Similar to our prior work on federal fiscal exposures, this report notes that state and local fiscal pressures can be thought of broadly and highlights trends in and simulations for state and local spending and revenue patterns that may expose the federal government to future spending or otherwise have implications for implementation of federal programs. This review of state and local governments’ fiscal pressures is not necessarily representative of all fiscal pressures facing state and local governments. This review provides a perspective on the issues facing these governments and how these pressures could affect federal programs and policies. States and localities face fiscal pressures when, taken as a whole, spending is expected to outpace revenues, based on current policies. Growth in individual categories of spending, absent corresponding revenue growth or decreases in other spending, can be a source of fiscal pressures. Similarly, fiscal pressures may arise from revenue trends that do not keep pace with overall spending. Growth in individual spending categories or a decline in individual revenue categories alone does not constitute a fiscal pressure. Changes in the makeup of state and local government services and revenues may be choices that reflect economic or demographic changes or a change in public preferences. Fiscal pressures can result from spending growth or revenue declines that are not the direct result of current state and local policy choices, but instead reflect automatic spending growth (for example in response to population shifts or an increase in the number of people eligible for government programs) or declines in revenue due to changes in the economy (e.g., increases in internet sales, which affect states’ ability to capture sales tax). Individual expenditure categories can also face fiscal pressures; (e.g., employee pension funds experiencing growth rates below the rates assumed in budget forecasts which then become underfunded liabilities). This work is primarily focused on long-term pressures, but the state and local government sector can also face short-term fiscal pressures that can arise from unexpected developments—such as a natural disaster or a recession—that cause substantial increases in spending or reductions in revenue. The recession that began in December 2007 caused significant immediate fiscal pressures in the form of reduced tax revenues and increased demand for certain programs, including Medicaid and unemployment benefits. Because this report focuses primarily on long- term pressures and some of the state and local data on government spending were only available through 2007, the effects of this recession are not included in the statistical analysis of variation among the states. To address fiscal pressures and comply with balanced budget requirements, state and local governments may offset increased costs in one program by making cuts to other programs, but they may have less flexibility to adjust certain types of spending. For example, state and local government employee pension benefits are often defined in state law or local ordinances or charters and, in that sense, pension benefits for current retirees are largely protected from states’ or localities’ responses to fiscal pressures. On the other hand, retiree health benefits for those employees may not have the same level of legal protection. Spending on programs such as street paving may have no legal protection, but instead be an implicit commitment grounded in the public’s expectations for the provision of government services. Flexibility to adjust revenues may also be constrained explicitly (e.g., caps on tax increases), or implicitly, (e.g., tax increases can be politically unpopular). The obligation of state and local governments to repay their long-term debt also varies, and a substantial portion of that debt has limited claims on the assets and revenues of state and local governments. About 60 percent of total state and local long-term debt outstanding is in the category of revenue bonds secured by a specific revenue-generating entity and provide no recourse to any other governmental assets or revenues in the event of default. In contrast to revenue bonds, general obligation bonds, which comprise about 40 percent of total state and local long-term debt outstanding, have payment of principal and interest secured by the full faith and credit of the issuer. Our March 2010 state and local fiscal model updates simulations showing that state and local governments’ long-term fiscal position will steadily decline through 2060 absent policy changes (see fig. 1). Our updated simulations for the state and local sector’s operating balance measure estimate operating deficits of about $39 billion for 2010 and $124 billion for 2011. These results confirm our recent finding that while states’ near- term revenue shortfalls have been cushioned by the temporary infusion of American Recovery and Reinvestment Act of 2009 (Recovery Act) funds, as shown in the insert within figure 1, states will continue to be fiscally stressed. These simulations suggest the fiscal pressures the sector faces and the extent to which these governments will need to make substantial policy changes to avoid growing imbalances. The size of these simulated deficits and state and local government balanced budget requirements imply the need for these governments to take action to reduce state and local government current expenditures, increase revenues, or do both in order to maintain balance. One way of measuring the long-term challenges faced by the 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 prevent operating deficits (or negative operating balances). Our simulations showed the present value of the fiscal gap over the period 2009 to 2058 was $9.9 trillion, or 2 percent of gross domestic product (GDP). We calculated that closing the fiscal gap over the next 50 years would require action to be taken today and maintained for each and every year going forward equivalent to a 12.3 percent reduction in state and local government current expenditures. Closing the fiscal gap through revenue increases would require action of a similar magnitude through increased state and local revenues. It is important to note that these estimates do not attempt to assume forthcoming policy actions by federal, state, or local governments and are based on analysis of historical data. Actual amounts will reflect policy actions taken by state and local governments to balance their budgets. The primary driver of the fiscal pressure confronting the state and local sector is the continued growth in health-related costs. State and local expenditures on Medicaid and the cost of health insurance for state and local retirees are expected to grow more than GDP. The health care cost growth assumptions in our model’s simulations do not include adjustments in response to the March 2010 passage of the Patient Protection and Affordable Care Act (PPACA). Precisely how the act will affect state costs is not yet clear and will likely vary among the states. CMS estimates that while the federal government will be responsible for the vast majority of increases in Medicaid expenditures over the next 10 years, state and local governments will also experience some increases. Some analysts predict state costs will likely increase most where Medicaid eligibility requirements provided less coverage than that required by PPACA. A portion of these additional costs to states will likely be offset by lower charity care costs. Over the last 30 years, health care spending has increased as a share of state and local spending, growing from 12 percent of overall state and local expenditures in 1978 to 20 percent in 2008 (see fig. 2). Trends in expenditures for other non-health categories of state and local government spending reflect some fluctuations in the federal role in some of these functions. For example, shifts in social welfare spending reflect federal policy changes to the Temporary Assistance for Needy Families program (TANF, previously known as Aid to Families with Dependent Children) in the mid-1990s. With the creation of TANF, the number of families who received cash assistance fell significantly, from an average of 4.8 million just prior to the creation of TANF to 1.7 million in 2008. State and local expenditures on income security programs, including welfare spending, declined from 10 percent of overall state and local expenditures in 1978 to 7 percent in 2008. Education spending also declined as a share of all state and local government spending, from 40 percent in 1978 to 36 percent in 2008. However, inflation-adjusted spending on education increased over this time period, so this decline in education spending as a share of all state and local government spending largely reflects shifts resulting from faster growth in spending on health care. State and local government revenues increased from $786 billion in 1978 to more than $2 trillion in 2008. About $1.4 trillion—or 68 percent—of the sector’s receipts are comprised of tax receipts, including personal income, sales, and property taxes. Federal grants comprise the second largest source of receipts for the sector, providing about $399 billion to the sector in 2008. The sector had about $251 billion in other receipts in 2008, including fees, income on assets, and contributions for government insurance. Revenue streams from different sources (i.e., taxes, federal grants, and other) have been relatively stable as a percent of GDP over the past 30 years, with some short-term fluctuations and recent declines due to the recession. States’ current tax receipts held relatively steady and ranged from 8 to 10 percent of GDP between 1978 and 2008. Total tax receipts were 68 percent of aggregate state and local government revenues in both 1978 and 2008 (see fig. 3). Other receipts also held relatively steady during the period of analysis at 1 to 2 percent of GDP. Growth in state government tax revenue slowed around the start of the recession that began in December 2007 (see fig. 4). State and local current tax receipts declined for four consecutive quarters, starting in the third quarter of 2008. State tax collections totaled $715.2 billion in fiscal year 2009, down 8.6 percent from the $782.1 billion collected in fiscal year 2008. The National Governors Association (NGA) and NASBO reported in June that the severe national recession has drastically reduced tax revenues due to significant declines in sales, personal income, and corporate income tax collections. NGA and NASBO also reported that as state revenue collections historically lag behind any national economic recovery, state revenues will likely remain sluggish throughout fiscal years 2011 and 2012. In the first quarter of calendar year 2010, state tax revenues were higher than in the same period in 2009. This positive news is tempered by the small size of the projected growth rates in many states. Some of these revenue losses were offset by increased federal funding provided by the infusion of Recovery Act funds discussed below. However, states continued to take actions to address revenues in fiscal years 2009 and 2010. Actions taken by state and local governments to close their budget gaps included raising fees, laying off employees, across-the- board cuts to state programs, and drawing on states’ rainy day or reserve funds. States also reduced state aid to localities, a budget-balancing strategy that shifts the fiscal pressure from the state to local governments. Federal grants were a relatively consistent proportion of the state and local sector’s total revenue over the past 30 years. Federal grants ranged from 2 to 3 percent of GDP during this time, increasing from $179 billion in 1978 to $399 billion in 2008. Health care grants have increased as a share of federal grants to state and local governments. Health care grants (including Medicaid) grew from 21 percent of federal funds provided to the sector in 1978 to 58 percent in 2008 (see fig. 5). Non-health care federal grants include funds for education, housing, income security, and other functions that are administered by multiple levels of government and community-based organizations. More recent data for 2009 reflect substantial increases in federal grants— largely from the Recovery Act. The largest categories of Recovery Act funding for state and local governments include Medicaid (Federal Medical Assistance Percentage), education (State Fiscal Stabilization Fund), and transportation (highways and transit). Actual federal outlays to states and localities under the Recovery Act totaled approximately $137.1 billion through July 9, 2010. Outlays in health and education and training constituted 88 percent of total Recovery Act outlays to states and localities in fiscal year 2009. These Recovery Act funds were used by states and localities to fund a range of programs and services and thereby helped to partially address budget gaps. However, state and local officials reported that they continued to take actions to further address existing budget shortfalls. The rates of growth in expenditures and revenues varied among the states during the past 30 years, both overall and within specific categories of expenditures and revenues. State and local government total general expenditures (capital and current) grew slightly faster than total general revenues—both own-source and federal grant revenues—in most states during the period from 1977 to 2007. In addition, state and local government current expenditures grew faster than own-source revenues in almost all states between 1977 and 2007 (see fig. 6). The state and local sector as a whole generally avoided operating deficits despite current spending growing faster than own-source revenues in part because the growth in federal grants for the purpose of funding current spending somewhat exceeded the growth in current spending. In addition, from 1995 to 2007, the sector increasingly financed capital purchases by issuing debt, rather than with revenues, which left more revenues available to pay for current expenditures. As a result, the sector usually remained in surplus during this time period, as illustrated above in figure 1, and states increased their reserves between 2000 and 2006. However, if the overall trend of expenditure growth in excess of revenue growth persists; state and local government expenditure growth will put increasing pressure on state and local governments going forward. The growth of intergovernmental revenue from the federal government (federal grants) was mixed. State and local current expenditures grew faster than federal grant revenues in more than half of the states (see fig. 7). Such growth means that, in those states, federal funding supported a decreasing share of state and local government current spending over this time period. State and local current expenditures grew more slowly than federal grant revenues in the other states between 1977 and 2007. States with faster growth in expenditures generally also had faster growth in federal grant revenues but this pattern also included variation among states. Some states that had similar expenditure growth rates had federal grant revenue growth rates that differed by more than 1 percentage point. The growth of federal grant revenues relative to the growth of own-source revenues was also mixed. In about half of states, federal grant revenues grew slower than own-source revenues and in the other half, states’ federal grant revenues grew faster than own-source revenues during the past three decades. For the state and local government sector in the aggregate, federal grants grew as a share of state and local current expenditures from 1977 to 2007 for three of the four types of spending that we assessed—health and hospitals, education, and public welfare (which includes Medicaid spending). Variation also existed among states and categories. Federal grants for health and hospitals showed the greatest overall increase relative to state and local current expenditures on health and hospitals. For the state and local government sector as a whole, federal grants for health and hospitals grew at an annual rate of 6.4 percent, 2.4 percentage points faster than the 4.0 percent growth in state and local government spending on health and hospitals (table 1). Growth rates within this category varied considerably among states—in more than two-thirds of the states, federal funds were an increasing share of state and local spending on health and hospitals. Federal grants for education grew at an annual rate of 3.8 percent, 0.3 percentage points faster than the 3.5 percent growth in state and local governments’ current expenditures for education. Federal education grant funding grew faster than state and local governments’ education expenditure growth in more than half of the states. Federal grants for public welfare grew at an average annual rate of 6.1 percent, 0.8 percentage points faster than the 5.3 percent growth in state and local governments’ public welfare spending. Only for housing and community development did sector-wide spending grow faster than related federal grant revenues. In the aggregate, federal grants for housing and community development grew at an average annual rate of 5.3 percent, 0.6 percentage points less than the 5.9 percent growth in state and local spending on housing and community development. Variations in spending, revenue, and debt patterns among and within states over time reinforce the challenge of designing a federal response to recent trends or in anticipation of future trends. We examined these variations in selected categories of expenditures and revenues, which are described in table 2. To examine these variations, we assessed selected categories of expenditures, revenues, and debt using three measures. 1. To get a sense of the relative proportion represented by each category in each state, we calculated (a) selected expenditure categories as shares of general current expenditures in 2007, (b) selected revenue categories as shares of general revenues in 2007, and (c) long- and short-term debt as shares of total revenues in 2007. 2. To assess how fast each category grew between 1977 and 2007 in each state, we calculated the growth rate for each selected expenditure, revenue, and debt category. 3. To compare the growth in these categories relative to growth in each state’s resources, we compared the growth rate for each selected expenditure, revenue, and debt category to the growth rate in total state personal income between 1977 and 2007. We chose total personal income as a proxy for each state’s resources or fiscal capacity. For example, when expenditures in a state are growing faster than personal income, the share of the state’s resources that are dedicated to state and local government services is growing. Over the long run, such growth could create a fiscal pressure. This analysis also identified the number of states where growth in a category was (a) greater than total personal income growth for that state or (b) less than total personal income growth for that state. State and local government expenditure growth rates varied substantially by category among states (see table 3). Between 1977 and 2007, general expenditures for the state and local government sector increased at an average rate of 4.0 percent per year and ranged from a minimum of 2.2 percent to a maximum of 6.8 percent in individual states. Current expenditures and capital outlays by the state and local government sector displayed a similar pattern, but with a wider range of growth rates for individual states. State and local government expenditures varied in terms of the shares of expenditures represented by different categories of spending both among states and over time within states. We examined state and local government expenditures for four spending categories— corrections, elementary and secondary education, health and hospitals, and public welfare—as well as categories for salaries and wages and interest on the general debt. Variation across states in personal income growth, a proxy for a state’s fiscal capacity growth, also likely contributed to differences among states in expenditure growth. Between 1977 and 2007, personal income in the United States grew at an annual rate of 3.3 percent with a range of 1.7 percent to 6.6 percent for individual states. In most states, both general expenditures and current expenditures grew faster than personal income between 1977 and 2007 (see fig. 8). At the same time, the number of states for which state and local government expenditures grew faster than personal income varied among key categories. Corrections: Corrections expenditures grew at a rate of 6.7 percent—the fastest growing expenditure category during the time period we assessed. All states experienced growth in this type of expenditure and growth rates ranged from 0.6 percent to 10.0 percent in individual states. Virtually every state experienced a growth rate faster than the growth in total personal income. However, corrections spending only represented 3.3 percent of current expenditures for state and local governments in 2007. Education: Spending on elementary and secondary education increased in all states between 1977 and 2007. However, almost all states experienced declines in these expenditures as a percent of current expenditures because other expenditure categories grew faster. Over the same period, spending on elementary and secondary education grew faster than personal income in almost two-thirds of states. In the aggregate, spending on elementary and secondary education made up 23.7 percent of state and local government current expenditures in 2007, making it the largest functional expenditure category. Health and hospitals: Expenditures on health and hospitals grew at an average rate of 4.0 percent per year for the state and local government sector as a whole between 1977 and 2007. Over the same period, growth rates in some states were as high as 7.2 percent, and inflation-adjusted spending on this category increased in virtually all states. Spending on health and hospitals grew faster than personal income in almost two-thirds of states. State and local governments as a whole allocated 9.3 percent of current expenditures to health and hospitals in 2007, with individual states allocating between 2.6 and 17.5 percent. Public welfare: Spending on public welfare, including Medicaid, grew at a rate of 5.3 percent between 1977 and 2007. Growth rates for public welfare expenditures during the same period ranged from 2.3 to 10.9 percent in individual states. Spending on public welfare by state and local governments grew faster than personal income in all states between 1977 and 2007. Aggregate public welfare expenditure by the state and local government sector grew from 15.2 to 19.6 percent of current expenditures during the same period. In 2007, public welfare made up between 12.5 and 30.6 percent of current expenditures in individual states. Salaries and wages: State and local government spending on salaries and wages grew at an average annual rate of 2.9 percent between 1977 and 2007 and growth ranged from 0.4 percent to 5.5 percent for individual states during this time period. Spending on total salaries and wages grew slower than personal income in almost all states. Overall, state and local government spending on salaries and wages dropped from 53.5 percent of current expenditures in 1977 to 38.5 percent in 2007. Total salaries and wages overlaps with sector-specific functional expenditure categories (e.g. education, public welfare, corrections, etc.), and is thus not considered a separate functional category. Interest on the general debt: Expenditures on interest on the general debt increased in almost all states between 1977 and 2007, with average annual growth rates that varied from a low of -1.2 percent to a high of 7.4 percent. Almost two-thirds of states experienced growth greater than the growth in total personal income. Spending for interest on the general debt varied substantially within and among the states between 1977 and 2007. On average in the United States, states spent 4.7 percent of current expenditures on interest on general debt in 2007, but this ranged from a low of 1.8 percent to a high of 8.0 percent. Although state and local government revenues grew slower than expenditures in most states between 1977 and 2007, revenue growth rates varied substantially among states during this period. Revenues grew at an average annual rate of 3.8 percent and ranged from 1.7 to 6.7 percent for individual states. States experienced varying growth rates for individual revenue categories and each relied on the various types of revenues to a different extent (see table 4). Own-source revenue made up a stable fraction of revenue collected by the state and local government sector, measuring 78.1 percent in 1977 and 79.9 percent in 2007. However, in individual states, own-source revenue ranged from 58.9 to 86.4 percent of state and local government revenue in 2007. Own-source revenue grew at an annual rate of 3.8 percent for the sector, but grew at rates from 1.3 to 6.9 percent in individual states. As with expenditure growth, variation across states in personal income growth, a proxy for fiscal capacity growth, also likely contributed to variation across states in revenue growth. In most states, revenue grew faster than personal income between 1977 and 2007 (see fig. 9). Most of the components of revenue also grew faster than personal income in most states over the same period. Total taxes: Tax revenues grew in almost all states between 1977 and 2007, with growth rates as high as 6.9 percent annually. These changes in tax revenues reflect both policy changes (e.g., changes in income tax rates) and economic changes (e.g., changes in population or total taxable personal income). Most state and local government tax revenues stem from three types of taxes—individual income taxes, general sales taxes, and property taxes. While more than two-thirds of the states experienced growth in total taxes greater than the growth in personal income between 1977 and 2007, almost all states also experienced declines in total taxes as a percent of general revenue because other revenue categories (i.e., federal grants and total charges and miscellaneous revenue) grew faster. For the state and local government sector in the aggregate, total taxes made up 54.8 percent of revenue in 2007. The share of revenue collected as taxes in individual states ranged from about 37 to about 69 percent. For the state and local government sector, property taxes as a share of revenue declined between 1977 and 2007, while individual income taxes increased and general sales taxes remained relatively stable. Individual income taxes: Individual income taxes emerged as the fastest growing tax category, growing at an annual rate of 4.3 percent. Receipts in states that collected individual income taxes ranged from 0.7 percent to 24.6 percent of revenue collected in 2007. For the sector in the aggregate, individual income tax revenues made up 12.4 percent of revenue in 2007. Individual income taxes made up more than 20 percent of state revenues in a few states while 7 states had no broad-based income tax during this period of analysis. Individual income taxes grew faster than personal income in more than two-thirds of the states. Sales taxes: General sales taxes grew an average of 3.8 percent per year for all states between 1977 and 2007. Sales tax growth ranged from -0.8 percent to 7.8 percent in individual states. Four states did not have a general sales tax during the period of analysis and sales tax revenues constituted more than 20 percent of state and local government revenues in a few states. Sales tax revenues grew faster than personal income in more than two-thirds of the states during this period. Property taxes: Of the three major categories of taxes, growth in property tax revenues showed the least amount of variation among the states and grew an average of 3.2 percent per year with growth rates ranging from 0.3 to 6.8 percent in individual states. For the sector in the aggregate, property taxes made up 16.5 percent of revenue in 2007. Property taxes ranged from 6.2 to 34.1 percent of revenue collected in individual states in 2007. A majority of states experienced property tax growth greater than the growth in personal income. Total charges and miscellaneous revenue: This category emerged as the fastest growing overall revenue category, with an aggregate annual growth rate of 4.8 percent. All states experienced growth in this category while almost all states experienced growth relative to personal income. These growth rates indicate that, on the whole, state and local governments are increasingly relying on charges and miscellaneous revenue to finance their programs and services. For the state and local government sector in the aggregate, total charges and miscellaneous revenue comprised 25.2 percent of revenues in 2007. Federal grants: In the aggregate, federal grant revenues also grew faster than tax revenue, at an average annual rate of 3.9 percent. Growth rates of federal grant revenue for individual states varied between 0.4 and 6.9 percent. Federal grants to the state and local government sector represented 20.1 percent of revenues in 2007, slightly less than the 21.9 percent they contributed in 1977. Federal grants made up between 13.6 and 41.1 percent of revenues for state and local governments in individual states in 2007. More than two thirds of the states experienced growth in federal grant revenue greater than growth in personal income. Between 1977 and 2007, total state and local government debt grew at an annual rate of 4.2 percent, driven largely by long-term debt, which grew at an annual rate of 4.3 percent. A major portion of long-term debt is private purpose and utility debt, which have a limited claim on state and local revenue and assets in the event of default. According to National Income and Product Accounts data, there has been a long-term downward trend in aggregate state and local government sector net savings over the past 30 years. Short-term debt increased over this period at a rate of 0.2 percent in the United States. Short-term debt equaled approximately 1 percent of total state and local government revenue in 2007. States varied significantly with respect to trends in debt. For example, a few states experienced declines in levels of long-term debt, while two-thirds of the states experienced growth greater than the growth in personal income over that period. More than two-thirds of the states experienced real declines in short-term debt, while a small number of states had real dollar increases in the level of short-term debt of more than 15 percent. Given the nature of the partnership among levels of government in providing services to the public and the economic interrelationships among levels of government, understanding patterns in state and local government expenditures and revenues is crucial for identifying and analyzing potential fiscal pressures for the sector. The federal government partners with state and local governments to achieve national priorities through implementation of a variety of programs. Such programs range from Medicaid, a joint federal-state program that finances health care for certain categories of low-income individuals, to disaster recovery, where the federal government provides significant financial assistance after major disasters, but state and local governments play the lead role in disaster recovery. The interconnectedness which defines intergovernmental programs requires that all levels of government remain aware of and ready to respond to fiscal pressures. Such awareness and readiness to respond must also acknowledge the array of assumptions used to develop simulations identifying potential future pressures. Since many federal programs are implemented with state and local governments, fiscal pressures confronting the sector could affect implementation of federal programs and policies. The persistent long-term pressures outlined earlier in this report may require states and localities to fundamentally reassess their spending and revenue policies. The emergence of the recent cyclical downturn has hastened the need for action and increased the sense of urgency for state and local governments. In our work involving oversight of Recovery Act funds, we found that many states have reported significant declines in the number of management and oversight staff—limiting states’ ability to ensure proper implementation and management of Recovery Act programs. These recent findings reinforce the expectation that states may not be able to provide current levels of services for federally funded programs they administer if budget actions such as layoffs and furloughs of state employees continue. These challenges have implications for a wide range of federal, state, and local programs, policies, and activities. The following discussion of state and local fiscal pressures provides additional context for understanding the potential implications for future federal policies to supplement the analysis of expenditure and revenue data which identified the existence of and variation in these pressures. The fiscal pressure created by the growth in health care expenditures discussed earlier in this report is combined with the anticipated December 31, 2010 end of increased Medicaid funding for states provided through the Recovery Act. States’ approaches to preparing for the end of Recovery Act funding vary, depending on budget gaps and governments’ balanced- budget requirements. According to a recent report by the National Conference of State Legislatures, 30 states built into their proposed or enacted fiscal year 2011 budgets an assumption that Congress would extend increased Medicaid funding. In addition to this near-term pressure, it is not entirely clear how states’ Medicaid expenditures will be affected by the Patient Protection and Affordable Care Act over the long term. CBO estimated the cost of health care reform efforts over the 2010- 2019 period as well as the effects on the deficit in the decade beginning in 2020. However, CBO has also noted the imprecision of these calculations because of the great degree of uncertainty associated with the estimates. CBO has not extrapolated estimates further into the future because the uncertainties surrounding them are magnified even more. Looking forward, states have concerns about the long-term sustainability of their Medicaid programs. In addition to the known fiscal challenges and uncertainty regarding future health care expenditures, the nation’s physical infrastructure is under strain. Estimates of the costs to repair, replace, or upgrade aging infrastructure so that it can safely, efficiently, and reliably meet current demands, as well as expand capacity to meet increasing demands, top hundreds of billions of dollars. Addressing these challenges is complicated by the breadth of the nation’s physical infrastructure—including aviation, highway, transit, rail, water, and dam infrastructure—which is owned, funded, and operated by all levels of government and the private sector. In this environment, the infrastructure improvements that all levels of government want will compete for scarce resources and may exceed what the nation can afford. Accordingly, decisions about the appropriate level of distribution and spending on infrastructure are both difficult and enormously important. State and local governments also face fiscal pressures from pensions offered to employees. Declines in pension asset values stemming from the recent recession affect the sector’s long-term fiscal position. The state and local government sector experienced a decline in pension asset values of 27.6 percent—from $3.2 trillion at the end of 2007 to $2.3 trillion at the end of 2008. The contribution rate required for the sector to fund the plans on an actuarial basis increased to 9.9 percent of the sector’s wages, according to our March 2009 estimate, which is higher than the actual 2008 contribution rate of 8.3 percent. In 2008 we reported that the percentage of the 65 large public pension plans we analyzed that had a funded ratio (actuarial value of assets divided by actuarial accrued liabilities) of 80 percent or better decreased steadily from about 90 percent in 2000 to 58 percent in 2006. More recent studies by others found that aggregate state and local pension funding levels continued to decline in 2008 and are expected to decline significantly in 2009 and over the next few years as the full effect of the recent financial crisis is realized. Consistent with our prior work, these studies found wide variation in funding levels among plans. For example, the Pew Center on the States found that in 2008, 12 state pension funds had funded ratios above 90 percent and 8 had funded ratios less than 65 percent. Low funded ratios will eventually require action by state and local governments to improve funding and may shift costs to future generations. While reducing benefits could improve funding requirements, state and local governments may not be able to do so for existing employees due to guarantees by state constitutions or contracts. Improving funding may require increased contributions. Many governments have often contributed less than the amount needed to improve or maintain funded ratios. Low contributions raise concerns about the future funded status of these plans. State and local governments also face fiscal pressure from other postemployment benefits (OPEB), the largest of which is typically retiree health benefits. Accounting standards issued by the Governmental Accounting Standards Board in 2004 require governments to account for the costs of OPEB as employees earn the benefits and as costs are accrued, rather than when the benefits are paid or provided. Because state and local governments have historically funded retiree health benefits when paid or provided rather than when the benefits are earned, much of their OPEB liability is unfunded, raising concerns about the fiscal pressures state and local governments face in the coming decades. In a 2009 review, we found that the total unfunded OPEB liability reported in states and the largest local governments’ comprehensive annual financial reports (CAFR) exceeded $530 billion. We reported that spending on state and local government retirees’ health benefits is expected to more than double as a share of total operating revenues by 2050, from 0.9 percent to 2.1 percent. The Pew Center on the States published similar findings on OPEB obligations and found that state governments’ OPEB liability in fiscal year 2008 was $587 billion to pay for current and future benefits, with only $32 billion of that amount pre-funded. Low funded ratios will eventually require action by state and local governments to close the gap between promised benefits and dedicated resources and may shift costs to future generations. Similar to state and local employee pensions, while reducing benefits could improve funding, state and local governments may not be able to do so for existing employees without changing current guarantees in contracts. In the absence of such changes, improving funding may require increased contributions. The federal government also has an interest in investing in the education of children to establish a well-educated and skilled workforce that will enhance U.S. competitiveness in the global marketplace. As we have previously reported, the federal government accounts for about 9 percent of the total investment in K-12 education, with state and local sources covering the rest. The federal government provided an estimated $166.9 billion over the 3-year period from fiscal years 2006-2008—for an average of $55.6 billion per year—to administer 151 different federal K-12 and early childhood education programs. In addition to these funds, the Recovery Act provided about $85 billion in discretionary funding for 14 existing and 3 new K-12 and early childhood education programs. Some of these funds can also be used for postsecondary education and noneducation purposes. Even with the influx of Recovery Act funds, the budget condition of local educational agencies (LEA) across the country is mixed, with some still facing large budget cuts. The budgetary picture for LEAs ranges widely across states. The budget pressures facing LEAs contribute to a fiscal pressure with long-term implications for our nation’s workforce and competitiveness depending on how these pressures are addressed. As we have previously reported, state and local governments are not alone in facing a broad array of daunting fiscal pressures. As the federal government confronts its own long-term and growing fiscal challenges, its ability to continue to provide growing intergovernmental revenue could be constrained. These federal fiscal pressures are also likely to influence future federal policies to provide countercyclical federal fiscal assistance. Beyond the recent recession, state and local governments’ continued and growing fiscal challenges will add to the nation’s overall fiscal difficulties. Figure 10 shows simulations for the federal fiscal path under alternative assumptions and overlays the simulated fiscal imbalance of the state and local government sector. The overlay of the state and local government model’s simulations with our federal fiscal model shows that state and local governments’ fiscal challenges impose further fiscal challenges on the nation’s economy in the next several decades. Countercyclical federal assistance provided by the Recovery Act and other federal programs to address the recent recession will not alleviate the long-term structural fiscal challenges facing state and local governments. The combined long- term fiscal challenges for all levels of government further complicate the process of sorting out competing demands for federal funds and other fiscal resources. As we have previously reported, our long-term simulations also show that absent policy changes, the federal government faces an unsustainable growth in debt, as debt held by the public as a share of GDP could exceed the historical high reached in the aftermath of World War II by 2020. Figure 11 also shows a measure of the increased burden facing state and local governments. Because state and local governments are generally prohibited from using debt to finance operating deficits, state and local debt will not actually increase as shown in this figure. However, the figure is an indicator of the cumulative growing pressure on their budgets and their economies. The simulations suggest that federal debt could exceed 100 percent of GDP by 2019 and reach 200 percent of GDP by 2032. At some point, such a growing debt burden becomes unsustainable and some combination of increased interest rates, higher inflation, or the dollar’s depreciation could force action to reduce federal deficits. In addition, many of the long-term fiscal challenges the nation faces, including health care cost growth and the aging population, have already begun to affect the federal budget—in some cases sooner than previously estimated—and the pressures only grow in the coming decade. For example, Social Security cash surpluses have served to reduce the unified budget deficit. However, CBO recently estimated that due to current economic conditions the program will run small temporary cash deficits for the next 4 years and then, similar to the Trustees’ estimates, run persistent cash deficits beginning in 2016. The fluctuation and eventual disappearance of the Social Security cash surplus will put additional pressure on the rest of the federal budget. Given these fiscal conditions, it is likely the federal government could find the trade-off between providing countercyclical assistance to states during future periods of economic downturn and addressing long-term federal fiscal challenges more and more pronounced over time. Recent events have further exacerbated fiscal challenges for all levels of government. Although the economy is fragile, there is wide agreement on the need to begin to change the long-term fiscal path without slowing the recovery because the magnitude of the changes needed grows with time. While the drivers of the long-term fiscal outlook have not changed, the sense of urgency has. Actions to address the nation’s long-term fiscal outlook will be needed at all government levels in coming years and the challenges cannot simply be shifted from one level of government to another. As we agreed with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution of it until 14 days from the date of this letter. The report will be available at no charge on GAO’s Web site at http://www.gao.gov. If you or your staff have any questions about this letter, please contact me 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 report. GAO staff who made major contributions to this report are listed in appendix II. We examined the fiscal challenges facing state and local governments. Specifically, we examined (1) the fiscal pressures facing state and local governments during the next several decades and the past expenditure and revenue trends that influence these pressures, (2) state and local government expenditure and revenue trends to identify patterns among states, and (3) what is known about the implications of long-term state and local government fiscal pressures for current and future federal policies. To characterize and quantify the long-term fiscal outlook for the state and local government sector over the next 50 years, we drew information from the March 2010 update to our state and local government fiscal model. Specifically, we present simulations of the state and local sectors’ operating budget balance as a percentage of gross domestic product (GDP) and an estimate of the fiscal gap—the amount of spending reduction or tax increase needed to prevent operating deficits (or negative operating balances). To develop these long-run scenarios, we simulate each major receipt and expenditure category of the state and local government sector in future years using the Bureau of Economic Analysis’s National Income and Product Accounts (NIPA) as our primary data source. We simulate the growth in each category of receipts and expenditures using the Congressional Budget Office’s (CBO) economic assumptions whenever possible. In several cases we were not able to obtain existing projections and needed to develop our own assumptions about the likely future growth path of certain receipts or expenditures. For example, because 2009 data on total employment were not available from NIPA at the time of our analysis, we used data from the Bureau of Labor Statistic’s Current Employment Statistics program to estimate the sector’s 2009 employment level. To describe long-term trends in state and local government revenues and expenditures, we examined NIPA data over the past 30 years. We analyzed changes in the shares of state and local expenditure, revenue, and federal grant categories as a percent of total expenditures, revenues, and federal grants respectively from 1978 to 2008. We also examined inflation-adjusted growth in expenditure and revenue categories as a percent of GDP. In addition, we provide information on the effect of the recent recession on state and local government tax revenues using NIPA data (2001 through the first quarter of 2010) to show declines in recent years. We also reviewed our prior reports and those of others to identify what is known about these trends and factors that affect them. To examine trends in state and local government expenditure and revenue patterns among the states, we used U.S. Census Bureau government finance data and GDP price index data from NIPA to calculate inflation- adjusted values of selected expenditure and revenue categories for each state (including the District of Columbia) and for the U.S. for 1977-2007, excluding 2001 and 2003 because data were not available in those years. Data for 1977, 1982, 1987, 1992, 1997, 2002, and 2007 are based on the U.S. Census Bureau, Census of Governments, which surveys all state and local governments in the United States. Data for the other years are based on the Annual Survey of Government Finances. In these years, local government finance statistics are based in part on a sample of local governments in the United States. We determined that the U.S. Census Bureau data were the best available data for the purpose of examining variation in trends among the states. We previously reported that this data comprises the most comprehensive and consistent set of data on this subject. We assessed the reliability of the data we used for this review and determined that they were sufficiently reliable for our purposes. However, due in part to definitional differences among the states, such as those of coverage (what constitutes a government entity) or measurement (cash vs. accrual accounting) the data cannot be used as financial statements, to measure a government’s fiscal condition, or to calculate a surplus or deficit. We examined patterns between state and local revenue growth and growth in overall state and local spending using data from the U.S. Census Bureau. For each state and the District of Columbia, we plotted the average annual growth rate in real own-source revenues against the average annual growth in real current expenditures from 1977 to 2007. We then counted the number of states in which spending grew faster, slower, and at the same rate as own-source revenues. We analyzed growth in current expenditures against growth in federal grant revenues and total general expenditures against total general revenues using the same approach. To examine the extent to which federal grants supported selected categories of state and local government spending, we compared average annual growth in federal grants from 1977 to 2007 using U.S. Census Bureau data for four expenditure categories—health and hospitals, education, public welfare, and housing and community development—to the growth in those expenditure categories over the same time period. We also tabulated the number of states in which federal grant revenues grew faster than current expenditures, and the number of states in which federal grants grew slower than current expenditures. To identify categories of spending that could influence fiscal pressures, we analyzed NIPA data on aggregate expenditures by category. Specifically, we selected for further analysis spending categories for which there were at least $100 billion in expenditures in 2008, and which, as a percent of GDP, experienced a positive annual growth rate between 1978 and 2008. We also included ‘Corrections’ because it had the highest growth rate of all categories, and is identified in the literature as a growing expense for some states. We then selected analogous categories in the U.S. Census Bureau data to analyze expenditure trends by category and state. To examine state and local government spending for personnel, we added ‘total salaries and wages’ to our list of expenditure categories. To examine variation among the states, we examined the state and local government finances using three measures: To get a sense of the relative proportion represented by each category in each state and for the United States, we calculated (a) selected expenditure categories as shares of general current expenditures in 2007, (b) selected revenue categories as shares of general revenues in 2007, and (c) long- and short-term debt as shares of total revenues in 2007. To assess how fast each category grew between 1977 and 2007 in each state, we calculated the average annual growth rate for each selected expenditure, revenue, and debt category using regression analysis. For each expenditure and revenue growth rate calculation, we identified the U.S. average growth rate and the minimum and maximum growth rates across the states. Because changes in the levels of expenditures and revenues can be affected by changes in state fiscal capacity—such as increased tax revenues due to population growth—we compared the average annual growth rate for each category of spending, revenues, and debt to the average annual growth rate in state personal income. To compare the growth in these categories relative to growth in each state’s resources, we compared the growth rate for each selected expenditure, revenue, and debt category to the growth rate in total state personal income between 1977 and 2007. We chose total personal income as a proxy for each state’s resources or fiscal capacity. When expenditures in a state are growing faster than personal income, the share of the state’s resources that are dedicated to state and local government services is growing. Over the long run, such growth could create a fiscal pressure. This analysis also identified the number of states where growth in a category was (a) greater than total personal income growth for that state or (b) less than total personal income growth for that state. We used state personal income as a proxy for state fiscal capacity even though we previously reported that personal income is an incomplete measure of state resources because it excludes some sources of income potentially subject to state taxation, such as corporate income produced within the state, but not received by state residents. We recently reported that total taxable resources, as reported by the Department of the Treasury, is a more comprehensive measure of state financing ability than personal income. We did not use total taxable resources as the measure of state fiscal capacity in this analysis because the Department of the Treasury only began calculating it in the 1980s and therefore it was not available for the full period of our analysis. We also did not use GDP-by- state as the measure of states’ fiscal capacity because the calculation of GDP-by-state changed in 1997 such that the data before and after that year are not comparable. To provide additional context for understanding the fiscal pressures facing state and local governments and the potential implications for federal programs and policies, we reviewed our prior reports and reports of think tanks, including the Pew Center on the States and the Nelson A. Rockefeller Institute of Government, and associations representing state and local government officials, including the National Governors Association, the National Association of State Budget Officers, and the National Conference of State Legislatures. We did not fully analyze every pressure nor identify the full range of possible federal policy implications. To show the combined long-term fiscal challenges for all levels of government, we draw on simulations developed in our most recent update to the federal fiscal model for combined federal, state, and local surpluses and deficits as a percentage of GDP. We also simulate federal debt, state and local debt, and cumulative shortfalls as a percentage of GDP. We obtained historical values for federal debt from Historical Tables, Budget of the United States Government, Fiscal Year 2011 and historical values for state and local government debt from the Federal Reserve Board’s Flow of Funds Accounts. Simulated values are from our most recent fiscal outlook reports. We conducted our work from February 2010 to July 2010 in accordance with all sections of GAO’s Quality Assurance Framework that are relevant to our objectives. The framework requires that we plan and perform the engagement to obtain sufficient and appropriate evidence to meet our stated objectives and to discuss any limitations in our work. We believe that the information and data obtained, and the analysis conducted, provide a reasonable basis for any findings and conclusions. Stanley J. Czerwinski, (202) 512-6806 or czerwinskis@gao.gov. Michelle Sager (Assistant Director), Keya Chateauneuf, Andrew Ching, Susan Etzel, Shannon Finnegan, Richard Krashevski, Courtney LaFountain, and Max Sawicky also made key contributions to this report.

Summary: State and local governments work in partnership with the federal government to implement numerous intergovernmental programs. Fiscal pressures for state and local governments may exist when spending is expected to outpace revenues for the long term. GAO was asked to examine (1) the long-term fiscal pressures facing state and local governments and historical spending and revenue trends, (2) spending and revenue trends to identify patterns among states, and (3) what is known about the implications of these fiscal pressures for federal policies. Using aggregate data from the Bureau of Economic Analysis's National Income and Product Accounts, this analysis draws on results from the March 2010 update to GAO's state and local government fiscal model. GAO's model uses historical data to simulate expenditures and revenues for the sector for the next 50 years. Data from the U.S. Census Bureau are used to analyze patterns of state and local government expenditures and revenues among the states from 1977 to 2007, the most recent 30-year period for which these data were available. A review of GAO and other reports synthesizes what is known about the implications of these long-term fiscal pressures for future federal policies. Understanding patterns in state and local government expenditures and revenues is crucial for identifying and analyzing potential future fiscal pressures for the sector. The March 2010 update to GAO's state and local fiscal model updates simulations that state and local governments' long-term fiscal position will steadily decline through 2060 absent policy changes. The primary driver of the fiscal pressure confronting the state and local sector is the continued growth in health-related costs. Over the last 30 years, health care spending has increased as a share of state and local spending, growing from 12 percent of overall state and local expenditures in 1978 to 20 percent in 2008. While the temporary infusion of funds from the American Recovery and Reinvestment Act of 2009 helped cushion near-term revenue shortfalls, states will continue to be fiscally stressed. The rates of growth in expenditures and revenues varied among the states during the past 30 years, both overall and within specific categories. Current expenditures grew faster than own-source revenues in almost all states between 1977 and 2007. Average annual growth rates of state and local government expenditures and revenues varied substantially by category and among states. For example, public welfare (which includes Medicaid) was one of the fastest growing expenditure categories. In the aggregate, inflation-adjusted spending on public welfare grew at an average annual rate of 5.3 percent per year and growth rates in individual states ranged from 2.3 percent to 10.9 percent. The growth of intergovernmental revenue from the federal government (grants) also varied among the states. State and local current expenditures grew faster than federal grant revenues in more than half of the states. Despite these trends, the sector in the aggregate usually remained in surplus during this 30-year period. The sector avoided operating deficits, in part because of federal grant growth, and in part because, from 1995 to 2007, the sector increasingly financed capital purchases by issuing debt, rather than with revenues, which left more revenues available to pay for current expenditures. However, if the overall trend of state and local government expenditure growth in excess of revenue growth persists, this growth will put increasing pressure on state and local governments going forward. All levels of government face long-term fiscal challenges which could affect future federal funding of intergovernmental programs, as well as the potential capacity of state and local governments to help fund and implement these programs. The interconnectedness which defines intergovernmental programs requires that officials at all levels of government remain aware of and ready to respond to fiscal pressures. These pressures have implications for a wide range of federal, state, and local programs, policies, and activities, and include costs associated with health care, physical infrastructure, state and local employee pensions and retiree health benefits, and education, among other areas. Actions to address the nation's long-term fiscal outlook will be needed at all government levels in coming years and the challenges cannot be adequately met by shifting burdens from one level of government to another. GAO does not make recommendations in this report.