Build America Bonds, the Medicaid Expansion, and Trust Between the States and the Feds

States trying to decide whether to expand their Medicaid programs to cover more low-income uninsured might want to take a look at the fate of a more obscure federal program—cash subsidies to state and local governments that sell certain kinds of bonds, especially Build America  Bonds.

If they do, they’ll see what happens to a federal promise of aid when that commitment gets caught up in bigger fiscal issues.  

For months, states have been mulling the Medicaid expansion–one of the most controversial provisions of the 2010 Affordable Care Act. Obamacare made what sounded like an offer governors couldn’t refuse: Agree to cover 16 million more low-income people under Medicaid and the feds will pick up the full cost of the expansion from 2014 through 2016 and pay 90 percent through 2020.

Bubbling just beneath the surface of the debate over whether states should take the deal is an issue of trust: Would the feds keep their part of the bargain? After all, there is nothing in the ACA to prevent a future Congress from reneging on this promise and, as part of a deficit cutting agreement, slashing the federal contribution to, say, 75 percent.  That’s still a better deal than the usual federal Medicaid match that averages about 60 percent, but lots less generous than 90 percent.   

And that brings us to BABs. In 2009, Congress offered state and local governments another deal they couldn’t refuse, this time to encourage them to borrow with taxable debt instead of traditional tax-exempt munis.  

Because taxable bonds carry higher yields than tax-exempts, the idea was that Treasury would give state and local governments direct cash subsidies to partially offset their extra borrowing costs.  

State and local issuers took the deal and BABs were a huge hit. Investors—many of which don’t pay taxes–happily traded off the tax-exemption for the higher yield. Between 2009 and 2010, when Congress let the scheme expire, state and local governments sold $181 billion of taxable munis, and took the cash rebate.

It seemed like a great deal all around.

Except last week, as a result of the sequester, Treasury slashed $255 million from the $3.35 billion it was supposed to pay this year in subsidies for BABs (along with some other taxable munis). That leaves those state and local issuers on the hook for those higher yields but with about 8 percent less in federal aid than they were promised. Sometimes, life just isn’t fair.        

To be honest, BABs are not the Medicaid expansion. Because the bond program is so much smaller and more obscure, it was relatively easy for it to become collateral damage in the sequester. And until now only muni market denizens have noticed. By contrast, any attempt to cut back on the federal promise to fund the Medicaid expansion would set off an instant political firestorm.  

In addition, the BAB program is something of an orphan. Congress allowed it to die in 2010 and the Obama Administration has shown little interest in reviving it. The Medicaid expansion, by contrast, is a centerpiece of the ACA and, at least as long as Democrats are around, will have powerful friends. Obama, in fact, insists that Medicaid is entirely off the table in current budget talks.

However, the program suffers from the old Willy Sutton problem: If Congress and the President ever do make their long-awaited fiscal Grand Bargain, Medicaid is where a big chunk of the money is.

I still think the Medicaid expansion is a good deal for states. But, then, I thought BABs were as well. Note to governors: Caveat emptor.