U.S. States, the Medicaid Program, and Tax Smoothing

This paper tests the tax smoothing theory by focusing on its implication that a change in permanent government spending should result in an equal sized change in the tax rate. The effect of Medicaid, a state administered, federal and state funded medical insurance program for the poor, on state tax rates is investigated. The Medicaid program provides a natural experiment for this test as states are required to cover certain groups in order to receive federal matching money. Additionally, during the 1980s, a series of federal mandates greatly increased state Medicaid expenditures. Two stage least squares is used on a panel of U.S. states (1978-1994) to test whether changes in permanent state Medicaid expenditures resulted in equal sized tax rate changes. Tax smoothing as a positive theory of state government behavior is rejected. Additionally, it is found that this rejection cannot be attributed to the stringency of balanced budget rules.