States and localities will record operating balances with an aggregate deficit of 1.6 percent of gross domestic product this year, according to the report. Absent any reforms, the deficit will balloon to 2.7 percent within 30 years. (see chart below)
To close the fiscal gap, governments would need to trim current expenditures by 14.2 percent and maintain that level of spending as a share of GDP in future budgets. While states and localities face several short-term fiscal hurdles -- namely pension shortfalls and declining property tax revenues -- narrowing the gap will prove even more difficult in the decades to follow.
“The longer we wait, the bigger the problem becomes and the harder it will be to solve,” said Stan Czerwinski, who heads the GAO group that authored the report.
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Most notably, the report cites rising health costs as the primary driver of the sector’s long-term fiscal challenges. Medicaid expenditures, along with health insurance costs for public employees and retirees, are expected to rise sharply. The GAO projects state and local governments’ total health-related costs to climb from the current 3.8 percent of GDP to 7.2 percent of GDP by 2060, while non-health costs will decline from 10.5 percent to 7.7 percent of GDP over the same time period.
“Long term, it’s not a revenue or expenditure issue,” says Czerwinski. “It’s a health care issue.”
So far, about half of states have opted to expand Medicaid coverage under the Patient Protection and Affordable Care Act, for which the federal government will initially cover all of the costs. States’ funding share will gradually rise to 10 percent by 2020 – still a considerable expense.
But with uncertainty surrounding implementation of the legislation and fluctuating health costs, the report concluded the effects of ACA were not yet known.
The GAO based its projections on a model simulating more than 100 equations comparing projected expenses and revenues, factoring in Congressional Budget Office estimates for economic growth. The analysis does not account for future policy changes; only current policies in place.
Accordingly, any spending cuts from Washington could make matters worse for states and localities.
The across-the-board federal cuts stemming from sequestration left Medicaid and most other programs states administer largely unscathed. This could very well change, though, if lawmakers target certain grant programs as they seek a more permanent solution to the country’s fiscal woes, said Don Boyd, a senior fellow at the Rockefeller Institute of Government.
Federal funding accounts for about a third of most states’ revenues.
States will need to address their pension obligations, Boyd said, along with rising health costs pushed up by an aging population.
On the revenue side, eroding tax bases have “buried” states, Boyd said. The economy has slowly shifted from goods to services, which governments traditionally are reluctant to collect taxes on. Furthermore, the rise of the Internet made it difficult to collect sales tax, particularly with the growth of downloadable music and e-Books.
Tax receipts are nearing pre-recession levels in terms of nominal dollars, but haven't returned to where they were as a percentage of GDP.
Boyd cited a few key issues to watch that should loom large as states and localities look to meet their long-term fiscal pressures.
A slowdown of health care cost increases or an economy that gains momentum could help considerably. On the other hand, changes to federal mandates, tax policy or funding cuts could make a dent in state and local government coffers for years to come.
“They need to tackle these programs bit by bit, year after year,” Boyd said. “Governments don’t have the luxury of waiting 10 years.”
Additional charts and an explanation of the study methodology can be found in the GAO report.
State and Local Operating Balance Measure as % of GDP | Infographics
