The measures are:  Net lending or borrowing—the balance of all receipts and  expenditures during a given time frame. This indicates the need for the  sector to borrow funds or draw down assets to cover its expenditures. Operating balance net of funds for capital expenditures—or  simply the “operating balance”—a measure of the ability of the  sector to cover its current expenditures out of current receipts. In  developing this measure we subtract funds used to finance longer-term  projects—such as investments in buildings and roads—from receipts  since these funds would not be available to cover current expenses. But the  simulation suggests that while projected balances for both net lending or  borrowing and the operating balance remain in their historical ranges for  the next several years, the balances will soon begin to decline and will fall  below their historical ranges within a decade. That is, the model suggests  that the state and local government sector will face increasing fiscal stress  in just a few years. These projected deficits—worsening throughout the projection time frame  under an unchanged policy scenario—indicate that, because most state and  local governments cannot actually run such deficits for any length of time,  these governments will need to make tough choices on spending and tax  policy to meet their budget requirements and to promote favorable bond  ratings. Another way of measuring the long-term challenges faced by the state and  local sector is through a measure known as the “fiscal gap.”  With deficits  rising rapidly as shown in figure 1, the outstanding debt of the state and  local sector will experience unprecedented growth. Two types of state  and local expenditures in particular will likely rise quickly due to escalating  medical costs. For example, even though the wages and salaries of primary and secondary  education employees are a large expenditure of the state and local sector,  under our base-case assumptions these costs are not expected to grow any  faster than the rate of growth of the general economy and will not  represent an increasing burden on governments relative to their revenues. Substantial Policy Changes Would Be Needed to Prevent the Fiscal Decline in the State and Local Government Sector

We developed several scenarios with alternative assumptions to better  understand the sensitivity of our results. The assumptions varied in these alternative  scenarios include (1) the growth of tax receipts, (2) the growth in state and  local expenditures, and (3) the rate of growth in health care costs. Tax Receipts Would Need to Rise Considerably Faster than Historical Experience to Enable the Operating Balance to Remain in Historical Range

In the base-case model, we assume that current policy, such as tax rates  and structures, will remain unchanged. State and Local Expenditures Would Need to Be Cut Substantially to Maintain Fiscal Balance

Our base-case model assumes that current policies are maintained,  primarily by holding the number of employees in the sector constant as a  percentage of population, assuming state and local workers receive pay  increases equal to those of private-sector employees, and assuming the  total cost of many goods procured by the sector to provide services rises  with increases in the population being served and the rate of inflation in the  economy. Given the importance of health care expenditures as a  driver for the long-term fiscal outlook, we also model the impact of  different health care expenditure growth assumptions. State and Local Fiscal Challenges Add to the Nation’s Fiscal Difficulties

Since 1992, we have produced long-term simulations of what might happen  to federal deficits and debt under various policy scenarios. Our most  recent long-term federal simulations show ever-larger deficits resulting in a  very large and growing federal debt burden over time. Just as in the state  and local government sector, the federal fiscal difficulties stem primarily  from an expected explosion of health-related expenditures. Once all receipts and expenditures of the sector are simulated forward  through 2050, we develop summary indicators of the state and local  government sector’s fiscal status. Because the model covers the state and  local government sector in the aggregate, the fiscal outcome of individual  states and localities cannot be captured. Projection of Receipts of the State and Local Government Sector

The model provides projections for each type of receipt of state and local  governments. Accordingly, several tax receipt categories  grow at the same rate as their underlying tax bases. Other Federal Grants to Finance Current Expenditures

In addition to Medicaid grants, the federal government provides grants  intended to finance other current expenditures of state and local  governments. Measures of Fiscal Balance

We use two measures of fiscal balance in our report:  net lending or  borrowing and the operating balance. Net Lending or Borrowing

The first projected balance measure is NIPA’s net lending or borrowing,  which is the difference between total receipts and total expenditures and is  analogous to the federal unified surplus or deficit. Operating Balance Net of Funds for Capital Expenditures

The second balance measure we use is a GAO-developed measure that we  call the operating balance excluding funds for capital expenditures. This  measure is designed to be roughly akin to the operating budgets of  subnational governments—budgets which these governments are generally  required to balance or nearly balance. Some combination of tax receipts, federal  investment grants, and debt can be used to finance state and local  government investment. In particular, we provide information on (1) the  development of several key demographic and economic factors such as  future employment, retirement, and wages for the state and local  workforce that are necessary for the simulations of future pension and  retiree health care costs; (2) how we project the necessary contribution  rate to pension funds of state and local governments; and (3) how we  project the future yearly pay-as-you-go expenditures of employee and  retiree health insurance. The cost of health care has been  increasing faster than gross domestic product (GDP) for many years.
Why GAO Did This Study

State and local governments provide an array of services to their residents, such as primary and secondary education, libraries, police and fire services, social programs, roads and other infrastructure, public colleges and universities, and more. These subnational governments may face fiscal stress similar to the federal government. Given the nature of the partnership among levels of government in providing services to Americans and the economic interrelationships among levels of government, understanding potential future fiscal conditions of the state and local government sector is important for federal policymaking. To provide Congress and the public with this broader context, we developed a fiscal model of the state and local sector. This report describes this model and provides (1) simulations of the state and local government sector's long-term fiscal outlook, (2) an analysis of the underlying causes of potential fiscal difficulties for the sector, (3) a discussion of the extent to which the long-term simulations are sensitive to alternative assumptions, and (4) an examination of how the state and local government sector could add to future federal fiscal challenges. The potential fiscal outcomes of the state and local government sector are projected through two fiscal balance measures: net lending or borrowing and what we call the operating balance. Net lending or borrowing--which is roughly analogous to the federal unified surplus or deficit--is a measure of the balance of all receipts and expenditures during a given time frame. Historically, total expenditures have usually exceeded total receipts, and the sector issues debt to cover part of the costs of its capital projects. As such, net lending or borrowing typically measures the need for the sector to borrow funds or draw down assets to cover its expenditures. The operating balance net of funds for capital expenditures--referred to in this report as the "operating balance"--is a measure of the ability of the sector to cover its current expenditures out of current receipts, that is, the balance of expenditures and receipts related to activities taking place in a given year. Most states have some sort of requirement to balance operating budgets. Projects with longer time frames are typically budgeted separately from the operating budgets and financed by a combination of current receipts, federal grants, and the issuance of debt. Because some current receipts may be used to fund part of longer-term investments, we developed a measure of the operating balance that makes adjustments for the extent to which current receipts are unavailable to fund current expenditures because they have been spent on longer-term projects, such as investments in buildings and roads.

What GAO Found

Our model shows that in less than a decade the state and local government sector will begin to face growing fiscal challenges. Both fiscal balance measures (1) net lending or borrowing and (2) the operating balance--are likely to remain within their historical ranges in the next few years, but both begin to decline thereafter and fall below their historical ranges within a decade. That is, absent policy changes, state and local governments will face an increasing gap between receipts and expenditures in the coming years. Since most state and local governments actually face requirements that their operating budgets be balanced or nearly balanced in most years, the declining fiscal conditions our simulations suggest are really just a foreshadowing of the extent to which these governments will need to make substantial policy changes to avoid these potential growing fiscal imbalances. As is true for the federal sector, the growth in health-related expenditures is the primary driver of the fiscal challenges facing the state and local government sector. In particular, two types of state and local expenditures will likely rise quickly. The first is Medicaid expenditures, and the second is expenditures by these governments for health insurance for state and local employees and retirees. Conversely, other types of expenditures of state and local governments in the aggregate--such as wages and salaries of state and local workers, nonhealth transfer payments (e.g., family assistance), and investments in capital goods--are assumed to grow slower than gross domestic product (GDP). Moreover, under the current policy scenario of the base case, most revenue categories grow at approximately the same rate as GDP. Therefore, the projected rise in health-related expenditures is the root of the fiscal difficulties these simulations suggest will occur. Although health care expenditures clearly appear to be a looming problem for the state and local government sector, the extent of fiscal difficulties faced by any given state or local government will vary with its individual expenditure and tax profile. We also used the model to examine how the fiscal balance measures would be affected over the long-term under assumptions that differed from those of our base case. In particular, we analyzed scenarios that differ across three factors: (1) the rate of growth in tax receipts, (2) the rate of growth in expenditures, and (3) the rate of growth in medical care expenditures. Some of the alternative scenarios were designed to examine the extent to which a change in base-case assumptions for any of these factors would enable the state and local government sector to maintain fiscal balances in their historical ranges. We found that it would be difficult to address the expected future fiscal deficits solely through tax increases or solely through expenditure cuts. Since 1992, we have produced long-term simulations of what might happen to federal deficits and debt under various policy scenarios. Our most recent long-term federal simulations show ever larger deficits resulting in a very large and growing federal debt burden over time.4 In that work, we found that federal fiscal difficulties stem primarily from an expected explosion of health-related expenditures. Our findings thus show that the state and local sector will provide an additional drag on an already declining federal government fiscal outlook and that the critical problem of escalating costs of health care is an economywide problem that will need to be addressed by all levels of government.