NCPA - National Center for Policy Analysis

The Fiscal Health of the States

February 24, 2012

The troubled state of the federal government's debt obligations has stolen attention away from the equally precarious situation of many of the 50 states.  While many state lawmakers are able to report financial statistics that are technically healthy, these figures rely upon bad assumptions and understate the liabilities that state governments will be forced to cover in the near future, say Jeffrey Miron and Robert Sarvis of the Mercatus Center.

  • By current accounting standards, the officially reported net debt of state and local governments is merely 1.9 percent of gross domestic product (GDP).
  • However, these standards allow state agencies to assume an 8 percent interest rate for funding liabilities (largely pensions for state workers), but this assumes risky investment choices for certain liabilities.
  • More fittingly, certain liabilities should be discounted using a risk-free investment portfolio -- a strategy that tracks with Treasury bills and is likely to yield only about 3 percent interest.
  • Using this more appropriate discounting metric, finance professors Robert Novy-Marx and Joshua Rauh found that measured liabilities exceed official liabilities by roughly $1.3 trillion.

This financial strain is driven by rapidly increasing state-level expenditures.  These outlays, which have been growing steadily for several decades, are driven primarily by rising health care costs.  As states seek to fund their portion of the Medicaid entitlement, they have been forced to spend more, thereby accumulating the aforementioned levels of debt.

  • State and local expenditures have grown from roughly 8 percent of GDP in 1962 to more than 14 percent in 2008.
  • This rate of growth is expected to continue (and could possible accelerate) upon full implementation of the Patient Protection and Affordable Care Act (PPACA) which will force states to increase expenditures on Medicaid.
  • Because of this growth, most states will hit a 90 percent debt-to-GDP ratio within two to three decades -- a level that economics Professors Carmen Reinhart and Ken Rogoff conclude will impose substantial additional burden on the states in interest payments.

To help states mitigate this financial strain, the federal government should convert allocations for Medicaid into block grants with minimal stipulations, granting states freedom to implement cost-saving policies.

Source: Jeffrey Miron and Robert Sarvis, "The Fiscal Health of the States," Mercatus Center, February 2012.

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