Summary

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.

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.