health care reforms and its budget situation, policymakers and the public should keep a few basic principles in mind. In particular, any new funding for health care (or for other new programs) should be: • Robust to the business cycle. The need for state-supported health insurance peaks when the economy is declining. Therefore, revenues should not come from recession-sensitive sources, such as an income tax surcharge on high earners. Such revenues tend to fall during downturns because the returns on capital gains and exercised stock options also fall when the economy weakens. • Minimally disruptive to productive economic activity. In general, the best taxes are those that are hard to avoid by altering individual behavior or by employing creative accounting methods. Of course, policymakers occasionally want to encourage behavioral change through taxation. If they wish to curb teen smoking, for example, a cigarette tax might produce the desired response. However, revenues will tend to decline as behavior is affected. • Borne by those who benefit. Many groups will benefit from expanded health insurance coverage, and they should share in its cost. However, workers whose employers do not currently provide health insurance will benefit most. This principle argues in favor of an expanded payroll tax on workers whose firms do not provide health insurance coverage. Equitable. California has a tradition of progressivity, exempting many low-income individuals from income taxation and maintaining relatively generous expenditure programs. To this end, the state may want to provide subsidies to offset the costs of health insurance for low-income workers. 2 • Reliable. A dedicated source of funds will be essential to ensure that annual revenues match program costs. To the extent possible, funds should also be insulated from other spending requirements such as those under Proposition 98, which guarantees that roughly 40 percent of California’s General Fund goes to public schools and community colleges. There is no single revenue source that can fulfill all of these criteria. Moreover, the principles listed above can be contradictory in practice. We would therefore prefer to fund expanded coverage through a combination of new revenues, including a small universal payroll tax and higher cigarette and alcohol taxes. The payroll tax could be similar to the current funding system for the State Disability Insurance (SDI) program. If it were limited to firms that did not offer health insurance or to employees who did not participate in employer plans, it would be equivalent to the “in-lieu” fee or “pay or play” aspect of the Nuñez-Schwarzenegger plan that was rejected in January. The universal payroll tax would act as a backstop against the fluctuations in other funding sources and could be reduced as projected cost savings were realized. While these funding options would decrease the progressivity of California’s tax system, we think the trade-offs in terms of benefits to low-income workers would offset the additional tax costs. As economists, we would prefer to keep revenue sources fungible, or available for many uses. However, given California’s recurring budget crises and segmented spending rules, protecting the funding for expanded health care coverage—or for any other new programs—from encroachment by other government programs is essential. For example, if the new revenues