State can’t rely on raising hospital taxes to survive next recession

State officials knew settling a multi-billion-dollar lawsuit filed by Connecticut’s hospital industry posed risks.

That’s why Gov. Ned Lamont built emergency provisions allowing state government to back out of the deal if federal Medicaid funding — which will pay for more than half of the settlement — is dramatically reduced in future years.

But shifting fiscal winds from Washington, D.C., aren’t the only risk Connecticut faces.

For good or ill, state officials relied on aggressive increases in hospital taxes to keep Connecticut’s finances in balance during an extremely sluggish recovery from the last recession. Between 2013 and this year, hospitals pumped more than $1 billion into the state’s coffers, funds that otherwise might be raised by income tax hikes, municipal aid reductions, program cuts or all of the above.

But under this settlement, the state pledges to keep hospital taxes flat through 2026 — even though history suggests Connecticut and the nation are overdue for another economic downturn.

That means if another recession arrives in the new year or soon thereafter, Connecticut won’t have the hospitals to bail them out.

Even critics of the tax, who argue the hospital tax hikes of the past decade were a mistake that hurt the state in the long run, acknowledge that lawmakers and Lamont will face some very tough choices during the next downturn.

“That’s the part that’s starting to scare me,” said Rep. Toni E. Walker, D-New Haven, longtime co-chairwoman of the Appropriations Committee.

“If we can’t get any more revenue somewhere else, then we have to cut, and this is going to become a war.”

State Rep. Toni Walker

Walker, who supported the hospital lawsuit settlement, said it was a mistake for state government to lean so heavily on the industry during the last recovery. But she also said Connecticut’s social services safety net and its municipal aid program have gotten significantly leaner over the past decade and shouldn’t be targeted for more cuts when the next recession comes.

“If we can’t get any more revenue somewhere else, then we have to cut,” Walker said, “and this is going to become a war.”

Lawmakers and Gov. Dannel P. Malloy created the hospital levy in 2011 as a tax in name only. The industry paid $350 million to the state, which responded by redistributing all of those funds, plus another $50 million, back to hospitals.

Connecticut didn’t lose out because these supplemental payments helped the state to leverage hundreds of millions of dollars annually in federal Medicaid reimbursements — a back-and-forth arrangement encouraged by Washington and employed by most states.

But as Connecticut’s recovery from the last recession plodded along far slower than officials anticipated, Malloy and lawmakers gradually increased the tax, scaled back the supplemental payments — and forfeited huge federal dollars in the process.

Hospitals, who paid a total of nearly $2 billion more than they received between 2013 and 2019 collectively, sued four years ago on grounds that this system abused the process allowed under Medicaid.

“Most people accepted this settlement was the right thing to do because of the fear of the possible outcome — that a court could say you have to refund all of this money,” said Sen. John Fonfara, D-Hartford, co-chair of the tax-writing Finance, Revenue and Bonding Committee.

“Most people accepted this settlement was the right thing to do because of the fear of the possible outcome — that a court could say you have to refund all of this money.”

Sen. John Fonfara

Facing an industry claiming roughly $4 billion in damages, Connecticut agreed to pay $1.8 billion to hospitals over the next seven years — with just over half being covered by federal Medicaid reimbursement payments.

And while that deal also came with a pledge to modestly trim hospital tax rates — and avoid any hikes — through 2026, lawmakers were happy to remove a multi-billion-dollar risk. “I think that was enough, alone, for most people” to back the deal, Fonfara said.

“But the discipline part, cleaning up our finances, I don’t know if people are realizing we’re going to have to bite the bullet,” he added.

The war and bullet-biting Fonfara and Walker fear is possible despite overwhelming bipartisan support for the settlement, largely because there’s little-to-no agreement on what Connecticut can tap as an alternative cash cow.

Many of Walker’s fellow Democrats in the House and Senate majorities are wary of further cuts in spending on social services and local aid.

If there’s no other acceptable alternative, progressive Democrats say the answer should center on raising income taxes on Connecticut’s wealthiest residents. Though the state’s largest revenue engine is fairly progressive at the lower end — households earning less than $35,000 per year usually have no tax liability — that progressiveness flattens out quickly.

Many middle-class and rich households all pay an effective tax rate that ranges between 5% and 6.5 %. [The highest earners, singles making more than $500,000 per year and couples topping $1 million, pay 6.99%.]

But Lamont, a wealthy Greenwich businessman, and the growing number of Democratic legislators from Fairfield County, have staunchly opposed income tax hikes aimed exclusively at the rich. The administration fought hard this past session to kill a proposal for an income tax surcharge on investment-related earnings of Connecticut’s wealthiest households.

Combine that with traditional Republican legislative opposition to tax hikes of any kind, and there’s no easy consensus on what might replace hospitals as Connecticut’s budget cure-all.

“I viewed the hospital tax as more of a gimmick than a systemic change,” said Deputy House Minority Leader Vincent J. Candelora, R-North Branford, a veteran of the finance committee and another advocate of the lawsuit settlement.

The “systemic change” Candelora and many of his fellow Republican lawmakers favor involve significant reductions in state employee benefits.

“I viewed the hospital tax as more of a gimmick than a systemic change. We have to start making tougher decisions.”

Deputy House Minority Leader Vincent Candelora

But those are locked in by contract through mid-2027 and state employee unions, which granted concessions in 2009, 2011 and 2017, say they’re done until lawmakers are ready to ask the rich to pay more taxes.

GOP leaders counter by saying lawmakers could still vote to scale back, or even eliminate, certain retirement benefits effective mid-2027 — and enjoy some budgetary savings now. Because benefit obligations would be less in the future, they argue, Connecticut could scale back its payments now into those programs.

The unions, Lamont, and many Democrats in the legislature, have countered that this approach violates collective bargaining rules and wouldn’t survive a court challenge. 

“I think that’s always been the elephant in the room,” Candelora said. “Democrats and the unions are there at all costs to protect each other. We have to start making tougher decisions.”

Lamont, and others, are hoping it won’t come to that.

The economy has slowed somewhat, but 2019 closed without a national recession.

More importantly, Connecticut currently has a record-setting $2.5 billion in its emergency reserve, and the rainy day fund could clear $2.8 billion by the end of next summer.

This would leave the state with a fiscal cushion approaching 15% of annual spending — the maximum allowed by law.

Still, that’s no guarantee that Connecticut won’t have to cut spending and/or raise taxes in the next downturn.

During the last recession — between 2008 and 2010 — annual tax receipts in the General Fund fell from $12.5 billion to $10.9 billion.

A downturn like the last one, followed by a similarly sluggish recovery, easily could consume all of the state’s reserves and still leave Connecticut’s finances in the red.

Despite this, some say Connecticut’s path forward out of any recession involves strengthening its hospital industry, not weakening it.

Both Lamont and Connecticut Hospital Association CEO Jennifer Jackson hailed the deal as an economic step forward.

“Prolonging litigation in court would benefit nobody, and certainly not the residents of our state,” Lamont said. “Going forward, it is my hope that this partnership will put us on a new path in which we can work with our hospitals and partner in a way that benefits the quality of care for our state’s residents while simultaneously addressing the cost of that care.”

“Today marks the start of a new partnership with the state that will strengthen health care in Connecticut for the benefit of everyone who lives here,” Jackson said.

University of Connecticut economist Fred Carstensen, who was commissioned by the CHA in 2015 to analyze the provider tax, concluded it not only weakened the economy, but cost the state more than it raised.

“The state probably lost $2 billion in other tax revenue because of the negative feedback,” Carstensen said.

Hospitals, which are some of the state’s largest employers, trimmed staff and put off investing in new equipment and specialized treatment programs. Support businesses, such as medical and equipment suppliers, also were harmed.

“All of those people were not paying income tax, were not paying sales tax,” he said.

Legislators and Malloy also failed to understand the concept of medical tourism — that many people travel to other states for better access to health care, particularly specialized services. 

And as patients go, doctors, nurses and medical suppliers follow, Carstensen said.

“It’s a compound thing, keeping your folks in Connecticut to get their medical services and attracting more people from out of state to come,” he said, adding that Connecticut’s health care industry lost significant ground to the Boston and New York metro markets over the past decade.

The Malloy administration repeatedly defended the escalating hospital tax, noting the industry still paid its top executives robust salaries.

More importantly, the Malloy administration argued, the expansion of health care access brought about by the federal Affordable Care Act channeled a huge swath of new patients — and business — into hospitals.

The industry countered by saying this growth chiefly came from Medicaid patients whose care cost hospitals more than government payments could cover.

But while hospitals were forced to adjust over the past decade, Fonfara said, it will be state government’s turn to make even harder choices in the years to come.

And though there’s no consensus on what to do if or when the reserves run dry, the Hartford lawmaker said he’s optimistic legislators will turn to a more sustainable solution the next time one is needed.

“I think we’ve learned the hard way when we’re not disciplined how much it hurts us,” he said. “That’s what people are fed up with.”