	State and Local Governments Will Need to Make Policy Changes to Maintain Long-Term Fiscal Balance

Our simulations suggest that the sector will likely continue to face a  difference between revenue and spending during the next 50 years. This  long-term outlook is measured by the operating balance—a measure of  the sector’s ability to cover its current expenditures out of current  receipts. While both expenditures and revenues are projected to  increase as a percentage of gross domestic product (GDP) during the  simulation period, a difference between the two is projected to persist  because expenditures are generally expected to grow at a faster rate than  revenues. Health Care Cost Growth and Other Factors Contribute to the State and Local Sector’s Fiscal Imbalance

		Medicaid and Employee Health Benefits Are Key Drivers of Long-Term Spending

Our simulations suggest that growth in the sector’s overall spending is  largely driven by health care expenditures. For example, in 2017, wages and salaries of state and local government  employees constituted a large expenditure for the sector. However, these  expenditures are projected to decline as a percentage of GDP during the  simulation period. Policy Changes and Other Considerations Could Affect the State and Local Government Sector’s Fiscal Outlook

While our long-term simulations do not account for pending or future  federal policy changes that will result in changes to expenditures and  revenues, an understanding of several recent federal policy changes  related to taxes and health care are important to note because they  present sources of uncertainty for the state and local government sector’s  long-term fiscal outlook. In addition, as is the case in any model that is  reliant on historical data to simulate a long-term outlook, other  considerations, such as economic growth and rates of return on pension  assets, could shift future fiscal outcomes. The effect of TCJA on the long-term state and local fiscal outlook is still  evolving, and will likely depend on how states incorporate the law’s  changes into their state income tax rules. As discussed earlier in this report, our simulations suggest that Medicaid  spending will make up an increasing share of the state and local  government sector’s operating expenditures in the future. Under this scenario, our simulations show that the  sector’s negative operating balance will continue to grow larger  throughout the simulation period. Specifically, we developed a model  that projects the levels of receipts and expenditures of the state and local  government sector (henceforth, the sector) in future years based on  current and historical spending and revenue patterns. These variables track state and local government receipts in table 1  above as follows:
State and local government personal income tax revenue is the sum  of state personal income tax revenue and local personal income tax  revenue;
State and local government personal tax revenue is the sum of  personal income tax revenue and other personal tax revenue;
State and local government revenue from taxes on production and  imports is the sum of general sales tax revenue, excise tax revenue,  property tax revenue, and revenue from other taxes on production and  imports;
State and local government current tax revenue is the sum of  personal tax revenue, revenue from taxes on production and imports,  and corporate income tax revenue;
State and local government current transfer receipts are equal to  federal Medicaid grants minus Medicare Part D payments to the  federal government, plus other federal grants (excluding investment  grants), transfer receipts from businesses, and transfer receipts from  persons;
State and local government current receipts are the sum of current tax  revenue, current transfer receipts, income on assets, social insurance  contributions, and government enterprise surplus;
State and local government capital transfer receipts are the sum of  federal investment grants and estate and gift tax revenue; and
State and local government total receipts are the sum of current  receipts and capital transfer receipts. Our unit of analysis is the state and local government sector as a  whole, so our results provide an assessment of the sector’s fiscal  outlook.
Why GAO Did This Study

Fiscal sustainability presents a national challenge shared by all levels of government. Since 2007, GAO has published simulations of long-term fiscal trends in the state and local government sector, which have consistently shown that the sector faces long-term fiscal pressures. While most states have requirements related to balancing their budgets, deficits can arise because the planned annual revenues are not generated at the expected rate, demand for services exceeds planned expenditures, or both, resulting in a near-term operating deficit.
This report updates GAO's state and local fiscal model to simulate the fiscal outlook for the state and local government sector. This includes identifying the components of state and local expenditures likely to contribute to the sector's fiscal pressures. In addition, this report identifies considerations related to federal policy and other factors that could contribute to uncertainties in the state and local government sector's long-term fiscal outlook.
GAO's model uses the Bureau of Economic Analysis's National Income and Product Accounts as the primary data source and presents the results in the aggregate for the state and local sector as a whole. The model shows the level of receipts and expenditures for the sector until 2067, based on current and historical spending and revenue patterns. In addition, the model assumes that the current set of policies in place across state and local government remains constant to show a simulated long-term outlook.

What GAO Found

GAO's simulations suggest that the state and local government sector will likely face an increasing difference between revenues and expenditures during the next 50 years as reflected by the operating balance--a measure of the sector's ability to cover its current expenditures out of its current receipts. While both expenditures and revenues are projected to increase as a percentage of gross domestic product (GDP), a difference between the two is projected to persist because expenditures are expected to grow faster than revenues throughout the simulation period.
GAO's simulations also suggest that growth in the sector's overall spending is largely driven by health care expenditures--in particular, Medicaid spending and spending on health benefits for state and local government employees and retirees. These expenditures are projected to grow as a share of GDP during the simulation period. GAO's simulations also suggest that revenues from personal income taxes and federal grants to states and localities will increase during the simulation period. However, revenues will grow more slowly than expenditures such that the sector faces a declining fiscal outlook.
GAO also identified federal policy changes that could affect the state and local government sector's fiscal outlook. For example, the effects of the recently-enacted Tax Cuts and Jobs Act will likely depend on how states incorporate the Act into their state income tax rules. In addition, other factors, such as economic growth and rates of return on pension assets, could shift future fiscal outcomes for the sector.