US state and local finances -- getting by for now; big challenges in healthcare and pensions long-term

24 Jul 2012 by Jim Fickett.

In fiscal 2012 state and local government finances have improved slightly. Longer term, it is noteworthy that total revenue has been approximately flat for a decade. The challenges ahead are substantial. For example total healthcare costs – including Medicaid and healthcare for current and retired employees, is already crowding out other services, and is likely to rise, in the next two decades, by an amount approximately equal to the total taken in by income taxes.

This is a good time to catch up on the condition of state (and local government) finances. It has been a year since I've reported on this area in depth, and a very helpful report has just come out from the “State Budget Crisis Task Force”, a committee set up by co-chairs Paul Volcker and Richard Ravitch (the latter a former lieutenant governor of New York). This post is based on three main sources:

  • The Fiscal Survey of States, a joint effort of state governors and legislatures, which surveys the condition of state general funds twice a year
  • National Income and Product Accounts for state and local government – this is the only regular (quarterly), comprehensive overview of state and local finances
  • The above-mentioned Task Force one-time report

General fund spending shows slight increases in 2012 and 2013

The Fiscal Survey of States covers mainly state general funds. The general fund is by no means the whole state budget, but its condition does give a flavor for current solvency and growth.

From the June report:

Fiscal 2011 data represent actual figures, fiscal 2012 figures are estimated, and fiscal 2013 data reflect governors’ recommended budgets. …

fiscal 2013 general fund revenues are projected to increase by … 4.1%, and additional recommended spending is … projected to increase by … 2.2% … while aggregate state revenues will be above their pre-recession levels in fiscal 2013 [nominal, not so for real], total general fund spending will not yet surpass pre-recession levels. …

Fiscal 2012 was the first year since the recession where a large number of states did not make substantial mid-year budget cuts. To date, only eight states have reported a total of $1.7 billion in enacted mid-year budget cuts for fiscal 2012, compared with 19 states enacting $7.4 billion in mid-year budget cuts in fiscal 2011

(The report gives only a nominal rate of increase for 2013, since it will a long time before the BEA estimates a deflator for state expenditures. I have estimated the real increase for 2013 by subtracting the current CPI inflation rate from the report's nominal rate.)

Any report you see these days from the states expresses alarm about Medicaid. The problem has been building for many years, but is especially acute just now because the special recession-related help from the Federal government allowed the states to ignore the problem just a few more years, and that help is now ended.

State funds directed towards Medicaid have increased dramatically in fiscal 2012, while federal spending rapidly declined due to the expiration of the enhanced federal matching rates temporarily authorized by the American Recovery and Reinvestment Act. State spending on Medicaid increased by 20.4% in fiscal 2012, Meanwhile federal spending declined by 8.2% in fiscal 2012.

Overall state and local budgets have been more or less level for a decade

The National Income and Product accounts provide a comprehensive, quarterly overview of revenues and expenditures in several categories, for state and local governments in aggregate. This gives a good idea of trends in the main components of the budget. News articles tend to focus on the latest quarter, but the long-term trends are usually more important. Note below that total income, and its two main components, tax revenue and transfers from the Federal government, are all at roughly the same level (in real terms) as ten years ago. A similar picture obtains on the spending side. State and local governments are in an age of flat budgets, and much of their trouble comes from being very unrealistic about the business cycle, ramping up in bubbles and then having to cut back when the bubble is over.

The big long-term problems are pensions and healthcare

The report of the State Budget Crisis Task Force, which came out on the 17th of July, provides an excellent overview of the long-term challenges facing state and local governments. The emphasis is on (1) the main forces on the long-term budget outlook, (2) the consequences for services, and (3) the political process. I would strongly recommend reading the whole (hundred page or so) report if you are contemplating buying property or moving. Services are going to be under real strain for decades, and you really should understand how bad the situation is likely to be in any place you are considering for a long-term home.

The executive summary has a nice overview of the importance of the topic, in terms of services, and outlines that the main stressors are pensions and healthcare:

The United States Constitution leaves to states the responsibility for most domestic governmental functions: states and their localities largely finance and build public infrastructure, educate our children, maintain public safety, and implement the social safety net. State and local governments spend $2.5 trillion annually and employ over 19 million workers— 15 percent of the national total and 6 times as many workers as the federal government. State governments are coping with unprecedented challenges in attempting to provide established levels of service with uncertain and constrained resources. …

Certain large expenditures are growing at rates that exceed reasonable expectations for revenues:

  • Medicaid programs are growing rapidly because of increasing enrollments, escalating health care costs and difficulty in implementing cost reduction proposals. At recent rates of growth, state Medicaid costs will outstrip revenue growth by a wide margin, and the gap will continue to expand.
  • Pension funds for state and local government workers are underfunded by approximately a trillion dollars according to their actuaries and by as much as $3 trillion or more if more conservative investment assumptions are used.
  • Unfunded liabilities for health care benefits for state and local government retirees amount to more than $1 trillion. …

The conclusion of the Task Force is unambiguous. The existing trajectory of state spending, taxation, and administrative practices cannot be sustained. The basic problem is not cyclical. It is structural. The time to act is now.

It is in the nature of the political process that transparency is low. It requires considerable study to evaluate the state of long-term finances in any particular location.

State budget practices make achieving fiscal stability and sustainability difficult:

  • While almost all states have constitutional or statutory balanced budget requirements … The use of borrowed funds, off-budget agencies, and the proceeds of asset sales are not uncommon practices, often rendering balanced budgets illusory.
  • The lack of financial transparency makes it more difficult for the public to understand the critical nature of problems

Education is a key focus in the fights over necessary cuts. Higher education is mainly a state function, while K-12 is mainly a local responsibility. The trend in higher education seems to be towards maintaining roughly the existing level of services, but transferring costs from state budgets to tuition.

State government education employment in most states is related primarily to public higher eduction … where employment has continued to rise significantly through the recession and recovery, reflecting in part the increased demand for higher eduction that usually comes with recessions …

By contrast, states have cut non-education employment sharply – in prisons, hospitals, institutions, courts, and state agencies … In contrast, in each of the nine previous recessions, state government non-education employment either did not decline at all or declined by much less …

This is a fundamental shift in the way governments have responded to recessions and appears to signal a willingness to “unbuild” state government in a way that has not been done before. …

On a per-full-time-enrolled-student basis, state support has declined since its peak of $8,316 in 2001 to $6,290 in 2011 (in constant dollars), the lowest level in the last 25 years. And in fiscal year 2012, there was another reduction of 7.6 percent in constant dollars. Net tuition revenue per FTE has increased from $3,450 to $4,774 in that same period. …

flagship public universities are already on the road to de facto privatization, while junior colleges and local universities will continue to depend heavily on state and local support.

K-12 education is the largest single budget item in many local budgets, and is constantly being contested. This is not a simple issue. There is some truth to the teachers' claim that they are doing an invaluable service, essential to the future of the nation, and should not be cut. And there is some truth to the claim that the teachers' unions wield excessive power, and that some fat could be cut.

most state fiscal officials believe that as soon as state revenues and economies resume normal growth, states will replace the amounts of the education aid cuts that have been necessary during the current fiscal hard times, as they have done in the past. However, there is also recognition that continued growth in state Medicaid spending and increasing pressure on states to increase funding for pensions and OPEB [Other Post-Employment Benefits – mainly healthcare] may well continue to crowd out even modest growth in state K-12 eduction spending in the near term. …

Inflation in education costs …

Teachers are well organized in most states; their salaries and benefits have been steadily increased in good times, and only in times of severe financial distress have their salaries been capped or slightly reduced. …

Outlook for state funding of K-12 education, near term and long term

With the ending of ARRA grants in 2011 and the continued slow growth in state revenues, state aid for K-12 education in most states is being either reduced or held flat as other state spending priorities, such as uncontrollable Medicaid costs and underfunded pensions crowd out any increases in spending for education. Nonetheless, state aid for K-12 education generally has not yet been reduced to levels below those existing a decade ago on a per-pupil basis.

In the longer term, if states get relief from Medicaid cost pressures and pension and employee health care underfunding, education aid is likely to remain the biggest category of state general fund spending; but its growth will remain related to growth in enrollment levels, state economic and revenue growth, and inflation in education costs, and it will remain the primary target of state budget cutters during periods of fiscal distress – not just because the large size of education budgets makes them a tempting “cash cow” but because there is no clear, measurable relationship between levels of education spending and educational attainment.

A strength of this report is finding a way to bring home the bottom line impact of various trends and policies. They have grouped together the two main categories of healthcare costs – Medicaid and costs for current and retired employees – and explain that if growth in healthcare costs continues on the current trend, in two decades the increase in costs for these two categories will be about the same size as total income tax revenues.

According to [GAO] projections, state and local government health expenditures will rise from approximately four percent of gross domestic product in 2012 to more than six percent by 2035 …

Two percent of GDP - roughly the rise from 2012 to 2035 … is approximately $300 billion annually … That is more than the state and local government sector spends on higher education, about half of what it spends on elementary and secondary education, and roughly equivalent to what the sector raises from either the income tax or the general sales tax. … Many states and localities are on a course that is not sustainable over the longer term. [The GAO report clarifies that the health-related expenditures are a combination of employee/retiree healthcare and Medicaid.] …

Medicaid costs have been growing faster than the economy since the program's inception … When the program was only a small part of state spending, states were able to fund this imbalance in growth. But Medicaid is now such a large part of state spending – 24 percent of total funds … – that the imbalance (or structural budget gap) can no longer be absorbed without significant cuts to other essential state programs like education or unpopular tax increases or both. …

[And for an example of the difficulties:]

Confronted with severe budget imblances in the past several years, California has pursued an aggressive program to reduce or at least contain Medicaid costs. Its fiscal year 2012 budget included $2 billion in proposed Medicaid cuts and savings. But most of these cuts and savings required federal approval, and many of the proposals were rejected by the [federal Centers for Medicare and Medicaid Services]. The largest item that was approved, a 10 percent reduction in provider payments, has not been implemented because of a lawsuit brought by providers. …

State-administered OPEB plans have unfunded liabilities of more than $600 billion. Similar liabilities for locally administered plans are likely even larger, since local workforces are almost three times as large as state workforces. The combined state and local government liabilities are likely to be well above $1 trillion. If the federal government increases the eligibility age for Medicare, OPEB liabilities could increase further, because state and local government retiree health plans generally provide substantial benefits for the transition period between retirement (usually under age 65) and eligibility for Medicare.

Most governments fund these benefits on a pay-as-you-go basis rather than contributing to a funded plan.

Incidentally, many states have attempted to cut back promised retirement obligations. The legal issues are still being clarified. The layman's summary is that healthcare benefits are likely to face some cuts, but it is very difficult to cut pension benefits that have already been earned – for example, “There has been only one case in which a bankruptcy court has impaired a pension obligation”.

A significant problem for the states is that tax revenues have been eroding over the long term.

State tax revenue has been eroding

On average, sales taxes account for about a third of state tax revenue. The sales tax base – that is, the value of taxed goods and services – declined from 55 percent of personal income in 1970 to 35 percent in 2010, because of consumer spending shifts towards lightly taxed services, the difficulty of collecting taxes on internet-related transactions, and state choices that narrow their tax bases. …

Motor fuel taxes … are usually levied in fixed amounts on the quantity of good sold (e.g. 10 cents per gallon) … they don't keep pace with inflation … Between 1960 and 2010 state and local motor fuel taxes declined relative to the economy by 60 percent …

State tax revenue has become increasingly volatile …

The personal income, sales, and corporate income taxes are states' most economically sensitive and volatile revenues, and they have grown in importance in recent years. Together they accounted for only 38 percent of state tax revenues in 1950, but had grown to 72 percent by 1990, contributing to increased overall volatility.

Data note

For more background on the two regularly recurring data sources, see the two Reference pages Fiscal Survey of States and NIPA state and local budgets.