This is the accessible text file for GAO report number GAO-07-1080SP 
entitled 'State and Local Governments: Persistent Fiscal Challenges 
Will Likely Emerge within the Next Decade' which was released on July 
18, 2007. 

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United States Government Accountability Office: 

GAO: 

State and Local Governments: 

Persistent Fiscal Challenges Will Likely Emerge within the Next Decade: 

July 18, 2007: 

GAO-07-1080SP: 

GAO's State and Local Fiscal Simulations: 

For over a decade GAO has run long-term simulations showing that absent 
a change in policy, the combined effects of demographic changes and 
growing health care costs drive ever-increasing federal deficits and 
debt levels. The Comptroller General has repeatedly warned that the 
current fiscal path of the federal government is "imprudent and 
unsustainable". State and local governments provide an array of 
services to their residents, and the federal government relies on these 
governments to assist in the realization of national goals. State and 
local governments also rely on federal grants to varying extents. These 
subnational governments may also face fiscal stress. To provide 
Congress and the public with a broader national context, GAO has 
developed a fiscal model of the state and local sector. 

The GAO state and local model projects the level of receipts and 
expenditures of the sector in future years based on current and 
historical spending and revenue patterns. In the "base case" model we 
assume that the current set of policies in place across federal, state, 
and local governments remains constant. The primary data source for the 
model is the National Income and Product Accounts. The timeframe for 
the simulations parallels that of our federal fiscal model--the 
simulations extend until 2050. The state and local model examines the 
aggregate fiscal outcomes for the sector and does not examine the 
condition of any individual state or local government. 

For more information, contact Stanley J. Czerwinski at (202) 512-6520 
or czerwinskis@gao.gov or Thomas J. McCool at (202) 512-8678 or 
mccoolt@gao.gov. 

Figure 1: State and Local Receipts Net of Expenditures: 

[See PDF for image] 

Source: GAO analysis. 

Note: GDP is Gross Domestic Product. 

[End of figure] 

Our simulations for the state and local government sector indicate that 
in the absence of policy changes, large and growing fiscal challenges 
for the sector will begin to emerge within the next few years. Figure 1 
shows the gap between receipts and expenditures of the sector. 
Historical data from 1980 to 2006 are graphed along with our model 
simulations beginning in 2007 and running through 2050. We measure this 
gap in two ways. In one case we examine, for a given year, all 
receipts--including grants from the federal government for 
infrastructure projects--and all expenditures--including not only 
operating expenditures but also expenditures on such items as 
investments in buildings and roads. This provides a balance measure 
similar to the federal unified budget. While historically, total 
expenditures have usually exceeded total receipts--and the sector 
therefore issues debt to cover part of the cost of its capital 
projects--the simulations suggest that the size of the gap will exceed 
the historical range starting within the next decade. 

Unlike the federal government, most states have some sort of 
requirement for balancing their operating budgets, which do not include 
budgeting for longer-term investments. Therefore, we also examine a 
second case in which we evaluate a balance measure that we call an 
operating balance. Our definition of the operating balance is receipts 
available to fund current expenditures minus current expenditures. As 
shown in figure 1, these receipts usually have exceeded current 
expenditures.[Footnote 1] But the simulation suggests that within the 
next decade current expenditures will outstrip available receipts 
resulting in a deficit (e.g., a negative operating balance). This 
deficit--worsening throughout the projection timeframe under an 
unchanged policy scenario--indicates that state and local governments 
will need to make tough choices on spending and tax policy to meet 
their budget requirements and to promote favorable bond ratings. 

Fiscal Difficulties for State and Local Sector Are Driven by Rapidly 
Rising Health Care Costs: 

As is true for the federal sector, it is the growth in health-related 
costs that is a primary driver of the fiscal challenges facing the 
state and local government sector. In particular, two types of state 
and local expenditures will likely rise quickly because of escalating 
medical costs. The first is Medicaid expenditures, and the second is 
the cost of health insurance for state and local employees and 
retirees. Conversely, we found that other types of expenditures of 
state and local governments--such as wages and salaries of state and 
local workers, pension contributions, and investments in capital goods--
are expected to grow slightly less than gross domestic product (GDP). 
At the same time, most revenue growth is expected to be approximately 
flat as a percentage of GDP.[Footnote 2] As such, the projected rise in 
health-related costs is the root of the fiscal difficulties these 
simulations suggest will occur. Figure 2 shows our simulations for 
expenditure growth for health-related and other expenditures.[Footnote 
3] 

Figure 2: Health and Non-Health Expenditures of State and Local 
Governments: 

[See PDF for image] 

Source: GAO analysis. 

Notes: Historical data through 2006, projections from 2007 through 
2050. Interest expense is not included in this analysis. 

[End of figure] 

State and Local Fiscal Challenges Add to the Nation's Fiscal 
Difficulties: 

Since 1992, GAO has produced long-term simulations of what might happen 
to federal deficits and debt under various policy scenarios. GAO's most 
recent long-term federal simulations show ever-larger deficits 
resulting in a very large and growing federal debt burden over time. 
Just as in the state and local government sector, the federal fiscal 
difficulties stem primarily from an expected explosion of health- 
related expenditures. As we have noted elsewhere, the expected 
continued rise in health care costs poses a fiscal challenge not just 
to government budgets, but to American business and society as a whole. 
In short, the fundamental fiscal problems of the federal government and 
these subnational governments are similar and are linked. As such, 
solutions to address these challenges should be considered in tandem. 

Figure 3 shows two simulations for the federal fiscal path under 
alternative assumptions, and overlays the simulated fiscal imbalance of 
the state and local government sector.[Footnote 4] 

Figure 3: Federal and State/Local Surpluses and Deficits as a Share of 
GDP: 

[See PDF for image] 

Source: Historical data from the National Income and Product Accounts, 
and GAO analysis. 

Note: Historical data from 2000 through 2006, projections from 2007 
through 2050; state and local balance measure is similar to the federal 
unified budget measure. 

[End of figure] 

For the federal fiscal simulation denoted Baseline, we use 
Congressional Budget Office (CBO) projections for the next 10 years. 
Under this scenario, it is assumed that taxes and expenditures over the 
next 10 years are in line with current law. This means that a variety 
of tax provisions--mostly tax reductions--that are set to expire are 
allowed to expire, and that discretionary expenditures of the federal 
government grow with inflation. After the first 10 years, we use the 
Social Security and Medicare Trustees' 75-year intermediate ("best") 
estimates for those programs and CBO's mid-range Medicaid estimates. 
All other expenditures are held constant as a share of GDP after the 
first 10 years. Receipts are also held constant as a share of GDP after 
the first 10 years. Under the alternative federal simulation, we assume 
that during the next 10 years, expiring tax provisions are extended and 
that discretionary spending grows with GDP--a faster pace than 
inflation. After the 10-year timeframe, we assume that action is taken 
to return revenue to its historical share of GDP plus an additional 
amount attributable to deferred taxes (i.e., taxes on withdrawals from 
retirement accounts). This alternative also incorporates somewhat 
higher Medicare estimates reflecting a more realistic scenario for 
physician payments. The overlay of the base case state and local 
simulation shows that the state and local fiscal situation imposes 
further burdens on the nation's economy in the next several decades. 

Key Assumptions of GAO's State and Local Simulations: 

The GAO state and local model projects the level of receipts and 
expenditures of the sector in future years based on current and 
historical spending and revenue patterns. To develop these long-run 
simulations, we make projections for each major receipt and expenditure 
category of the state and local government sector in future years. On 
the receipt side, key categories of receipts for state and local 
governments include several types of taxes (personal income, sales, 
property, and corporate), income on assets owned by the sector, and 
grants from the federal government. Categories of expenditures include 
wages and salaries of state and local employees, health insurance 
costs, pension costs, payments of social benefits (e.g. Medicaid and 
unemployment), depreciation expense on state and local capital stock, 
interest payments on state and local financial debt, and other 
expenditures of the sector. In the "base case" model we assume that the 
tax structure is not changed in the future and that the provision of 
real government services per capita remains roughly constant. That is, 
a basic assumption of the primary model is that the current set of 
policies in place across state and local governments remains constant. 

(450612): 

FOOTNOTES 

[1] The explicit definition of our operating balance measure is all 
receipts, net of funds used for long-term investments, minus current 
expenditures. 

[2] The exception to this is Medicaid grants from the federal 
government. 

[3] Interest payments that these governments will need to pay on their 
outstanding debt will also likely be a rising expense for the sector in 
the future. Rising interest costs are merely a reflection of the 
sustained deficits the model predicts across future years. 

[4] In GAO simulations that combine the fiscal outcomes for all levels 
of government, the methodology underlying the federal simulations 
differs slightly from GAO's usual approach. Usually, GAO's federal 
budget simulations incorporate the negative effect on economic growth 
of large deficits that divert funds from private investment. In order 
to combine the federal and state and local budget simulations using a 
consistent set of economic assumptions, this feedback from deficits to 
economic growth is removed. With or without feedback, the simulations 
imply that current fiscal policy is unsustainable over the long term. 

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