The state of New Hampshire isn't high on most lists of culprits contributing to the huge federal budget deficit.

Long dominated by fiscal conservatives wary of the evils of deficit spending and big government -- and critical of the spendthrift ways of neighboring "Taxachusetts" -- it is one of only two states with neither a sales tax nor a general income tax.

But since 1991 New Hampshire has been able to preserve its unique low-tax status thanks largely to a loophole in Medicaid law that enabled its Republican leaders to get the taxpayers of the United States to cover a yawning state budget deficit.

"It was a scam, no question about it," said Douglas E. Hall, a Republican state legislator who helped devise the scheme in 1991 but now feels it enabled New Hampshire to postpone dealing with its underlying fiscal problems. "We're funding our state judicial system, our highway program and everything else out of a Medicaid loophole, which is being funded out of the {federal} deficit."

In Medicaid, the federal government partially reimburses states for their payments to hospitals, doctors and other providers of care to the medically needy. The reimbursements are based on a formula that varies depending on the wealth of a state. New Hampshire gets 50 cents from the federal government for every dollar it pays health service providers.

After a dispute with the Reagan administration, which was trying to limit Medicaid spending, Congress in 1986 barred the federal government from limiting state payments to Medicaid hospitals and in the process created a loophole. Several states soon discovered that they could pay hospitals as much as they wanted, collect matching Medicaid funds from Washington and then recover some of the money they had paid the hospitals in the form of state taxes or donations.

In effect, states padded their payments to the hospitals in order to generate more federal matching funds, then received a kickback from the hospitals.

Using the device in 1991 and 1992 -- the loophole has since been largely closed -- New Hampshire collected $407.3 million in additional federal Medicaid matching funds on top of its regular Medicaid stipend from Washington. But only a small amount of the windfall went to expanding Medicaid services to welfare recipients, the disabled and the elderly poor, according to half a dozen state officials.

About $50 million was distributed to 27 hospitals, but most of that money is still in reserve funds and has not been spent.

The number of Medicaid patients in New Hampshire did increase sharply because of a prolonged recession and new federal requirements to provide Medicaid to pregnant women and children.

And although the state's Medicaid spending did grow from $227.5 million in 1990 to $357.8 million in 1992, that growth was nowhere near enough to absorb the huge injection of new federal money -- nearly $200 for each of New Hampshire's 1.1 million people in the state's 1993 fiscal year. Top state officials don't hide the fact that federal Medicaid money was diverted to other purposes, apparently legally.

"If you ask me, did we use this money to create a bigger and better Medicaid program, we did not," said state Health and Social Services Commissioner Harry Bird. "We did do some things at the margins."

What the money from federal taxpayers enabled New Hampshire to do was balance its fiscal 1992 and 1993 budgets without broad new state taxes or deep spending cuts. "We used it to balance our budget," says state Rep. Donna P. Sytek, former chairman of the House Ways and Means Committee. "Probably it wasn't in the spirit of the law. But it was in the letter."

The New Hampshire Medicaid story illustrates the powerful role parochial interests play in boosting the federal deficit and suggests some of the problems President Clinton faces in trying to tame it.

As opposition to new taxes has increased, politicians at every level of government have become more creative in tapping the one source of funds that does not have to be offset with higher taxes now: the borrowing authority of the U.S. Treasury. Serious as the U.S. deficit may be to posterity, it grows without inflicting immediate pain.

Perhaps for that reason, politicians who regularly preach fiscal responsibility have regularly abandoned their principles when faced with choosing between the interests of their constituents and curbing the growth of the U.S. deficit.

In 1991, for example, then-New Hampshire Gov. Judd Gregg (R) took credit for solving the state's fiscal crisis, even though he did it with federal Medicaid funds. In 1992, he successfully ran for the U.S. Senate as a deficit cutter and self-described "skinflint" who was "going to stand up and be counted on the basis of fiscal conservatism."

New Hampshire Sen. Warren Rudman (R) inserted provisions in a key Medicaid bill during the final hours of the congressional session at the end of 1991 to protect New Hampshire's Medicaid scheme through June of 1993. A co-author of the Gramm-Rudman-Hollings deficit reduction law, Rudman said recently that he had no regrets about his role.

"My attitude was that if that's the way the game is played, we'll play it too," he said. "If we were going to have this loophole, I wasn't going to see New Hampshire stand idly by."

Rudman and former Democratic senator Paul E. Tsongas of Massachusetts now head a new public-interest lobby pressuring Washington to cut the deficit.

New Hampshire's fiscal problems began with the post-1989 collapse of the Boston-centered high-tech boom. The state went from having the nation's highest personal income growth and lowest unemployment rate to leading the nation in welfare cases and personal bankruptcies.

State finances were hurt by a drastic decline in receipts from New Hampshire's business profits tax, the state's largest source of tax revenues. "We got hit worse than Massachusetts," said Hall, a member of the state's House Appropriations Committee. "When the economy went kaplooey, the bottom fell out."

By late spring of 1991, as Gregg and the legislature got down to serious work on the biennial budget for fiscal 1992 and 1993 that would take effect in July, it appeared that there would be a 1992 revenue shortfall of around $35 million.

That March, Sytek said, she heard about a loophole in Medicaid law at a conference of state legislators. "They've got this little scheme and you can use it {the federal money} for highways," she quoted a Missouri legislator as telling her.

"When I went back to New Hampshire I mentioned it to Harry Bird. He said it wouldn't be ethical. I told the governor and he said, 'You can't do that.' But in June we were running out of money and the governor said, 'Let's do it.' "

By that time, others in state government were thinking along the same lines. Hall recalled that someone had brought him an article about Massachusetts's use of the loophole, and Sytek said an official in Bird's office also "had discovered the loophole, bless his heart."

The Bush administration had tried to block the loophole, but Congress frustrated the effort by forbidding the secretary of health and human services from regulating state taxes on Medicaid providers.

As a result, use of the devices exploded. By 1992, more than 30 states were using provider taxes" and "provider donations" to shift at least $10 billion in Medicaid costs from themselves to federal taxpayers, according to a recent study by Health Policy Alternatives, a Washington consulting group.

New Hampshire's "Medicaid Enhancement Fund," enacted on June 20, 1991, was the result of a deal between Gregg, Bird, the legislature and Gary Carter, president of the New Hampshire Hospital Association. "We had a hearing and it passed in three days," Sytek said.

For each $100 the hospitals paid into that enhancement fund as a "tax," the state would send them $106 as a Medicaid payment. The state would then claim a $53 federal matching payment -- half of the total payment. The enhancement fund approach generated $6 for the hospitals and $47 for the state treasury, all of it federal money.

"We figured how much we'd need {from the federal government}, then set our provider tax accordingly," said Hall, who stressed that health care considerations did not play the major role.

In August 1991, the state received its first federal payment of $40.5 million using the device.

A U.S. Health Care Financing Administration official indicated that the agency's hands were tied under the law at that time. As long as a state was paying its medical providers in accordance with an approved state plan, as New Hampshire was, the federal government had to reimburse, she said.

As New Hampshire's economy kept deteriorating in the fall of 1991, estimates of its 1992 budget shortfall rose to $164 million.

Sytek recalls a Nov. 5, 1991, "summit" meeting, attended by "all the grand pooh-bahs of the House and Senate." With the New Hampshire Republican primary only months away and Gregg planning to run for the U.S. Senate as a fiscal conservative, the possibility of imposing an income tax or sales tax was not seriously considered, she said. Since 1972, no candidate for governor has been elected without first taking a pledge to oppose any new broad-based tax.

Sytek said her suggestion was, "Why don't we just crank up the rate of the Medicaid tax" that had been enacted several months earlier.

The group decided instead on a separate new tax on hospitals, based on Medicaid patient discharges, that would enable the state government to generate enough federal matching funds to fill the hole in the state budget in fiscal 1992 and 1993 -- which would have been at least 20 percent of the $700 million derived from general revenues in each of the two years.

On Nov. 12, the legislature, meeting in one-day special session, easily approved the change. The House margin was 283 to 42 and the Senate approved it 19 to 3.

One House member voting against it was state Rep. William Riley (D), a history professor who favors a 2 percent income tax. "I thought it was despicable," he said. "We don't need to dip into this Medicaid scam because we haven't tapped one of the biggest sources there is: the income tax."

But the entire plan was in jeopardy in Washington, where negotiations were winding up between Congress, the Bush administration and the nation's governors over legislation that would sharply limit the ability of states to use such devices.

Working closely with Rudman, the New Hampshire Republicans were determined to protect their Medicaid provision until the start of a new budget-writing cycle this year.

To get protection, New Hampshire needed bill language that would provide a grace period for plans that had been enacted and adopted as late as that November.

"We argued it with the {Senate} Finance Committee staff, Rudman spoke to {Sens. Bob} Packwood {R-Ore.} and {then-Sen. Lloyd} Bentsen {D-Tex.}, and Rudman talked to {then-Budget Director Richard} Darman," said former Rudman aide Thomas Polgar.

In the final hours of the 1991 session of Congress, the legislation passed the U.S. Senate by unanimous consent -- avoiding debate and a formal vote -- after Rudman and dozens of other senators had secured technical changes protecting their states.

"Any time we could do something for the state we were happy," Polgar said. "This happened to be big."

The provisions enacted in November 1991 enabled New Hampshire to generate an additional $366.6 million in federal funds for its 1992 and 1993 budgets. About $44 million went to the hospitals and the other $322.6 million went to filling the hole in the state budget, according to information provided by the Health Care Financing Administration and the state.

State Commissioner of Health and Social Services Bird defended the state's action, saying that the money prevented cuts in programs -- including Medicaid. Between 1990 and 1993, he said, Medicaid went from 15 percent of the state's total budget to 19 percent. State Medicaid rolls were swelling in part because of new mandates from Washington requiring states to expand Medicaid services to some groups, Bird said.

"We rejected {paying} the unfunded mandates that Congress had put on the state and sent the bill back to them," he said.

Sen. Gregg did not return two phone calls to his office requesting comment.

Noting that Arkansas and Tennessee -- the home states of Clinton and Vice President Gore -- set up provider tax schemes, Concord lawyer Tom Rath said: "I don't think there's a lot of hand-wringing. Everybody just says {of new taxes}, 'Not on my watch.' "

The Reagan administration's elimination of revenue sharing and other grants to states had cut the U.S. share of the New Hampshire budget from one-third in the early 1980s to one-quarter in the mid-1980s. The Medicaid windfall brought the federal share back to the 1981 level.

"It's difficult to blame most states" for using such schemes, said Victor Miller, a Washington consultant. "Tax yields were down and federal fiscal support was drying up. But New Hampshire is different. It's a wealthy state with low taxes and saw the loophole as a way to continue its privileged status."

"My basic concern was that the federal government was getting screwed," said Rep. Bill Zeliff (R-N.H.) who opposed use of the loophole despite Republican loyalties. "We balanced the budget with this loophole. I don't think the federal government can continue to run in this way."

Another loophole in the program may have been the absence of controls over the use of federal funds received by the hospitals handling high volumes of Medicaid patients.

Only two of the 27 New Hampshire hospitals have spent what they got, according to reports submitted to the state. Others are considering a variety of uses for it, including setting up community clinics.

Concord Hospital is considering using its $3 million to set up a permanent fund, interest from which would be used to pay the rent or depreciation on a hospice to serve members of the community regardless of their elibility for Medicaid.

Few if any of the hospitals have used the Medicaid windfall to reduce rates to private patients and insurers. Yet hospital officials acknowledge that those rates already include some or all of the cost of caring for indigent patients.

"We never went into this thing to make all that we've gotten," said the hospital association's Carter.

Earlier this month, Gov. Steve Merrill (R) unveiled a new budget that relies on some $100 million a year in federal Medicaid matching funds generated by the state's payments to hospitals.

Under the more restrictive 1991 law intended to eliminate gimmicks, any tax on the hospitals to offset the payments will have to be broad-based and real. The governor did not reveal details of his plan.