State and Local Fiscal Challenges: Rising Health Care Costs Drive Long-term and Immediate Pressures
Published: 2008-11-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO was asked to provide its views on projected trends in health care costs and their effect on the long-term outlook for state and local governments in the context of the current economic environment. This statement addresses three key points: (1) the state and local government sector's long-term fiscal challenges; (2) rapidly rising health care costs which drive the sector's long-term fiscal difficulties, and (3) the considerations involved in targeting supplemental funds to states through the Medicaid program during economic downturns. To provide Congress and the public with a broader perspective on our nation's fiscal outlook, GAO previously developed a fiscal model of the state and local sector. This model enables GAO to simulate fiscal outcomes for the sector in the aggregate for several decades into the future. GAO first published the findings from the state and local fiscal model in 2007. This statement includes August 2008 data to update the simulations. This Committee and others also asked GAO to analyze strategies to help states address increased Medicaid expenditures during economic downturns. GAO simulated the provision of such supplemental assistance to states. As we previously reported, the simulation model adjusts the amount of funding states would receive based on changes in unemployment and spending on Medicaid services.
section_title: What GAO Found
paragraphs: Rapidly rising health care costs are not simply a federal budget problem. Growth in health-related spending also drives the fiscal challenges facing state and local governments. The magnitude of these challenges presents long-term sustainability challenges for all levels of government. The current financial sector turmoil and broader economic conditions add to fiscal and budgetary challenges for these governments as they attempt to remain in balance. States and localities are facing increased demand for services during a period of declining revenues and reduced access to capital. In the midst of these challenges, the federal government continues to rely on this sector for delivery of services such as Medicaid, the joint federal-state health care financing program for certain categories of low-income individuals. Our model shows that in the aggregate the state and local government sector faces growing fiscal challenges. Incorporation of August 2008 data shows that the position of the sector has worsened since our January 2008 report. The long-term outlook presented by our state and local model is exacerbated by current economic conditions. During economic downturns, states can experience difficulties financing programs such as Medicaid. Downturns result in rising unemployment, which can increase the number of individuals eligible for Medicaid, and declining tax revenues, which can decrease revenue available to fund coverage of additional enrollees. GAO's simulation model to help states respond to these circumstances is based on assumptions under which the existing Medicaid formula would remain unchanged and add a new, separate assistance formula that would operate only during times of economic downturn. Considerations involved in such a strategy could include: (1) timing assistance so that it is delivered as soon as it is needed, (2) targeting assistance according to the extent of each state's downturn, (3) temporarily increasing federal funding so that it turns off when states' economic circumstances sufficiently improve, and (4) triggering so the starting and ending points of assistance respond to indicators of economic distress.

section_title: Letter
paragraphs: I appreciate the opportunity to provide this statement for the record for  today’s hearing that discusses our observations on health care costs and  their relationship to long-term state and local government fiscal conditions  in the context of the current economic environment. Our economic  perspective on health care costs draws on historical data, simulations, and  analysis of policy options to reveal daunting challenges in need of  intergovernmental solutions. As Acting Comptroller General Gene Dodaro  testified before this committee in June, the nation’s long-term fiscal  outlook is driven primarily by rising health care costs and known  demographic trends.
Rapidly rising health care costs are not simply a federal budget problem.  Growth in health-related spending also drives the long-term fiscal  challenges facing state and local governments. The magnitude of these  pressures presents vexing long-term sustainability challenges for all levels  of government. The current turmoil in the financial sector adds to the  immediate fiscal and budgetary challenges for these governments as they  attempt to remain in balance in a rapidly changing and uncertain budget  environment. States and localities are facing increased demand for  services during a period of declining revenues and reduced access to  capital. In the midst of these challenges, the federal government continues  to rely on this sector for delivery of services such as Medicaid, the joint  federal-state health care financing program that covers medical costs for  certain categories of low-income individuals.
This statement addresses a few key points:  the state and local government sector’s long-term fiscal challenges,  the rapidly rising health care costs which drive the sector’s long-term  fiscal difficulties, and  the immediate considerations involved in targeting supplemental funds to  states through the Medicaid program during economic downturns.
This statement is based on our previous work on intergovernmental fiscal  issues, including reports and testimony on state and local government  fiscal challenges, our nation’s long-term fiscal challenges, and approaches  to providing federal fiscal assistance through Medicaid. We conducted this  performance audit in November 2008 in accordance with generally  accepted government auditing standards. Those standards require that we  plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives.
subsections: section_title: The State and Local Government Sector Faces Increasing Fiscal Challenges
paragraphs: Fiscal sustainability presents a national challenge shared by all levels of  government. The federal government and state and local governments  share in the responsibility of fulfilling important national goals, and these  subnational governments rely on the federal government for a significant  portion of their revenues. To provide Congress and the public with a  broader perspective on our nation’s fiscal outlook, we developed a fiscal  model of the state and local sector. This model enables us to simulate  fiscal outcomes for the entire state and local government sector in the  aggregate for several decades into the future. Our state and local fiscal  model projects the level of receipts and expenditures for the sector in  future years based on current and historical spending and revenue  patterns. This model complements GAO’s long-term fiscal simulations of  federal deficits and debt levels under varying policy assumptions. We  have published long-term federal fiscal simulations since 1992. We first  published the findings from our state and local fiscal model in 2007.
Our model shows that the state and local government sector faces growing  fiscal challenges. The model includes a measure of fiscal balance for the  state and local government sector for each year until 2050. The operating  balance net of funds for capital expenditures is a measure of the ability of  the sector to cover its current expenditures out of current receipts. The  operating balance measure has historically been positive most of the time,  ranging from about zero to about 1 percent of gross domestic product  (GDP). Thus, the sector usually has been able to cover its current  expenses with incoming receipts.
Our January 2008 report showed that this measure of fiscal balance was  likely to remain within the historical range in the next few years, but  would begin to decline thereafter and fall below the historical range within  a decade. That is, the model suggested the state and local government  sector would face increasing fiscal stress in just a few years. We recently  updated the model to incorporate current data available as of August 2008.  As shown in Figure 1, these more recent results show that the sector has  begun to head out of balance.
These results suggest that the sector is currently in an operating deficit.  Our simulations show an operating balance measure well below the  historical range and continuing to fall throughout the remainder of the  simulation timeframe.
Since most state and local governments are required to balance their  operating budgets, the declining fiscal conditions shown in our  simulations suggest the fiscal pressures the sector faces and are a  foreshadowing of the extent to which these governments will need to  make substantial policy changes to avoid growing fiscal imbalances. That  is, absent policy changes, state and local governments would face an  increasing gap between receipts and expenditures in the coming years.  One way of measuring the long-term challenges faced by the state and  local sector is through a measure known as the “fiscal gap.” The fiscal gap  is an estimate of the action needed today and maintained for each and  every year to achieve fiscal balance over a certain period. We measured  the gap as the amount of spending reduction or tax increase needed to  maintain debt as a share of GDP at or below today’s ratio. As shown in  figure 2, we calculated that closing the fiscal gap would require action  today equal to a 7.6 percent reduction in state and local government  current expenditures. Closing the fiscal gap through revenue increases  would require action of the same magnitude to increase state and local tax  receipts.
section_title: Rapidly Rising Health Costs Drive Long- term State and Local Sector Fiscal Difficulties
paragraphs: Growth in health-related costs serves as the primary driver of the fiscal  challenges facing the state and local sector over the long term. Medicaid is  a key component of their health-related costs. CBO’s projections show  federal Medicaid grants to states per recipient rising substantially more  than GDP per capita in the coming years. Since Medicaid is a federal and  state program with federal Medicaid grants based on a matching formula,  these estimates indicate that expenditures for Medicaid by state  governments will rise quickly as well. We also estimated future  expenditures for health insurance for state and local employees and  retirees. Specifically, we assumed that the excess cost factor—the growth  in these health care costs per capita above GDP per capita—will average  2.0 percentage points per year through 2035 and then begin to decline,  reaching 1.0 percent by 2050. The result is a rapidly growing burden from  health-related activities in state and local budgets. Our simulations show  that other types of state and local government expenditures—such as  wages and salaries of state and local workers, pension contributions, and  investments in infrastructure—are expected to grow slightly less than  GDP. At the same time, most revenue growth is expected to be  approximately flat as a percentage of GDP. The projected rise in health- related costs is the root of the long-term fiscal difficulties these  simulations suggest will occur. Figure 3 shows our simulations for  expenditure growth for state and local government health-related and  other expenditures.
On the receipt side, our model suggests that most of these tax receipts will  show modest growth in the future—and some are projected to experience  a modest decline—relative to GDP. We found that state personal income  taxes show a small rise relative to GDP in coming years. This likely  reflects that some state governments have a small degree of progressivity  in their income tax structures. Sales taxes of the sector are expected to  experience a slight decline as a percentage of GDP in the coming years,  reflecting trends in the sector’s tax base. While historical data indicate that  property taxes—which are mostly levied by local governments—could rise  slightly as a share of GDP in the future, recent events in the housing  market suggest that the long-term outlook for property tax revenue could  also shift downward. These differential tax growth projections indicate  that any given jurisdiction’s tax revenue prospects are uniquely tied to the  composition of taxes it imposes.
The only source of revenue expected to grow rapidly under current policy  is federal grants to state governments for Medicaid. That is, we assume  that current policy remains in place and the shares of Medicaid  expenditures borne by the federal government and the states remain  unchanged. Since Medicaid is a matching formula grant program, the  projected escalation in federal Medicaid grants simply reflects expected  increased Medicaid expenditures that will be shared by state governments.  These long-term simulations do not attempt to assume how recent actions  to stabilize the financial system and economy will be incorporated into the  federal budget estimates in January 2009.
section_title: Considerations for Targeting Supplemental Funds to States through the Medicaid Program during Economic Downturns
paragraphs: The outlook presented by our state and local model is exacerbated by  current economic conditions. During economic downturns, states can  experience difficulties financing programs such as Medicaid. Economic  downturns result in rising unemployment, which can lead to increases in  the number of individuals who are eligible for Medicaid coverage, and in  declining tax revenues, which can lead to less available revenue with  which to fund coverage of additional enrollees. For example, during the  most recent period of economic downturn prior to 2008, Medicaid  enrollment rose 8.6 percent between 2001 and 2002, which was largely  attributed to states’ increases in unemployment. During this same time  period, state tax revenues fell 7.5 percent. According to the Kaiser  Commission on Medicaid and the Uninsured, in 2008, most states have  made policy changes aimed at controlling Medicaid costs.
Recognizing the complex combination of factors affecting states during  economic downturns—increased unemployment, declining state revenues,  and increased downturn-related Medicaid costs—this Committee and  several others asked us to assist them as they considered a legislative  response that would help states cope with Medicaid cost increases. In  response to this request, our 2006 report on Medicaid and economic  downturns explored the design considerations and possible effects of  targeting supplemental assistance to states when they are most affected by  a downturn. We constructed a simulation model that adjusts the amount  of funding a state could receive on the basis of each state’s percentage  increase in unemployment and per person spending on Medicaid services.  Such a supplemental assistance strategy would leave the existing Medicaid  formula unchanged and add a new, separate assistance formula that would  operate only during times of economic downturn and use variables and a  distribution mechanism that differ from those used for calculating  matching rates. This concept is embodied in the health reform plan  released by Chairman Baucus last week.
Using data from the past three recessions, we simulated the provision of  such targeted supplemental assistance to states. To determine the amount  of supplemental federal assistance needed to help states address increased  Medicaid expenditures during a downturn, we relied on research that  estimated a relationship between changes in unemployment and changes  in Medicaid spending. Our model incorporated a retrospective  assessment which involved assessing the increase in each state’s  unemployment rate for a particular quarter compared to the same quarter  of the previous year. Our simulation included an economic trigger turned  on when 23 or more states had an increase in the unemployment rate of 10  percent or more compared to the unemployment rate that existed for the  same quarter 1 year earlier (such as a given state’s unemployment rate  increasing from 5 percent to 5.5 percent). We chose these two threshold  values—23 or more states and increased unemployment of 10 percent or  more—to work in tandem to ensure that the national economy had  entered a downturn and that the majority of states were not yet in  recovery from the downturn. These parameters were based on our  quantitative analysis of prior recessions. As shown in figure 4, for the  1990-1991 downturn, 6 quarters of assistance would have been provided  beginning with the third quarter of 1991 and ending after the fourth quarter  of 1992.
Analysis of recent unemployment data indicate that such a strategy would  already be triggered based on changes in unemployment for 2007 and  2008. In other words, current data confirm the economic pressures  currently facing the states.
Considerations involved in such a strategy include:    Timing assistance so that it is delivered as soon as it is needed,    Targeting assistance according to the extent of each state’s downturn,    Temporarily increasing federal funding so that it turns off when states’  economic circumstances sufficiently improve, and    Triggering so the starting and ending points of assistance respond to  indicators of states’ economic distress.
Any potential legislative response would need to be considered within the  context of broader health care and fiscal challenges—including  continually rising health care costs, a growing elderly population, and  Medicare and Medicaid’s increasing share of the federal budget. Additional  criteria could be established to accomplish other policy objectives, such as  controlling federal spending by limiting the number of quarters of  payments or stopping payments after predetermined spending caps are  reached.
section_title: Conclusions
paragraphs: The federal government depends on states and localities to provide critical  services including health care for low-income populations. States and  localities depend on the federal government to help fund these services.  As the largest share of federal grant funding and a large and growing share  of state budgets, Medicaid is a critical component of this  intergovernmental partnership. The long-term structural fiscal challenges  facing the state and local sector further complicate the provision of  Medicaid services. These challenges are exacerbated during periods of  economic downturn when increased unemployment leads to increased  eligibility for the Medicaid program. The current economic downturn  presents additional challenges as states struggle to meet the needs of  eligible residents in the midst of a credit crisis. Our work on the long-term  fiscal outlook for state and local governments and strategies for providing  Medicaid-related fiscal assistance is intended to offer the Committee a  useful starting point for considering strategic evidence-based approaches  to addressing these daunting intergovernmental fiscal issues.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: For information about this statement for the record, please contact  Stanley J. Czerwinski, Director, Strategic Issues, at (202) 512-6806 or  czerwinskis@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this  statement. Individuals making key contributions to this testimony and  related products include: Kathryn G. Allen, Director, Quality and  Continuous Improvement; Thomas J. McCool, Director, Center for  Economics; Amy Abramowitz, Meghana Acharya, Romonda McKinney  Bumpus, Robert Dinkelmeyer, Greg Dybalski, Nancy Fasciano, Jerry  Fastrup, Carol Henn, Richard Krashevski, Summer Lingard, James  McTigue, Donna Miller, Elizabeth T. Morrison, Michelle Sager, Michael  Springer, Jeremy Schwartz, Melissa Wolf, and Carolyn L. Yocom.
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