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State and Local Government Fiscal Sustainability and the “Trend Gap”

State and local governments could face several negative consequences—including tax increases, public service reductions and credit rating downgrades—unless a “trend gap” based on socioeconomic and other fundamental factors is closed, according to a recent paper published by the Federal Reserve Bank of Boston titled “Walking a Tightrope: Are U.S. State and Local Governments on a Fiscally Sustainable Path?”

The article, written by two economists, demonstrates that a growing trend gap results in a lower long-term ability on the part of state and local governments to raise revenues to meet public service demand and pay pension obligations.

Municipal Pension and Benefit Obligations Contribute to the Trend Gap

The fiscal sustainability of state and local governments in the United States has been a matter of increasing concern for a number of reasons, two of which are outlined below.

First, the rapid growth in state health care costs has exceeded the growth of state government revenue in recent decades. The nominal value of nationwide Medicaid spending grew about 10 percent annually between 1990 and 2004, while state general revenue grew only 6 percent. Consequently, Medicaid has replaced education as the largest state spending category. Medicaid accounted for nearly 24 percent of all state expenditures in 2011, according to the National Association of State Budget Officers.

Second, state and local governments face large unfunded pension and other post-employment benefit (OPEB) liabilities. Unfunded liabilities nationwide are estimated to be around $4 trillion, according to the authors. Creating large demands on revenue, these unfunded retirement benefits are already straining state and local budgets.

Pension and Other Benefit Costs Contribute to 30-Year Growth in Trend Gap

The authors define fiscal sustainability as the long-term ability of state and local governments to provide public services. They then analyze data from several sources and utilize the trend gap measure to assess state and local fiscal sustainability as it has evolved over the last 30 years. The trend gap measure takes into account the actuarially required contributions to pensions as well as other post-employment benefits, and removes short-term business cycle fluctuations.

The study found that, overall, the nationwide per capita trend gap increased during the past three decades, even without considering pension or OPEB costs. The trend gap is even larger after adding pension and OPEB funding requirements.

The nationwide per capita trend gap without pension or OPEB contributions was already above zero during most of the 2000s, indicating that expenses were outstripping municipal revenue.

The full trend gap, including pension and OPEB obligations, reached over $1,000 per capita in 2010. This means that the revenue-raising capacity of state and local governments fell short of the amount needed to meet public service demand and fulfill long-term obligations by that amount.

The trend gap results differ from findings in earlier studies conducted by the Government Accountability Office (GAO), which showed no clear trend in their measure of operating balance as a percentage of the Gross Domestic Product (GDP) during the last three decades. The trend gap methodology results in a different conclusion: the nationwide trend gap as a percentage of GDP increased over time, reaching more than 2 percent of GDP in 2010.

While social insurance and income maintenance programs have been significant contributors to the growth of the trend gap, pension and OPEB plans have also become increasingly important in driving up expenditure levels.

In Summary: Trend Gap May Spur Further Corrective Action

To continue to track the impact of these programs on local and state fiscal sustainability, the authors recommend that future studies employ the trend gap methodology, contending that utilizing the trend gap measure provides a more accurate picture than existing measures of the fiscal sustainability of U.S. state and local governments.

In the meantime, this may serve as yet another warning to state and local government officials that pension and benefit funding requirements will not go away.

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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