State and Local Governments: Persistent Fiscal Challenges Will	 
Likely Emerge within the Next Decade (18-JUL-07, GAO-07-1080SP). 
                                                                 
For over a decade GAO has run long-term simulations showing that 
absent a change in policy, the combined effects of demographic	 
changes and growing health care costs drive ever-increasing	 
federal deficits and debt levels. The Comptroller General has	 
repeatedly warned that the current fiscal path of the federal	 
government is "imprudent and unsustainable". State and local	 
governments provide an array of services to their residents, and 
the federal government relies on these governments to assist in  
the realization of national goals. State and local governments	 
also rely on federal grants to varying extents. These subnational
governments may also face fiscal stress. To provide Congress and 
the public with a broader national context, GAO has developed a  
fiscal model of the state and local sector. The GAO state and	 
local model projects the level of receipts and expenditures of	 
the sector in future years based on current and historical	 
spending and revenue patterns. In the "base case" model we assume
that the current set of policies in place across federal, state, 
and local governments remains constant. The primary data source  
for the model is the National Income and Product Accounts. The	 
timeframe for the simulations parallels that of our federal	 
fiscal model--the simulations extend until 2050. The state and	 
local model examines the aggregate fiscal outcomes for the sector
and does not examine the condition of any individual state or	 
local government.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-1080SP					        
    ACCNO:   A72889						        
  TITLE:     State and Local Governments: Persistent Fiscal Challenges
Will Likely Emerge within the Next Decade			 
     DATE:   07/18/2007 
  SUBJECT:   Balanced budgets					 
	     Budget administration				 
	     Budgeting						 
	     Budgets						 
	     Econometric modeling				 
	     Economic analysis					 
	     Federal/state relations				 
	     Fiscal policies					 
	     Health care cost control				 
	     Health care costs					 
	     Intergovernmental fiscal relations 		 
	     Local governments					 
	     Projections					 
	     State budgets					 
	     State governments					 

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GAO-07-1080SP

   

     * [1]Fiscal Difficulties for State and Local Sector Are Driven by
     * [2]State and Local Fiscal Challenges Add to the Nation's Fiscal
     * [3]Key Assumptions of GAO's State and Local Simulations

State and Local Governments:

Persistent Fiscal Challenges Will Likely Emerge within the Next Decade

United States Government Accountability Office

GAO

GAO-07-1080SP

Figure 1: State and Local Receipts Net of Expenditures

Note: GDP is Gross Domestic Product.

                                                                July 18, 2007

Our simulations for the state and local government sector indicate that in
the absence of policy changes, large and growing fiscal challenges for the
sector will begin to emerge within the next few years. Figure 1 shows the
gap between receipts and expenditures of the sector. Historical data from
1980 to 2006 are graphed along with our model simulations beginning in
2007 and running through 2050. We measure this gap in two ways. In one
case we examine, for a given year, all receipts--including grants from the
federal government for infrastructure projects--and all
expenditures--including not only operating expenditures but also
expenditures on such items as investments in buildings and roads. This
provides a balance measure similar to the federal unified budget. While
historically, total expenditures have usually exceeded total receipts--and
the sector therefore issues debt to cover part of the cost of its capital
projects--the simulations suggest that the size of the gap will exceed the
historical range starting within the next decade.

GAO's State and Local Fiscal Simulations

For over a decade GAO has run long-term simulations showing that absent a
change in policy, the combined effects of demographic changes and growing
health care costs drive ever-increasing federal deficits and debt levels.
The Comptroller General has repeatedly warned that the current fiscal path
of the federal government is "imprudent and unsustainable". State and
local governments provide an array of services to their residents, and the
federal government relies on these governments to assist in the
realization of national goals. State and local governments also rely on
federal grants to varying extents. These subnational governments may also
face fiscal stress. To provide Congress and the public with a broader
national context, GAO has developed a fiscal model of the state and local
sector.

The GAO state and local model projects the level of receipts and
expenditures of the sector in future years based on current and historical
spending and revenue patterns. In the "base case" model we assume that the
current set of policies in place across federal, state, and local
governments remains constant. The primary data source for the model is the
National Income and Product Accounts. The timeframe for the simulations
parallels that of our federal fiscal model--the simulations extend until
2050. The state and local model examines the aggregate fiscal outcomes for
the sector and does not examine the condition of any individual state or
local government.

For more information, contact Stanley J. Czerwinski at (202) 512-6520 or
[4][email protected] or Thomas J. McCool at (202) 512-8678 or
[5][email protected] .

Unlike the federal government, most states have some sort of requirement
for balancing their operating budgets, which do not include budgeting for
longer-term investments. Therefore, we also examine a second case in which
we evaluate a balance measure that we call an operating balance. Our
definition of the operating balance is receipts available to fund current
expenditures minus current expenditures. As shown in figure 1, these
receipts usually have exceeded current expenditures.^1 But the simulation
suggests that within the next decade current expenditures will outstrip
available receipts resulting in a deficit (e.g., a negative operating
balance). This deficit--worsening throughout the projection timeframe
under an unchanged policy scenario--indicates that state and local
governments will need to make tough choices on spending and tax policy to
meet their budget requirements and to promote favorable bond ratings.

Fiscal Difficulties for State and Local Sector Are Driven by Rapidly Rising
Health Care Costs

As is true for the federal sector, it is the growth in health-related
costs that is a 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 because of escalating medical costs.
The first is Medicaid expenditures, and the second is the cost of health
insurance for state and local employees and retirees. Conversely, we found
that other types of expenditures of state and local governments--such as
wages and salaries of state and local workers, pension contributions, and
investments in capital goods--are expected to grow slightly less than
gross domestic product (GDP). At the same time, most revenue growth is
expected to be approximately flat as a percentage of GDP.^2 As such, the
projected rise in health-related costs is the root of the fiscal
difficulties these simulations suggest will occur. Figure 2 shows our
simulations for expenditure growth for health-related and other
expenditures.^3

^1The explicit definition of our operating balance measure is all
receipts, net of funds used for long-term investments, minus current
expenditures.

^2The exception to this is Medicaid grants from the federal government.

^3Interest payments that these governments will need to pay on their
outstanding debt will also likely be a rising expense for the sector in
the future. Rising interest costs are merely a reflection of the sustained
deficits the model predicts across future years.

Figure 2: Health and Non-Health Expenditures of State and Local
Governments

Notes: Historical data through 2006, projections from 2007 through 2050.
Interest expense is not included in this analysis.

State and Local Fiscal Challenges Add to the Nation's Fiscal Difficulties

Since 1992, GAO has produced long-term simulations of what might happen to
federal deficits and debt under various policy scenarios. GAO's 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. As we
have noted elsewhere, the expected continued rise in health care costs
poses a fiscal challenge not just to government budgets, but to American
business and society as a whole. In short, the fundamental fiscal problems
of the federal government and these subnational governments are similar
and are linked. As such, solutions to address these challenges should be
considered in tandem.

Figure 3 shows two simulations for the federal fiscal path under
alternative assumptions, and overlays the simulated fiscal imbalance of
the state and local government sector.^4

^4In GAO simulations that combine the fiscal outcomes for all levels of
government, the methodology underlying the federal simulations differs
slightly from GAO's usual approach. Usually, GAO's federal budget
simulations incorporate the negative effect on economic growth of large
deficits that divert funds from private investment. In order to combine
the federal and state and local budget simulations using a consistent set
of economic assumptions, this feedback from deficits to economic growth is
removed. With or without feedback, the simulations imply that current
fiscal policy is unsustainable over the long term.

Figure 3: Federal and State/Local Surpluses and Deficits as a Share of GDP

Note: Historical data from 2000 through 2006, projections from 2007
through 2050; state and local balance measure is similar to the federal
unified budget measure.

For the federal fiscal simulation denoted Baseline, we use Congressional
Budget Office (CBO) projections for the next 10 years. Under this
scenario, it is assumed that taxes and expenditures over the next 10 years
are in line with current law. This means that a variety of tax
provisions--mostly tax reductions--that are set to expire are allowed to
expire, and that discretionary expenditures of the federal government grow
with inflation. After the first 10 years, we use the Social Security and
Medicare Trustees' 75-year intermediate ("best") estimates for those
programs and CBO's mid-range Medicaid estimates. All other expenditures
are held constant as a share of GDP after the first 10 years. Receipts are
also held constant as a share of GDP after the first 10 years. Under the
alternative federal simulation, we assume that during the next 10 years,
expiring tax provisions are extended and that discretionary spending grows
with GDP--a faster pace than inflation. After the 10-year timeframe, we
assume that action is taken to return revenue to its historical share of
GDP plus an additional amount attributable to deferred taxes (i.e., taxes
on withdrawals from retirement accounts). This alternative also
incorporates somewhat higher Medicare estimates reflecting a more
realistic scenario for physician payments. The overlay of the base case
state and local simulation shows that the state and local fiscal situation
imposes further burdens on the nation's economy in the next several
decades.

Key Assumptions of GAO's State and Local Simulations

The GAO state and local model projects the level of receipts and
expenditures of the sector in future years based on current and historical
spending and revenue patterns. To develop these long-run simulations, we
make projections for each major receipt and expenditure category of the
state and local government sector in future years. On the receipt side,
key categories of receipts for state and local governments include several
types of taxes (personal income, sales, property, and corporate), income
on assets owned by the sector, and grants from the federal government.
Categories of expenditures include wages and salaries of state and local
employees, health insurance costs, pension costs, payments of social
benefits (e.g. Medicaid and unemployment), depreciation expense on state
and local capital stock, interest payments on state and local financial
debt, and other expenditures of the sector. In the "base case" model we
assume that the tax structure is not changed in the future and that the
provision of real government services per capita remains roughly constant.
That is, a basic assumption of the primary model is that the current set
of policies in place across state and local governments remains constant.

(450612)

References

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