Arizona has a major public health problem: Too few people are smoking.

That's not the only fiscal problem the state faces. But it's one of them. Like many states, Arizona's public finances are in miserable shape. And much of the state's budget trouble can be attributed to a decade-old decision to finance an expansion of low-income health insurance coverage with revenue dependent on tobacco industry profits.

A little more than a decade ago, the state grew its low-income health insurance rolls, claiming the new enrollees would be paid for by revenue from a deal with tobacco industry. Now, with smoking rates (and tobacco industry revenues) falling, a budget crisis brewing, and a growing number of individuals eligible for Medicaid, the state has chosen to pare back its health coverage for low-income adults.

Starting July 8, the state's Medicaid program will implement changes expected to reduce the program's rolls by 117,000 single, childless adults over the next year. After much delay, the Obama administration last week finally granted Arizona permission to go through with the cuts, but only grudgingly. "We regret the action Arizona is taking," a federal Medicaid official told The Arizona Republic.

But looking back on their Medicaid program's recent history, Arizonans may have some regrets of their own. Initially, the state was reluctant to join Medicaid, waiting until 1982 before entering the joint federal-state health insurance program for the poor and disabled.

In 1998, the state signed onto the Master Settlement Agreement, a nationwide deal between state attorneys general and the major players in the tobacco industry. As part of the agreement, the tobacco industry agreed to compensate the public for years of health costs incurred by the public due to smoking-related illnesses through a series of payments to the states.

It was win-win for both sides: The tobacco industry got rid of its legal liability once and for all and the states created a new revenue source initially estimated to provide $206 billion during its first 25 years of existence—no tax hikes required. Arizona was entitled to 1.5 percent of the total.

The deal was sold to the public as a sort of financial justice. After decades of imposing billions in public health costs on taxpayers, the tobacco industry was finally forced to pay for its sins. But the practical effect was to make states partners with the very industry those states were ostensibly trying to punish.

Arizona was determined to put the partnership, and the revenue it was expected to provide, to use. In November 2000, the state's voters passed Proposition 204, which expanded Medicaid coverage to childless adults to 100 percent of the federal poverty line, up from the federal mandate of 34 percent.

Medicaid's crude fiscal incentives were too good to resist. The program is funded via a generous federal matching grant, so for every dollar that Arizona spent expanding Medicaid, the federal government would pitch in with an additional $1.96. There's no limit to the amount of matching funds a state can obtain, so the bigger the expansion, the more federal money a state can nab.

And it was all supposed to be free. Voters were promised in a "Fiscal Analysis" that the expansion could be "fully funded by Arizona's share of the Tobacco Settlement," according to columnist Robert Robb. A fact sheet distributed by the proposition's supporters said that it would use "no state tax money." The magic combination of tobacco settlement revenue and federal matching funds was irresistible for both the state's political class and its voters. In theory, the program would expand dramatically—and at no cost to taxpayers.

It sounded too good to be true—and it was. As Michael Greve, a senior fellow at the American Enterprise Institute, noted in a 2008 report, "it soon became clear that the MSA funds (and the federal dollars that they leverage) would not remotely cover Proposition 204's expansion of the Medicaid population and services."

The state faced two problems. First, the actual price tag on the Medicaid expansion came in higher than expected. Second, smoking rates—and thus tobacco industry revenues—were on the decline; by 2002, states had already received 14 percent less in tobacco payments than projected.

And so the program's costs dipped further into the general fund. According to the state government, general fund revenue dedicated to Medicaid has increased by nearly 65 percent since 2009 alone. Now Medicaid accounts for around 29 percent of the state's total general fund spending, up from 8 percent when Prop. 204 passed.

The federal-match incentives that made expanding the program so tempting initially also made it equally difficult to cut. What politician would willingly cut three dollars in benefits to save just one dollar in the state budget?

Faced with a billion-dollar budget hole, however, Arizona Gov. Jan Brewer finally took the plunge this year, calling for cuts that are expected to save a half billion dollars, including an estimated $190 million this year.

The only question remaining is whether the state will be permitted to make the cuts. Despite promises that no state tax revenue would be used, Prop. 204's text says that in order to pay for the coverage expansion, tobacco industry funds "shall be supplemented, as necessary, by any other available sources including legislative appropriations and federal monies." Critics of the cuts have taken the state to court, arguing that it has an obligation to fund the expanded benefits through supplemental measures, regardless of MSA funding or other budgetary troubles.

So a law sold on a promise that health coverage would be expanded without state tax revenues is now being reinterpreted as an obligation to use additional state tax revenues to fund the coverage expansion—whether legislators want to or not. Where are the smokers when you need them?

Peter Suderman is an associate editor at Reason magazine.