The fiscal health of many states has been severely strained by the prolonged economic slowdown following the recent recession, even after the official end of the recession in June 2009. State and local tax revenues have declined, expenditures for social insurance programs have increased, and federal assistance has begun to recede as federal aid related to the American Recovery and Reinvestment Act (ARRA) expires. Further, state and local governments are required to balance current operating budgets either annually or biennially. State and local governments have used a combination of rainy day fund withdrawals, tax increases, spending reductions, and in some instances, borrowing to meet these balanced budget requirements. Congress has become increasingly concerned that financial difficulties may lead state and local governments to take actions that could have an adverse impact on the economic recovery and that they may need additional federal government assistance. Part of this concern has focused on debt issued by state and local governments. This report will describe state and local government debt and analyze how debt is incorporated into state and local budgets. The report will also analyze the role the federal government has in state and local government debt structure. Other issues of interest to Congress include bond default risk and public pension underfunding. Bond default risk and underfunding public pensions are both integral parts of state and local finance, though somewhat beyond the scope of this report. Clearly, during economic downturns, the risk of bond default rises. In particular, those bonds secured by specific revenue streams and not the general obligation of the issuing jurisdiction are at greatest risk. Even so, municipal default has been relatively rare, only 54 defaults from 1970 to 2009, and has yet to become a significant issue in municipal finance. As for public pensions, debt is rarely used to finance future obligations and is generally discouraged by public finance professionals. Nonetheless, some states have used debt to fund pensions. As noted earlier, the level of state and local government debt and purported growth of this debt during the recession has generated congressional interest. Some observers have suggested that the pressure to provide additional federal assistance has increased as states are purportedly relying more on debt to finance operations. For example, H.R. 344 , the Fiscal Responsibility Effective Enforcement Act, would prohibit the Federal Reserve Board (the Fed) from buying short-term municipal securities, thus reducing the probability that the Fed would be asked to "bail-out" state and local governments. And, with regard to pensions, H.R. 567 and its Senate companion, S. 347 , would require non-federal government entities to provide more information about pension funding and require more conservative accounting rules for pension finances. More generally, Congress has also held several hearings on policies addressing the fiscal health of state and local governments. This section will describe the type of state and local government debt analyzed here and who holds this debt. In contrast to the federal government, most state and local governments maintain two budgets, an operating budget and a capital budget. The operating budget funds current expenditures such as employee salaries, payment for services, and interest payments on debt. Current revenues, such as taxes, fees, user charges, and intergovernmental aid, finance these expenditures. When observers refer to state and local government budget deficits, they are almost always referring to the operating budget. The timing of state and local revenue collection, however, typically does not match spending. Thus, most governments issue short-term debt to finance current spending then use future revenue to repay this debt. These notes are called revenue anticipation notes or tax anticipation notes. It is important to note that almost every state and local government is required to maintain a balanced operating budget from fiscal year to fiscal year, so only in rare circumstances is short-term debt carried over into the next fiscal year. The capital budget is typically used to finance infrastructure (or public capital) investment. The capital budget looks forward as far as 10 years for some states. The role of debt differs in the operating and capital budgets. Long-term debt is almost always intended for capital projects and as such is included in the capital budget. However, the interest expense on debt issued for the capital budget is included in the operating budget. No uniform definition of a "capital" expenditure exists, though most lean toward a common principle. The National Association of State Budget Officers (NASBO) provides the following brief explanation of how states identify spending for inclusion in the capital budget: States define the types of expenditures allowed in capital budgets to include such items as construction, improvements, land acquisition, site improvements, major renovations, and equipment. Definitions may also specify the anticipated useful life of a project and a minimum level of expenditure, with $25,000 being the most frequent minimum for capital budget expenditures. The ambiguity in some facets of this explanation is readily apparent. For example, the difference between a "major renovation" and a "minor renovation" may be arbitrary. Nevertheless, the use of capital budgets and balanced budget rules makes it relatively difficult for state and local governments to issue debt to fund current operating expenses. Some states, however, do have some flexibility to shift spending between the operating and capital budgets, from fiscal year to fiscal year, and from account to account. This flexibility diminishes the seemingly disciplined treatment of debt. In addition, many states create and use special purpose authorities for debt issuance. These special authorities, though part of state government, are typically not constrained by the budget discipline tools described above. State and local governments also incur future liabilities that are not bonds. For example, many states borrow directly from the federal government to finance current expenditures for unemployment compensation (UC). During recessions, the balance of these funds often falls to a point where states borrow to pay benefits. States can borrow from outside sources or from the federal government. As of December 29, 2011, 26 states and the U.S. Virgin Islands owed a combined $36.4 billion through trust fund loans from the federal government. These debts will be repaid through higher taxes on employers in most cases. A thorough examination of this type of debt and accompanying interest costs, though significant in some states, is beyond the scope of this report (for example, California owes almost $10 billion to the federal government or 27% of the total outstanding). Pension funds—in particular, defined benefit retirement funds—are also a significant liability or debt incurred by states and local governments. Recent studies have estimated that many state pensions are underfunded; one set the underfunding at $1 trillion. As with UC programs, a thorough examination of this type of debt is beyond the scope of this report. In addition to the discipline of budgetary rules, state and local government debt issuance is also constrained by the financial markets. As with any borrower, state and local governments need willing creditors to incur debt. The relative safety of state and local government debt and the federal income tax exclusion on interest payments on state and local bonds has created a strong demand for state and local government debt. What is also important to note is that entities that are otherwise non-taxable (or nontaxable foreign entities) have little interest in tax-exempt state and local debt. Individuals are the primary holders of state and local government debt. Figure 1 shows the holders of all outstanding municipal debt as of the third quarter of 2011. Households, mutual funds, and money market funds represent holdings of individuals and compose almost three-quarters (73%) of all debt outstanding (shades of blue in Figure 1 ). In past years, the rest of the world (ROW) held considerably less municipal debt. The recent increase in tax-exempt bond holdings by the ROW can be attributed to the change in the more favorable tax treatment of corporate-held tax-exempt debt and Build America Bonds (BABs). BABs are taxable and offer higher interest rates than tax-exempt bonds thus making them more attractive to non-taxable entities, such as pension funds and international investors. The next section provides more detail on the level of state and local government debt. The discussion relies on data provided publicly by the Federal Reserve Board and U.S. Bureau of the Census and attempts to establish the current debt position of state and local governments and how it has changed over time. The Fed and the United States Census Bureau (Census) publish information on state and local government debt outstanding. Both sources exhibit the relative importance of long-term debt. The Fed data are more current whereas the Census reports detailed data for both state and local government debt, albeit less current. The Fed reports that, as of the third quarter of 2011, $2.99 trillion of state and local government debt was outstanding. Of this total, long-term debt composed 98.4%. The Census reports that for FY2009, the latest year available, total state and local government outstanding debt was $2.68 trillion ($1.05 trillion in state debt and $1.64 trillion in local debt). The Census further reports that in FY2009 state long-term debt was 99.3% of state total outstanding debt and local long-term debt was 98.3% of local total outstanding debt. The amount of state and local government debt outstanding provides an indication of the relative magnitude of government borrowing. The government issuer, however, is not obligated to repay all of this debt; much of this debt is issued through debt vehicles called revenue bonds. Revenue bonds commit (or are secured by) a specified revenue stream, not the full faith and credit of the issuer. From 1996 through November 2011, roughly one-third of state and local government debt issued was general obligation debt and two-thirds was specific revenue-secured debt. By comparison, total corporate and foreign bonds held by U.S. residents was $11.4 trillion at the close of the third quarter of 2010, and U.S. Treasury debt just recently reached $14.1 trillion. Most corporate debt and all federal debt is backed by the full faith and credit of the issuer. The level of debt outstanding is best understood in the context of capacity to service that debt.