The state and local government sector consists of 50 state governments and 87,525 local governments. These local governments include 3,034 county governments, 19,429 municipal governments, 16,504 townships, 13,506 school districts, and 35,052 special districts. State and local governments provide vital services to citizens such as law enforcement, public education, and sewage treatment. Local governments derive their authority from the states, and the powers and responsibilities granted to local governments vary considerably. For example, while states generally provide authority to local governments to tax real property, local governments vary in their authority to levy other types of taxes, such as personal income or sales taxes. State and local governments collect receipts and receive federal funds to provide services to their constituents. In 2006, state and local governments received $1.9 trillion in total receipts. Taxes, such as property taxes, sales and excise taxes, personal income tax, and corporate income taxes, make up a large component of these receipts—fully $1.2 trillion. In addition, the federal government provided over $400 billion to state and local governments in the form of various grants (including Medicaid), loans, and loan guarantees. These federal funds accounted for approximately 22 percent of state and local government total receipts. State and local governments also obtain revenues from several other sources, such as income receipts on financial assets; certain receipts from businesses and individuals (such as vehicle and licensing fees); and, in some years, from surpluses on government-run enterprises that provide services such as energy, liquor, lotteries, and public transit. State and local governments fund a broad range of services such as public safety, housing, education, and public transportation programs. In 2006, state and local governments spent $691 billion on education—the largest expenditure category for the sector. These governments also spent $263 billion on projects such as highways, public transit, agriculture, and natural resources, and $242 billion on public safety services such as police and fire departments as well as prisons. State and local governments also provide a broad range of other services, such as income security for the poor and disabled, health-related services, housing and community development, recreation services such as parks, and utilities such as water, sewage, and energy. Budget processes vary considerably across the 50 states. According to the National Association of State Budget Officers (NASBO), about half of states enact budgets annually, while most others enact biennial budgets, and a few undertake a mix of annual and biennial budgeting. Most states budget separately for current operating costs and capital expenditures. The capital budget is used for states’ capital projects, and states frequently issue debt to help fund these investments. Most states have some form of balanced budget requirement for general funds—the fund that covers current operating costs—but the nature of these balanced budget requirements varies considerably. For example, some states require governors to submit a balanced budget, while others mandate that legislatures pass a balanced budget. Some direct governors to sign a balanced budget, and some require governors to execute a balanced budget. Many of the balanced budget provisions allow states to run small, short-term deficits. Our base case model rests on certain key assumptions. In particular, in the base case we assume that current federal, state, and local policies remain constant. On the receipt side, this translates into an assumption that the current tax structures of state and local governments are maintained in future years and that tax receipt growth reflects past experience, except that we remove the effect of past policy changes and the effects of unusual capital gains. On the expenditure side, we make assumptions that would generally be consistent with the maintenance of current policies in the provision of services to citizens. Since compensation of state and local employees is a large cost component of providing services to citizens, our assumptions about the growth in the number of state and local employees over time, as well as the growth in their wages, are significant components through which we implement the assumptions of the maintenance of current policy. Since 1980, the level of employment in the state and local sector has grown significantly faster than the U.S. population, but for our simulation we maintain state and local government employment as a steady share of the population over time. This would be consistent with the maintenance of current policy if there were no productivity gains in the sector, or a modest increase in real services, to the extent that state and local workers experience gains in productivity. Also, we assume that employees of state and local governments receive pay increases each year equal to those of private sector workers—an assumption that is generally consistent with historical experience. Finally, we assume that the total cost of many goods procured by the sector to provide services will rise with increases in the population being served and the rate of inflation in the economy. Table 1 summarizes the assumptions of the base case model. We calculated two measures of fiscal balance for the state and local government sector for each year until 2050. The measures are: Net lending or borrowing—the balance of all receipts and expenditures during a given time frame. This indicates the need for the sector to borrow funds or draw down assets to cover its expenditures. This measure is roughly analogous to the federal unified surplus or deficit. Operating balance net of funds for capital expenditures—or simply the “operating balance”—a measure of the ability of the sector to cover its current expenditures out of current receipts. In developing this measure we subtract funds used to finance longer-term projects—such as investments in buildings and roads—from receipts since these funds would not be available to cover current expenses. (See app. I for more detail on the measurement of this balance). Figure 1 shows values of the two balance measures—net lending or borrowing and operating balance—as a percentage of GDP under our base- case assumptions. Historical data from 1980 to 2006 are shown along with our model simulations beginning in 2007 and running through 2050. The figure shows that the two measures generally track one another. It also shows that, historically, net lending or borrowing has typically been negative, but rarely by more than 1 percent of GDP. This indicates that the sector generally issues debt—primarily to fund capital expenditures—but has done so at a reasonably stable pace. Additionally, the operating balance measure has historically been positive most of the time, ranging from about zero to about 1 percent of GDP. Thus, the sector usually has been able to cover its current expenses with incoming receipts. But the simulation suggests that while projected balances for both net lending or borrowing and the operating balance remain in their historical ranges for the next several years, the balances will soon begin to decline and will fall below their historical ranges within a decade. That is, the model suggests that the state and local government sector will face increasing fiscal stress in just a few years. Our simulations also indicate that by the mid-2020s the balance measures will both be well below their historical ranges, and will continue to fall throughout the remainder of the simulation time frame. These projected deficits—worsening throughout the projection time frame under an unchanged policy scenario—indicate that, because most state and local governments cannot actually run such deficits for any length of time, these governments will need to make tough choices on spending and tax policy to meet their budget requirements and to promote favorable bond ratings. Another way of measuring the long-term challenges faced by the state and local sector is through a measure known as the “fiscal gap.” With deficits rising rapidly as shown in figure 1, the outstanding debt of the state and local sector will experience unprecedented growth. 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. For the state and local sector, we calculated that to close the fiscal gap would require action today equal to a 15.2 percent tax increase or a 12.9 percent reduction in spending financed by non-grant revenues. The fiscal gap can also be expressed as a share of the economy or in present value dollars. We calculated that in 2007 dollars the fiscal gap amounts to $10.6 trillion, which represents 1.4 percent of the discounted value of GDP over the same time frame. Based on our review of the evidence, we estimate that expenditure growth for health care will be significant and these expenditures will constitute a rapidly growing burden for state and local governments. Two types of state and local expenditures in particular will likely rise quickly due to escalating medical costs. First, under CBO’s intermediate projections, federal Medicaid grants to states per recipient will rise by 1 percent 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. Second, we estimated future expenditures for health insurance for state and local employees and retirees. Specifically, we assume that the excess cost factor—the growth in these health care costs per capita above GDP per capita—will average 1.4 percentage points per year through 2035 and then begin to decline, reaching 0.6 percent by 2050. This results in a rapidly growing burden from these health-related activities in state and local budgets. In contrast, our implementation of assumptions about current policies indicated that, in aggregate, other expenditure categories grow less than GDP in our base-case simulations. For example, even though the wages and salaries of primary and secondary education employees are a large expenditure of the state and local sector, under our base-case assumptions these costs are not expected to grow any faster than the rate of growth of the general economy and will not represent an increasing burden on governments relative to their revenues. These base-case assumptions differ from historical experience in which real spending on primary and secondary education per pupil has risen in the past few decades. If such a trend were to continue, spending on education could place a growing burden on state and local governments in future years.