Gov. Arnold Schwarzenegger has proposed a system for achieving near-universal health coverage in California. One provision that is likely to be controversial is the use of a provider tax to help fund the increased state expenditures that would be required. There are at least four reasons why a provider tax may be a desirable way for California and other states to fund programs to provide universal health insurance coverage.

1. Revenue during recessions. States are subject to large revenue losses during troughs in the state’s business cycle, a problem that poses a major barrier to states’ aspirations to move toward universal coverage. The nature of most taxes is that their revenue yield is closely tied to the level of state economic activity. As consumer and business spending decline, so do tax revenues. States often suffer recessions that are deeper and longer than those of the economy as a whole. The problem is made worse because there is often upward pressure on expenditures just as tax revenues are declining. During dips in the economic cycle, demands for public services typically rise because more people need the assistance of state-subsidized safety-net programs. Most states have constitutional prohibitions against running deficits, so when they experience an economic downturn and consequent declining tax revenues, they are forced to cut back on spending.

If, in good times, states move toward universal coverage by providing increased assistance to lower-income people, health spending would be an even bigger share of the total state budget than now. So states suffering an economic recession would often be forced to cut back on the health coverage program to bring spending in line with revenues.

However, revenues from a provider tax are largely recession proof. People’s need for medical services does not decline during recessions: They still go to doctors and hospitals for care. Thus, the revenue from the provider tax would not fall appreciably, if at all, when the economy is in recession. In short, a provider tax would be a more stable source of revenue over the business cycle than nearly all other forms of tax, helping to lessen the need to curtail spending.

2. Health care inflation. Medical care costs have consistently outpaced the growth of the economy as whole and are likely to do in the future. So even if states did not have to worry about revenue shortfalls during periods of economic recession, over time they would likely find that the revenue that supports a comprehensive coverage expansion program would not keep pace with the need to fund that program. Payroll taxes, other business taxes, sales taxes, and income taxes all tend to grow at a rate roughly equal to the growth of the state economy, but not faster. A provider tax, in contrast, is very likely to grow at approximately the same pace as overall medical care costs, since provider costs are the primary source of increased health care costs. So a provider tax helps ensure that revenue will be sufficient over time.

3. Uncompensated care. Present payments to providers include an amount to cover what would otherwise be uncompensated care–that is, the costs that providers incur because some patients without adequate financial resources or any insurance receive free care or pay an amount that is less than the cost of providing the care. In these cases, most if not all of the uncompensated care costs get shifted to others through the insurance system. If providers were not able to shift these costs to payers, they could not remain economically viable.

Under a universal coverage or near-universal coverage system, most of uncompensated care would be eliminated. If uncompensated care costs are no longer incurred because of universal coverage, providers would enjoy a windfall gain. A provider tax is a way of “capturing” this provider savings. The provider tax eliminates the windfall gain. Assuming the provider tax collects an amount equal to the previous cost of uncompensated care, on average, net provider income stays the same. Now, of course, some providers are not providing uncompensated care or at least not a proportionate share. They would experience a net fall in income, but that is because they were enjoying “underserved” windfall gains before, being reimbursed at rates that included an amount for uncompensated care even though they were not incurring their “fair share” of the costs of providing such care. (I am indebted to Rick Curtis of the Institute for Policy Solutions for having brought this point to my attention.)

4. Business concerns. Business people (including providers) often object to taxes levied on any aspect of business activity. They say the tax (such as a payroll tax) will hurt their sales because they cannot pass on all the costs to their customers in the form of higher prices. There is some economic validity to this argument. Even when all businesses have to pay a comparable tax, if businesses try to pass on all the tax in higher prices, the result will be that the higher price will deter some customers from buying the product or service and revenue will fall. (If a payroll tax on restaurants causes restaurant owners to raise meal prices, some people will eat at home.) Profits for the taxed businesses might decline somewhat and production levels might fall slightly.

But a tax on providers is unlikely to have this effect. In the previous section, I pointed out that net provider costs would stay roughly the same after the tax because uncompensated care costs would decline, so there would be no real cost increase to pass on. But even if that were not the case, providers would almost surely be able to pass on most if not all of any net cost increase. Relatively small increases in the price of medical services are not likely to deter people from getting needed care. When people truly need medical care, they are not likely to be very sensitive to small price increases (especially given the long history of large price increases). This is particularly true because insurance covers so much of the cost. Insurers would generally pay the increased costs (since the tax would apply to all providers), as they do now when costs increase for other reasons. (This is not to say that insurers would not try to persuade providers to be more efficient.) Of course, insurers would pass on these costs to those who buy insurance. There would almost surely be no significant decline in the amount of medical services consumed and no real reduction in net revenue realized by providers as a whole.

Worth considering. For almost all states, achieving near-universal coverage will require coming up with new revenue, which almost certainly means imposing some kind of new tax or a tax increase. No tax increase will be easy to get through the political process, and a provider tax is no exception. But as this analysis shows, a provider tax has some economic advantages that make it worthy of consideration.