Expert Commentary

Are U.S. state and local governments on a fiscally sustainable path?

2013 study published by the Federal Reserve Bank of Boston on the growing gap between the revenues that state and local governments receive and their mandatory long-term obligations.

City Hall sign on a building

When the city of Detroit filed for bankruptcy in 2013, accusations flew over where the guilt lay. Emergency city manager Kevyn Orr faulted years of dysfunction and waste. Conservative columnist George F. Will blamed public-employee unions, while the Detroit Free Press singled out a toxic 2005 Wall Street deal that boosted pension obligations by $770 million. Former Michigan governor Jennifer Granholm said that national leaders could have done a better job preventing the “de-industrialization” of America, while others accused state officials for failing to stem a “white flight” to the suburbs.

Thankfully not all state and local governments are in as rough a shape as Detroit, and some trends are even looking up: The most recent figures from the U.S. Census Bureau indicate that, on average, revenues have increased for state and local governments nationwide since the 2008 recession, and for 2013 some states even reported budget surpluses. Despite the short-term good news, however, significant challenges loom: The Census Bureau report indicates that all state and local governments had total outstanding debts of $2.9 trillion in 2011 — and 61% of that was held by local governments.

Central to the problem is the continuing rise of state and local governments’ long-term obligations: Between 1990 and 2004 Medicaid spending grew 10% annually, outpacing the 6% average annual state revenue rate of growth. In 1987, health care costs made up 16% of local and state spending; today they represent 31%. The amount local and state governments should set aside for pensions increased at 8.6% annually from 2001 to 2010, and in 2012 unfunded pension liabilities were estimated at $4 trillion nationwide.

The growing disconnect between state and local governments’ income and expenditures — sometimes called a “structural deficit” or “fiscal instability” — is the subject of a December 2013 Federal Reserve working paper, “Walking a Tightrope: Are U.S. State and Local Governments on a Fiscally Sustainable Path?” The authors, Bo Zhao of the Federal Reserve Bank of Boston and David Coyne of U.C. San Diego, based their work on data from the U.S. Census Bureau’s Annual Survey of State and Local Finances, the Pew Center on the States, and other sources. In the study, they develop a sustainability measure they call the “trend gap” that takes into account actuarially required contributions (ARCs) to pension and other post-employment benefits (OPEB) and removes short-term fluctuations of the business cycle.

“Compared with well-studied federal fiscal sustainability, state and local fiscal sustainability is a relatively new concept, and even its meaning is unclear and open to interpretation,” the authors state. Because the majority of states are required by law to balance their budgets, shortfalls are often plugged by transfers from the federal government or service cuts. In their analysis, the scholars define fiscal sustainability as “the long-term ability of state and local governments to provide public services that their constituents demand and are willing to pay for.”

The study’s findings include:

  • The per-capita gap between state and local income and mandatory obligations has been growing for the past three decades. “The nationwide per capita trend gap without pension or OPEB ARCs was already above zero during most of the 2000s. The full trend gap, including pension and OPEB ARCs, reached over $1,000 per capita in 2010.” Without pension liabilities, the gap ranged between $700 and $1,000 per capita.
  • Including pension liabilities, the average trend gap for all U.S. states was approximately $1,100 per capita in 2010, with considerable regional variation. The Pacific states had the highest trend gap (approximately $1,600 per capita), followed by New England (about $1,250). The smallest gap was in the East South Central states, approximately $750 per capita.
  • The largest contributor to the growth in state and local financial obligations was in service and income maintenance (SSIM), which includes public welfare, hospitals, health, and social insurance administration but excludes unemployment insurance and workers’ compensation. About two-thirds of the national growth in SSIM expenditures was directly related to Medicaid.
  • States with larger gaps tend to have a larger population and higher unemployment rates. “Population size is positively correlated with the trend gap because it turns out to be positively and significantly correlated with the unemployment rate and the share of population of age 25 years old or older without a high school degree, which would increase trend expenditures and lower trend revenues, respectively.”

While the authors do not forecast future trend gaps, they cite several risk factors going forward: The Congressional Budget Office expects the U.S. economy to grow less than 2% before 2015 and between 2% and 2.5% from 2015 to 2023, with continued relatively high unemployment. In addition, “federal grants to state and local governments will almost certainly be cut in the near future.” All these factors increase the likelihood that state and local trend gaps will continue to grow.

Failure to achieve fiscal sustainability has significant downsides, they state. “First, it could shift fiscal burden to future generations of taxpayers, creating intergenerational inequity. Second, state and local governments may have to severely cut back public services at some point in the future in order to balance their budgets. Such a disruption to public services would harm residents’ quality of life and the local business environment. Third, the credit ratings of state and local governments could suffer, driving up their borrowing costs. In an extreme case, a severe lack of fiscal sustainability might induce investors to flee the municipal bond market, threatening the stability of the entire financial system.”

Related research: A 2013 report published in State and Local Government Review, “Collaborative Service Delivery: What Every Local Government Manager Should Know,” provides insight into how city managers have worked with other governments, private firms, and nonprofits to deliver services efficiently. The most common form of shared service delivery now involves contracts between governments, growing from 17% in 2002 to 20% in 2007, and 22% of the local governments surveyed indicated that they had brought back in-house at least one service that they had previously provided through some alternative private arrangement. When services were delivered by private firms, monitoring was found to be problematic: “Only 47.3% of managers involved with private firms as delivery partners reported that they evaluate that service delivery. By 2007, that was down to 45.4%.”

Keywords: municipal, fiscal sustainability, state and local fiscal trends, taxation, Great Recession, financial crisis

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