Black Lung Benefits Program: Oversight Is Needed to Address Trust Fund Solvency Strained by Bankruptcies

In May 2018, GAO reported that the Trust Fund, which pays disability benefits to certain coal miners, faced financial challenges. The Trust Fund has borrowed from the U.S. Treasury's general fund almost every year since 1979 to make needed expenditures. GAO's June 2019 testimony included preliminary observations that coal operator bankruptcies were further straining Trust Fund finances because, in some cases, benefit responsibility was transferred to the Trust Fund.

This testimony is based on GAO's report being released today, and describes (1) how coal mine operator bankruptcies have affected the Trust Fund, and (2) how DOL managed coal mine operator insurance to limit financial risk to the Trust Fund. In producing this report, GAO identified coal operators that filed for bankruptcy from 2014 through 2016. GAO analyzed information on commercially-insured and self-insured coal operators, and examined workers' compensation insurance practices in four of the nation's top five coal producing states. GAO also interviewed DOL officials, coal mine operators, and insurance company representatives, among others.

Coal mine operator bankruptcies have led to the transfer of about $865 million in estimated benefit responsibility to the federal government's Black Lung Disability Trust Fund (Trust Fund), according to DOL estimates. The Trust Fund pays benefits when no responsible operator is identified, or when the liable operator does not pay. GAO previously testified in June 2019 that it had identified three bankrupt, self-insured operators for which benefit responsibility was transferred to the Trust Fund. Since that time, DOL's estimate of the transferred benefit responsibility has grown—from a prior range of $313 million to $325 million to the more recent $865 million estimate provided to GAO in January 2020. According to DOL, this escalation was due, in part, to recent increases in black lung benefit award rates and higher medical treatment costs, and to an underestimate of one company's (Patriot Coal) future benefit claims.

Trust Fund, Filed from 2014 through 2016

DOL's limited oversight of coal mine operator insurance has exposed the Trust Fund to financial risk, though recent changes, if implemented effectively, can help address these risks. In overseeing self-insurance in the past, DOL did not: estimate future benefit liability when setting the amount of collateral required to self-insure; regularly review operators to assess whether the required amount of collateral should change; or always take action to protect the Trust Fund by revoking an operators' ability to self-insure as appropriate. In July 2019, DOL began implementing a new self-insurance process that could help address past deficiencies in estimating collateral and regularly reviewing self-insured operators. However, DOL's new process still lacks procedures for its planned annual renewal of self-insured operators and for resolving coal operator appeals should operators dispute DOL collateral requirements. This could hinder DOL from revoking operators' ability to self-insure should they not comply with DOL requirements. Further, for those operators that do not self-insure, DOL does not monitor them to ensure they maintain adequate and continuous commercial coverage as appropriate. As a result, the Trust Fund may in some instances assume responsibility for paying benefits that otherwise would have been paid by insurers.

GAO made three recommendations to DOL to establish procedures for self-insurance renewals and coal operator appeals, and to develop a process to monitor whether commercially-insured operators maintain adequate and continuous coverage. DOL agreed with these recommendations.

I am pleased to be here to discuss the report we are releasing today on  the need for improved oversight of coal mine operator black lung  insurance. The federal government’s Black Lung Disability Trust Fund  (Trust Fund) finances medical and cash assistance to certain coal miners  who have been totally disabled due to pneumoconiosis (also known as  black lung disease). Black lung benefits are generally to be paid by  responsible coal mine operators. However, the Trust Fund pays benefits  in certain circumstances, including in cases where no responsible mine  operator can be identified or when the liable mine operator does not pay.

As we reported in May 2018, the Trust Fund faces financial challenges.  Its expenditures have consistently exceeded revenue and the Trust Fund  has essentially borrowed with interest from the Department of the  Treasury’s (Treasury) general fund almost every year since 1979, which  was its first complete fiscal year. In fiscal year 2019, the Trust Fund  borrowed about $1.9 billion to cover its expenditures, according to  Department of Labor (DOL) officials.

In June 2019, we reported preliminary observations to this committee that  coal operator bankruptcies were further straining Trust Fund finances  because, in some cases, responsibility for benefit payments was  transferred from the bankrupt operator to the Trust Fund. This may  occur, for instance, when the amount of collateral the Department of  Labor (DOL) requires from a self-insured coal operator does not fully  cover the operator’s benefit responsibility should the operator become  insolvent.

Trust Fund revenue is primarily obtained through a tax on coal produced  and sold domestically, which we refer to in this report as the coal tax.  The coal tax rate has varied over the years. From 1986 through 2018, the  coal tax rate was $1.10 per ton of underground-mined coal and $0.55 per  ton of surface-mined coal, up to 4.4 percent of the sales price. In 2019,  the rate of the coal tax decreased to $0.50 cents and $0.25 cents per ton  of underground-mined and surface-mined coal, respectively, up to 2  percent of the sales price. In 2020, the rate of the coal tax increased to  pre-2019 levels. However, it is scheduled to decrease again beginning in  2021. With less revenue from the coal tax, the Trust Fund will likely need  to borrow more from Treasury’s general fund.

My statement summarizes the findings from the report we are releasing  today, which addresses: (1) how coal mine operator bankruptcies have  affected the Trust Fund, and (2) how DOL managed coal mine operator  insurance to limit financial risk to the Trust Fund. In summary, we found:

Three self-insured coal mine operator bankruptcies from 2014 through  2016 transferred about $865 million in benefit responsibility to the  Trust Fund, according to DOL estimates.

Several other self-insured operator bankruptcies have occurred  since 2016 that may also affect the Trust Fund.

Commercial black lung insurance helps limit Trust Fund exposure  to coal operator bankruptcies.

DOL’s limited oversight of coal mine operator insurance has exposed  the Trust Fund to considerable financial risk.

DOL began implementing a new self-insurance process in July  2019, but it lacks key enforcement procedures that could help to  prevent the reoccurrence of past oversight deficiencies.

DOL does not monitor the commercial-insurance policies  purchased by coal mine operators to secure their benefit liabilities.

We made three recommendations, and DOL agreed with them:

To establish procedures for self-insurance renewals;

To establish procedures for coal operator appeals; and

To develop a process to monitor whether commercially-insured  operators maintain adequate and continuous coverage.

For our report, we analyzed Bloomberg data and consulted DOL to  identify coal operators that filed for bankruptcy from 2014 through 2016;  analyzed National Council on Compensation Insurance (NCCI) data and  DOL documentation on commercially-insured and self-insured coal mine  operators; and examined workers’ compensation insurance practices in  four states—Kentucky, Pennsylvania, West Virginia, and Wyoming—to  identify relevant practices that could inform DOL’s administration of coal  operator insurance at the federal level. We also interviewed DOL officials,  coal mine operators, insurance company representatives, and officials  from the National Mining Association, NCCI, National Council of Self- Insurers, and the American Academy of Actuaries, among others. A more  detailed explanation of our methodology is available in our report.    The work upon which this statement is based was conducted in  accordance with generally accepted government auditing standards.

Some Self-Insured Operator Bankruptcies Shifted $865 million in Estimated Liability to the Trust Fund, but Commercial Insurance Coverage Can Help Limit Trust Fund Exposure

Of the eight coal mine operator bankruptcies we identified, three resulted  in a transfer of estimated benefit liability from the coal operator to the  Trust Fund and five did not, according to DOL. Figure 1 shows how many  operators were self-insured or commercially insured at the time of  bankruptcy, and if responsibility for benefits was shifted from the bankrupt  operator to the Trust Fund. Federal law generally requires coal mine  operators to secure their black lung benefit liability. A self-insured coal  mine operator assumes the financial responsibility for providing black lung  benefits to its eligible employees by paying claims as they are incurred.  Operators are allowed to self-insure if they meet certain DOL conditions.  For instance, operators applying to self-insure must obtain collateral in  the form of an indemnity bond, deposit or trust, or letter of credit in an  amount deemed necessary and sufficient by DOL to secure their  liability. Operators that do not self-insure are generally required to  obtain coverage from commercial insurance companies, state workers’  compensation insurance funds, or other entities authorized under state  law to insure workers’ compensation.

From 2014 through 2016, three self-insured coal mine operator  bankruptcies resulted in a transfer of $865 million of benefit liabilities from  the coal operators to the Trust Fund, according to DOL estimates (see  table 1). DOL estimates for how these bankruptcies will affect the Trust  Fund have considerably increased from what DOL had previously  reported. In June 2019, we reported that DOL estimated that between  $313 million to $325 million in benefit liabilities would transfer to the Trust  Fund as a result of these bankruptcies. In January 2020, however, DOL provided updated estimates stating that $865 million in benefit liabilities  would transfer to the Trust Fund as a result of these bankruptcies.  According to DOL, their estimates increased, among other reasons, to  account for higher black lung benefit award rates that occurred from fiscal  years 2016 through 2019, and higher medical treatment cost inflation in  recent years. Additionally, DOL’s prior estimate for the Patriot Coal  (Patriot) bankruptcy did not account for future claims and their effect on  the Trust Fund. The amount of collateral DOL required from these  operators to self-insure did not fully cover their estimated benefit  liabilities. When this occurs, benefit liabilities in excess of the collateral  can be transferred to the Trust Fund. For example, the collateral DOL  required from Alpha Natural Resources (Alpha) was about $12 million and  approximately $494 million of estimated benefit liability transferred to the  Trust Fund, according to DOL.

The three other self-insured coal mine operator bankruptcies we identified  did not affect the Trust Fund. Specifically, Arch Coal, Peabody Energy,  and Walter Energy were also self-insured operators, but DOL officials  said that their federal black lung benefit liabilities were assumed by a  reorganized company or by a purchaser, and therefore did not transfer to  the Trust Fund.

Insurance contracts or policies to secure operators’ benefit liabilities are  required by law to include a provision that insolvency or bankruptcy of an  operator does not release the insurer from the obligation to make benefit  payments. Additionally, state insurance regulation, insurer underwriting, risk management practices, and state guaranty funds help to protect the  Trust Fund from having to assume responsibility for paying black lung  benefits on behalf of bankrupt coal operators. Thus, by being  commercially insured, the two operators we identified that filed for  bankruptcy between 2014 and 2016—Energy Future Holdings and  Xinergy Ltd—did not affect the Trust Fund, according to DOL (see fig. 1).

Since 2016, several other self-insured operators have also filed for  bankruptcy, according to DOL officials, including Cambrian Coal, Cloud  Peak Energy, Murray Energy, and Westmoreland Coal. DOL officials said  that about $17.4 million in estimated black lung benefit liability will transfer  to the Trust Fund as a result of Westmoreland Coal’s bankruptcy. Given  the uncertainty of the bankruptcy process in terms of whether liabilities  will or will not transfer to the Trust Fund, however, DOL officials said that  they could not speculate on how these other bankruptcies may affect the  Trust Fund.

DOL’s Limited Oversight Has Exposed the Trust Fund to Financial Risk, and Its New Self-Insurance Process Lacks Enforcement Procedures

In overseeing coal mine operator self-insurance in the past, DOL did not  estimate future benefit liability when setting collateral or regularly review  operators to monitor their changing financial conditions. DOL regulations  require that collateral be obtained from operators in an amount deemed  necessary and sufficient to secure the payment of the operators’ liability.  To determine collateral amounts under the former process, agency  procedures stated that an operator’s net worth be assessed by reviewing,  among other factors, the operator’s audited financial statements and  black lung claims information. The amount of collateral was to be equal to  3, 5, or 10 years of the operator’s annual black lung benefit payments  made at the time of a coal operator’s self-insurance application  depending on its net worth. Specifically, if net worth was $1 billion or  greater, agency procedures set collateral equal to 3 years of benefit  payments. If net worth ranged from $500 million to $1 billion, collateral  was equal to 5 years of benefit payments. If net worth ranged from $10  million to $500 million, DOL set collateral equal to 10 years of benefit  payments. Agency procedures did not permit operators with net worth  less than $10 million to self-insure.

DOL’s former process for determining collateral did not routinely consider  potential future claims for which an operator could be responsible. The  agency periodically reauthorized coal operators to self-insure by  reviewing an operator’s most recent audited financial statement and  claims information, among other things. DOL prepared memos  documenting these reviews, and communicated with coal operators about  whether their financial circumstances warranted increasing or decreasing  their collateral.

Regulations state that DOL may adjust the amount of collateral required  from self-insured operators when experience or changed conditions so  warrant, but regular monitoring of self-insured operators was not  conducted. In reviewing the most recent reauthorization memos for each  of the self-insured operators, we found that while some of these operators  had been reauthorized more recently, others had not been in decades.  One operator in particular had not been reauthorized since 1988. There  were no written procedures that specified how often reauthorizations  should occur after an operator’s initial 18-month reauthorization.

DOL has other tools available to mitigate financial losses to the Trust  Fund. These include revoking an operator’s ability to self-insure; fining  mine operators for operating without insurance; and placing liens on  operator assets. Based on our review of agency documentation,  however, we found instances when officials did not use these tools to  protect the Trust Fund, or were hindered from doing so because of an  operator’s ongoing appeal or bankruptcy.

James River. In September 2001, DOL required $5 million in  additional collateral from James River Coal (James River), which  would have increased its collateral from $0.4 million to $5.4 million.  Although DOL did not receive the additional collateral, it did not  revoke the operator’s authority to self-insure, which is a potential  option under agency regulations. Further, DOL had not reauthorized  James River at any point from August 2001 until it filed for bankruptcy  in April 2014. If James River’s ability to self-insure had been revoked,  DOL could have potentially prevented the Trust Fund from being  responsible for claims based on a miner’s employment from 2001  through 2016, when James River liquidated. Additionally, if the  operator had been unable to obtain commercial insurance, the agency  could have potentially fined the operator for each day it operated  without insurance. Instead, no action was taken during these years  and estimated benefit liability of $141 million was shifted to the Trust  Fund, according to DOL. DOL officials stated that they do not have  records explaining why James River did not provide the additional  collateral or why they did not revoke its authority to self-insure.

Patriot. In August 2014, DOL required an additional $65 million in  collateral from Patriot, increasing its collateral from $15 million to $80  million. Patriot appealed this decision and, in the 8 months that  followed before Patriot filed for bankruptcy in May 2015, DOL did not  obtain additional collateral, or revoke Patriot’s ability to self-insure  because the appeal was still pending. DOL officials said they would  not typically revoke an operator’s authority to self-insure during an  ongoing appeal. As a result, DOL was hindered from using this  enforcement tool.

Liens on operator assets can be an effective tool to protect the Trust  Fund if an operator defaults on its benefit liability, but DOL officials said  they are hindered from using this tool if an operator files for bankruptcy.  DOL can place a lien on a coal operator’s assets under federal law if they  refuse the demand to pay the black lung benefit payments for which they  are liable. In the event of bankruptcy or insolvency, federal law states  that the lien imposed shall be treated in the same manner as a lien for  taxes due and owing to the United States under certain laws. However,  DOL officials said that operators rarely stop paying benefits until after  they file for bankruptcy. Once a bankruptcy occurs, DOL officials said that  they are generally prevented by the court from placing a lien and taking  an operator’s assets in lieu of payment of current and future benefit  liability. Under bankruptcy law, DOL officials said that they have no  special status over other creditors with outstanding financial claims. DOL  officials said that obtaining sufficient collateral is a better way to protect  the Trust Fund.

DOL’s New Self-Insurance Process May Help Address Problems, but Key Enforcement Procedures Are Needed

In July 2019, DOL began implementing a new process for coal mine  operator self-insurance that may help to address some past deficiencies,  if implemented effectively. Among other things, DOL will require operators  to periodically submit financial and claims information, including an  actuarial estimate of the operator’s current and future benefit liability. DOL  plans to use this information to assess the insolvency risk of each  operator. Depending on the results of their analysis, DOL plans to  categorize the risk-level of each applicant as low, medium, or high. DOL  will then set the amount of collateral required to self-insure by linking the  operator’s risk category to a corresponding percentage of the operator’s  actuarial estimated benefit liability. DOL policies state that they would  require a high-risk operator to secure with collateral 90 percent of  estimated benefit liability, a medium-risk operator to secure 45 percent,  and a low-risk operator to secure 15 percent. However, in February 2020,  DOL officials said they plan to revise these percentages to 100 percent,  85 percent, and 70 percent for high-risk, medium-risk, and low-risk  operators, respectively.

Coal mine operators that are already authorized to self-insure will be  required to submit, among other things, an annual renewal application.  DOL plans to use this information to update their insolvency risk analysis.  If an operator’s risk category changes (e.g., from low-to medium-risk),  DOL plans to send a form to the operator requiring an additional amount  or type of collateral. Upon receiving the completed form, and proof that  the collateral has been obtained, DOL stated that they will notify the  operator that its authority to self-insure has been reauthorized.

DOL’s new self-insurance process made important changes, but  overlooked other key internal control improvements that are needed to  protect the financial interests of the Trust Fund. DOL’s new requirements  for setting collateral and for the more frequent review of self-insured  operators are key components of internal controls, which call for agency  management to implement control activities through policy. However,  DOL’s new self-insurance procedures do not specify (1) the duration of an  operator’s self-insurance authority, (2) the time frames for submitting  renewal applications and supporting documentation, and (3) the  conditions under which an operator’s self-insurance authority would not  be renewed. Our report recommends that DOL implement procedures for  coal mine operator self-insurance renewal that clarifies how long an  operator is authorized to self-insure; when an operator must submit its  renewal application and supporting documentation; and the conditions  under which an operator’s self-insurance authority would not be renewed.  DOL agreed with this recommendation and stated that it will ensure  letters granting or renewing self-insurance authority will inform operators  that their authorization expires in one year and that they must submit  renewal information three months in advance of the expiration date.

DOL staff are hindered from taking enforcement action during an  operator’s ongoing appeal, as previously mentioned. DOL policies state  that an operator may request reconsideration if its self-insurance  application has been denied or if it believes the collateral required by DOL  is too high to secure its benefit liability. However, DOL lacks procedures  that specify, among other things, the length of time that operators have to  submit supporting information. Further, DOL does not specify a goal for  how much time DOL appeals decisions should take. For example, in  October 2015, DOL recommended revoking Murray Energy’s (Murray)  authority to self-insure due to deteriorating financial conditions. Murray  appealed this decision, and DOL officials said they postponed responding  to the appeal until their new self-insurance process was implemented.  However, Murray filed for bankruptcy in October 2019 and DOL had not  revoked its authority to self-insure or requested additional collateral  because Murray’s appeal was still pending and DOL was still evaluating  how much collateral it would require from the operator under its new self- insurance process.

Our report recommends that DOL develop and implement procedures for  self-insured coal mine operator appeals that identify time lines for self- insured operators to submit documentation supporting their appeals and  that identify a goal for how much time DOL should take to make appeals  decisions. DOL agreed with this recommendation and stated that they will  ensure letters denying self-insurance will inform operators that they have  a 30-day appeal period (limited to one extension), and that DOL has set a  goal of resolving all appeals within 90 days of the denial letter.

Commercial Insurance Oversight Improvements Are Needed

We found that DOL does not monitor coal mine operators that do not self- insure and, thus, must commercially insure their federal black lung  liabilities to make certain they maintain adequate and continuous  coverage as required by law. In the absence of effective DOL monitoring,  we evaluated the potential risk that uninsured operators could pose to the  Trust Fund. Specifically, in examining the 13 largest coal mine operators  that do not self-insure, we found that some insurers erred in reporting  black lung policies and in one instance an operator did not have adequate  coverage.

We found six operators (parent or subsidiary) that were not insured for  the entire 3-year period from 2016 through 2018, according to our  review of DOL data. When we discussed our findings with DOL,  agency officials had to research each operator individually and in  some cases contact the operator or their insurer to find out whether or  not they had been covered. DOL concluded that these entities were  insured. However, the insurers had not properly reported the federal  black lung endorsement on new policies or subsequent renewals, in  addition to other reporting issues.

One of these six operators also had, inadvertently, not maintained  adequate commercial coverage for its mining operations in Texas,  and had not self-insured those operations. In this instance, the  operator obtained an excess loss policy that only pays claims once  they exceed a high threshold and, therefore, is not sufficient by itself  to secure the payment of the operator’s benefit liability.

Designing processes to achieve agency objectives and respond to risks is  a principle of effective internal controls. Without a process to monitor  operator compliance with program insurance requirements, DOL risks not  identifying a lapse or cancellation of operator coverage. This could result  in the Trust Fund having to assume responsibility for paying benefits that  would otherwise have been paid by an insurer.

Our report recommends that DOL should develop and implement a  process to monitor operator compliance with commercial insurance  requirements and periodically evaluate the effectiveness of this process.  DOL agreed with this recommendation and stated that it will modify  existing computer systems to identify lapses or cancellations of  commercial insurance coverage, and require operators identified as  having lapsed or cancelled coverage to obtain or provide proof of  coverage within 30 days.

Chairwoman Adams, Ranking Member Byrne, and Members of the  Subcommittee, this concludes my prepared statement. I would be happy  to respond to any questions you may have at this time.

If you or your staffs have any questions concerning this testimony, please  contact Cindy Brown Barnes at (202) 512-7215 or  brownbarnesc@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this  statement. GAO staff who made key contributions to this testimony are  Alicia Puente Cackley, (Director), Blake Ainsworth (Assistant Director),  Patrick Ward (Assistant Director), Justin Dunleavy (Analyst-in-Charge),  Alex Galuten, Rosemary Torres Lerma, Olivia Lopez, Scott McNulty, and  Almeta Spencer.

This is a work of the U.S. government and is not subject to copyright protection in the  United States. The published product may be reproduced and distributed in its entirety  without further permission from GAO. However, because this work may contain  copyrighted images or other material, permission from the copyright holder may be  necessary if you wish to reproduce this material separately.

The federal government’s Black Lung Disability Trust Fund faces financial challenges and has borrowed billions to cover costs. The Trust pays benefits to certain coal miners when no coal mine operator can be held responsible, or when the liable operator does not pay.

Three mine operator bankruptcies have further strained Trust finances by transferring $865 million in estimated benefit responsibility to the Trust—and more bankruptcies are expected.

In the report on which this testimony is based, we made 3 recommendations to the Department of Labor calling for better oversight of mine operator insurance to help limit future federal liability.


Intergovernmental Issues: Key Trends and Issues Regarding State and Local Sector Finances

State and local governments work together with the federal government to deliver a broad range of public services. GAO's prior work has shown that the state and local government sector will likely face fiscal pressures during the next 50 years due to a gap between spending and revenues. The fiscal sustainability of the state and local government sector is essential to effectively implement intergovernmental programs.

GAO was asked to review recent trends in state and local government expenditures and revenues, fiscal pressures for state and local governments with intergovernmental implications, and the implications of federal policy for these pressures. This report (1) examines trends in state and local government expenditures and revenues during the past two decades; and (2) synthesizes expert views regarding the effects of federal policy on state and local government fiscal conditions.

GAO analyzed data from the Bureau of Economic Analysis National Income and Product Accounts, the U.S. Census Bureau and the National Association of State Budget Officers.

GAO also interviewed a nongeneralizable sample of experts from organizations that represent state and local governments, professionals who provide financial and credit risk information (credit rating agencies), and researchers from think tanks to better understand how federal policies affect state and local government fiscal conditions.

During the past two decades, the state and local government sector experienced overall growth in spending and revenue. Specifically, inflation-adjusted spending increased from about $1.7 trillion in 1998 to about $2.8 trillion in 2018. Health spending accounted for the largest increase. Inflation-adjusted revenues increased from about $1.6 trillion in 1998 to about $2.6 trillion in 2018. Taxes comprised the largest revenue category.

From 1997 to 2017, state and local government expenditures and revenues grew faster than state gross domestic product in most states. On average, growth in expenditures outpaced growth in revenues by 0.3 percentage points per year during the period. Increases in public welfare spending drove spending growth (spending largely for states' share of Medicaid), while federal grants and user charges drove revenue growth.

Domestic Product (GDP) in Most States from 1997 to 2017

Source: GAO analysis of U.S. Census Bureau and Bureau of Economic Analysis data. | GAO 20-437

Experts identified a range of issues facing state and local governments that could affect the sector's fiscal condition. Those most frequently mentioned included:

Health care. Experts expressed concerns regarding their ability to meet future Medicaid enrollment demands in an economic downturn.

Federal budget uncertainty. Uncertainty in the future of federal assistance as well as the timing of federal appropriations, including federal government shutdowns, affected state and local governments' program planning.

Physical infrastructure. Aging infrastructure costs and uncertainty in federal funding sources placed pressure on the sector to identify alternative revenue sources for transportation projects.

Tax policy . Provisions of the law known as the Tax Cuts and Jobs Act had varied effects on the sector, but most experts agreed it is still too early to assess the act's full effects on state and local government revenues.

Natural disasters . Experts acknowledged the important contribution of federal financial support for disaster response and recovery and noted some states' mitigation efforts to address the increasing frequency and cost of disasters. Credit rating firms are considering the effects of climate change in their credit analyses of state and local governments.

State and local governments work together with the federal government  to deliver a broad range of public services. Federal funds for government  programs implemented in partnership with states and localities support  health care, education, public safety, infrastructure, and other policy  goals. Successful implementation of federal policy goals in these areas is  therefore contingent on state and local governments’ fiscal stability.  Consequently, the fiscal health of state and local governments is an issue  of critical interest to federal policymakers.

You asked us to provide information on and analyze trends in state and  local government expenditures and revenues, fiscal pressures facing  state and local governments, and the implications of federal policy actions  on state and local governments’ fiscal health. This report (1) examines  recent trends in state and local government expenditures and revenues;  and (2) synthesizes expert views regarding the effects of federal policy on  state and local government fiscal conditions.

To describe recent trends in state and local government expenditures and  revenues, we analyzed aggregate data on state and local expenditures  and revenues using inflation-adjusted data from the Bureau of Economic  Analysis’s (BEA) National Income and Product Accounts and the U.S.  Census Bureau (Bureau) during a 20-year period—which includes  periods of economic growth and two recessionary periods. For purposes  of this review, we determined that the BEA National Income and Product  Accounts and Bureau data were sufficiently reliable for our analysis of  trends in state and local government expenditures and revenues. Our  data reliability assessment included reviewing relevant documentation,  interviewing knowledgeable BEA and Bureau officials, and reviewing the  data to identify obvious errors or outliers. We also reviewed our prior  reports and those of other organizations examining state and local  government fiscal conditions to identify what is known about these trends  and factors that may influence them.

As part of our analysis of state and local government expenditure and  revenue trends, we examined state rainy day funds to better understand  how states prepare for future economic downturns. To do this, we  analyzed data from the National Association of State Budget Officers  (NASBO) on state rainy day fund balances and general fund  expenditures. We found the NASBO data to be sufficiently reliable for our  analysis of state rainy day funds.

This review is not necessarily representative of all fiscal pressures facing  state and local governments. For example, the scope of the review does  not include tax expenditures or pressures specific to individual state or  local governments.

To obtain expert views regarding the effects of federal policy on state and  local government fiscal conditions, we conducted a series of structured  interviews with a nongeneralizable sample of individuals from 17  organizations with recognized expertise in state and local budgeting and  finance, economics, public policy, and intergovernmental issues. We  identified three categories of experts and selected individuals within each  category. They included: (1) individuals from organizations representing  state and local government officials; (2) providers of financial and credit  risk information, such as credit rating agencies; and (3) researchers from  think tanks with expertise in state and local government finance, including  taxes, budgeting, and intergovernmental relations.

To select experts within each category, we reviewed publicly available  work and professional affiliations, as well as other criteria to determine  their relative expertise related to state and local government fiscal and  intergovernmental issues. Appendix I includes additional detail about the  scope and methodology of the review, including a list of the organizations  represented by the experts we interviewed and how we analyzed the  information they shared with us.

We conducted this performance audit from January 2019 to March 2020  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

State and local governments rely on a range of revenue sources to  support their activities, including federal grants, user charges, and taxes.  The share of revenue generated from different types of state and local  taxes and user charges—also referred to as own-source revenue—varies  by state or local government. State and local governments face fiscal  pressures when, taken as a whole, spending exceeds revenues. Fiscal  pressures may reflect growth in selected expenditure categories without  corresponding revenue growth or other spending reductions.

To alleviate fiscal pressures and comply with balanced budget  requirements, state and local governments may seek to reduce spending,  increase revenues, or both. For example, state and local governments  may offset increased costs in one program by making cuts to other  programs where they have more flexibility to adjust certain types of  spending. Alternatively, if their ability to adjust spending is limited, they  may seek additional revenue by increasing existing taxes or user charges  or imposing new ones. For example, some programs may have spending  that is defined or required in state law and must be funded annually,  regardless of broader economic circumstances. Other spending may not  be subject to legal or other requirements and is thus subject to decisions  influenced by current fiscal pressures.

Changes in the makeup of state and local government services,  spending, and revenues may reflect economic or demographic changes,  a change in spending priorities, or changes in federal policy. Fiscal  pressures can result from spending growth or revenue declines that are  not the direct result of current state and local policy choices. These  choices may instead reflect automatic spending growth (for example, in  response to population shifts or an increase in the number of people  eligible for government programs) or declines in revenue due to changes  in the economy (for example, a shift from goods to services without a  corresponding shift in the tax base). Individual expenditure categories can  also face fiscal pressures. For example, employee pension funds can  experience investment returns below the rates of return assumed in  budget forecasts, which can then become underfunded liabilities.

State and Local Governments Experienced Overall Growth in Expenditures and Revenues during the Past 20 Years

State and Local Government Expenditures and Revenues Increased in Most Categories from 1998 to 2018

From 1998 to 2018, state and local government expenditures increased  from about $1.7 trillion in 1998 to about $2.8 trillion in 2018. Figure 1  shows that most state and local government expenditure categories  experienced slight shifts during this period. While some categories  declined as a share of total spending, inflation-adjusted spending  increased in all expenditure categories. Health expenditures reflected the  largest increase in inflation-adjusted spending, increasing from $288  billion in 1998 to $670 billion in 2018. As a share of total expenditures,  health spending increased by 7 percentage points, from 17 percent in  1998 to 24 percent in 2018.

Inflation-adjusted spending on education—the largest share of state and  local expenditures—increased by more than $300 billion from 1998 to  2018. However, as a share of total spending, education expenditures  decreased by 2 percentage points during the period, in large part,  because of the sizable growth in health expenditures during this time  period.

From 1998 to 2018, state and local government revenues increased from  about $1.6 trillion in 1998 to about $2.6 trillion in 2018 (see figure 2). In  every year between 1998 and 2018, state and local government taxes  (i.e., personal income, sales, excise, property, corporate, and other taxes)  comprised the largest category of receipts for the sector, providing about  $1.8 trillion or 69 percent of total revenues in 2018. With the exception of  interest receipts, all revenue categories increased in inflation-adjusted  dollars from 1998 to 2018. Interest receipts decreased from $108 billion  or 7 percent of total revenues in 1998 to $72 billion or 3 percent of total  revenues in 2018.

Federal grants comprised the second largest category of state and local  government revenues in both 1998 and 2018 (see figure 2). As a share of  total revenues, federal grants increased from $288 billion or 17 percent of  total revenues in 1998 to $569 billion or 22 percent in 2018, an increase  of $281 billion or 5 percentage points.

Figure 3 provides a more detailed breakdown of federal grants to state  and local governments from 1998 to 2018. Compared to other grant  categories, health grants reflected the only increase in state and local  government federal grants, increasing from 53 percent in 1998 to 70  percent in 2018. Most of this growth occurred after 2010, following the  enactment of the Patient Protection and Affordable Care Act (PPACA),  which offered federal Medicaid funding for states choosing to expand their  programs to low-income adults. As a share of total federal grants,  income security grants reflected the largest decrease—from 26 percent in  1998 to 17 percent in 2018. However, income security grants increased  in inflation-adjusted dollars, from $75 billion in 1998 to $96 billion in 2018.  The decline in income security grants, as a share of total federal grants,  reflects shifts in federal grants to state and local governments resulting  from faster growth in health grants during the 20-year time period.

State and Local Government Expenditures and Revenues Grew Faster Than State Gross Domestic Product and Varied by Type

In most states, growth in both state and local government expenditures  and revenues exceeded growth in state gross domestic product (GDP)  from 1997 to 2017. As shown in table 1, growth in expenditures equaled  or exceeded growth in state GDP in each of the 5-year periods from 1997  to 2017. Revenues grew faster than state GDP, on average, during the  20-year period, though they grew somewhat slower than state GDP from  2008 to 2012. Table 1 also shows that state and local government  expenditures, revenues, and state GDP all experienced more robust  growth during the first half of the 20-year period (1997 to 2007) than in  the second half of the period (2008 to 2017).

On average, growth in state and local government expenditures outpaced  growth in state and local government revenues by about 0.3 percentage  points per year. As shown in figure 4, expenditures grew faster than  revenues in 43 states from 1997 to 2017. We have previously reported on  state and local government expenditure growth trending in excess of  revenue growth and its implications for increasing state and local  government fiscal pressures. For example, our most recent simulations  suggest that the state and local government sector could continue to face  a gap between expenditures and revenues during the next 50 years.  Because many state and local governments are required to balance their  operating budgets, they will most likely need to make policy changes  involving some combination of reduced spending and increased  revenue.

Most Types of Expenditures Grew among States, with Public Welfare Spending Showing the Fastest Growth

Spending in most expenditure categories grew faster than or at the same  rate as state GDP in a majority of states from 1997 to 2017 (see table 2).  State and local government expenditures, as a whole, grew at an average  annual rate of 2.8 percent from 1997 to 2017 and faster than state GDP in  43 states. Public welfare spending showed the fastest growth among all  state and local government expenditure categories, growing at an  average annual rate of 4.9 percent per year during the period.

Public welfare. Public welfare—which includes Medicaid and welfare  programs, such as Temporary Assistance to Needy Families—grew faster  than all other spending categories from 1997 to 2017. Public welfare grew  faster than state GDP in all but two states at an average annual rate of  4.9 percent during the period. The Centers for Medicare & Medicaid  Services (CMS) Office of the Actuary projected that Medicaid spending  would grow at an average rate of 5.7 percent per year, from fiscal years  2017 to 2026, with projected Medicaid expenditures reaching more than  $1 trillion by fiscal year 2026. Since Medicaid is a matching formula  grant program, the projected growth rate reflects expected increased  Medicaid expenditures that will be shared by state governments.  Furthermore, our long-term simulations of the state and local government  sector’s fiscal outlook have shown that health expenditures are expected  to continue to increase faster than the economy during the next 50  years.

Hospitals and health. Expenditures on hospitals and health—which  include state and local government spending on public health and  hospitals, but not Medicaid—grew at an average rate of 2.6 percent per  year from 1997 to 2017. Across all states, average annual growth in spending on hospitals and health ranged from -2.8 percent per year to 7.8  percent per year, reflecting the largest spread of any spending category.  Further, growth in spending on hospitals and health was not distributed  evenly across this range. In eight states, hospital and health expenditures  grew at an average annual rate of less than 1 percent, while the average  annual growth rate exceeded 3 percent in 20 states.

Education services. Spending on education services (i.e., schools,  colleges, other educational institutions, educational programs for adults,  veterans, and other special classes) grew at an average rate of 2.6  percent per year and faster than state GDP in 36 states from 1997 to  2017. This average annual growth rate reflects faster growth of 4.1  percent per year, on average, from 1997 to 2007 and slower growth of 0.7  percent per year, on average, from 2008 to 2017. During the second half  of the 20-year period, from 2008 to 2017, spending on education services  grew more slowly than state GDP in 39 states.

Public safety. Spending on public safety, which includes state and local  government services, such as police, fire protection, and corrections,  grew in all states at an average rate of 2.5 percent per year from 1997 to  2017. In 34 states, public safety spending grew faster than state GDP  during the period. Further, public safety expenditures grew faster than 3  percent in 13 states and slower than 1 percent in three states during the  same period.

Transportation. Spending on transportation grew at an average annual  rate between -1.4 percent and 7.2 percent from 1997 to 2017. In 35  states, transportation spending grew between 1 percent and 3 percent  per year, on average, during this period. Transportation spending grew  slower than 1 percent per year on average in seven states, while in nine  states, transportation spending grew faster than 3 percent, on average,  per year.

Environment and housing. Expenditures on environment and housing,  which include functions related to natural resources and housing and  community development programs, grew, on average, at a rate equal to  state GDP from 1997 to 2017 and ranged from a low of 0.3 percent to a  high of 6.4 percent. Environment and housing spending exceeded state  GDP growth in 24 states, while these expenditures grew more slowly than  state GDP in 27 states. From 1997 to 2007, environment and housing  spending grew at an average rate of 4.3 percent per year. From 2008 to  2017, this spending category grew at an average annual rate of .03  percent.

Government administration. Government administration includes  functions related to managing the government’s day-to-day work, such as  financial administration, judicial and legal costs, and central staff services  and personnel agencies. Spending in this category grew slightly slower  than state GDP at an average rate of 2.1 percent per year from 1997 to  2017. Government administration spending grew faster from 1997 to  2007 (at an average rate of 3.6 percent per year) than from 2008 to 2017  (at an average rate of 0.4 percent per year).

Other selected expenditures. Interest on debt spending (i.e., all  spending on borrowed money except utility debt) grew slower than state  GDP in 48 states, while annual growth ranged from -5.1 to 2.5 percent  across states. From 2008 to 2017, spending on debt interest decreased  by an average annual rate of 2.1 percent from 2008 to 2017. Insurance  benefits and repayment expenditures, which include retirement benefits,  was the fastest growing category of selected expenditures. Average  annual growth in interest paid to finance debt equaled -0.1 percent.  Salaries and wages for state and local government employees grew  slower than state GDP in 46 states and slower than 1 percent per year in  seven states.

Growth in the Sector’s Revenues Driven by Federal Grants and User Charges

General revenues, as a whole, grew faster than state GDP in 35 states  from 1997 to 2017 with the fastest growth in federal grants (3.5 percent  per year) and user charges (3.1 percent per year). Table 3 shows state  and local government revenue broken down into two larger categories: (1)  federal grants, which include all federal fiscal aid to state and local  governments; and (2) own-source revenue, which includes all general  revenue state and local governments generate from their own sources,  such as taxes and user charges.

In the following section, we discuss trends in selected revenue categories  identified in table 3. These selected revenue categories—federal grants,  user charges, and property taxes—represent the three largest categories  of revenue for the state and local government sector.

Federal grants. Federal grants were the fastest growing source of  revenue for the sector from 1997 to 2017, growing in every state and  faster than state GDP in 45 states at an average annual rate of 3.5  percent. During the same period, state and local governments’ own- source revenue (i.e., taxes and user charges) grew at an average rate of  2.2 percent per year and ranged from -1.7 percent to 3.9 percent per  year. However, state and local governments’ own-source revenue grew  faster than state GDP in about half of the states. At the same time, this   revenue growth varied among grant categories and across states.

User charges. State and local government user charges comprised the  second fastest growing revenue category for the sector from 1997 to  2017. User charges grew faster than state GDP in 40 states, at an  average rate of 3.1 percent per year. In addition, user charges grew in  every state, at an average rate between 0.9 percent and 6.2 percent per  year.

Total taxes. State and local government taxes, the largest category of  own-source revenue, grew slower than state GDP from 1997 to 2017.  Specifically, state and local government total tax revenues grew at a rate  of about 2.1 percent per year, on average. As shown below, for the three  major tax categories—property, sales, and individual income—growth  varied overall and across states.

Property taxes. Property taxes were the fastest growing category  for the sector—growing in nearly all states at an average rate of 2.6  percent per year from 1997 to 2017. Property taxes grew faster  than state GDP in 36 states and faster than 3 percent per year in  17 states. Property taxes drove own-source revenue growth during  this time period. Compared to other tax revenue categories,  property taxes have been a relatively stable revenue source for  local governments. In addition, property taxes grew at an average  rate of 1.4 percent per year from 2008 to 2012, while both sales  and income taxes showed negative growth during the period.

Sales taxes. Sales taxes grew at an average rate of 2 percent per  year from 1997 to 2017, ranging from a low of -0.6 percent to a  high of 4.1 percent. Revenue from sales taxes grew slower than  state GDP in 28 states and slower than 1 percent per year in six  states. Slower sales tax growth could reflect a shrinking sales tax  base for state and local governments. Many states do not levy a  tax on services—which represents more than two-thirds of all  consumption. These states must therefore raise sales tax revenue  from a smaller base.

Individual income taxes. From 1997 to 2017, growth in individual  income taxes showed greater variation across states and over time  than either property or sales taxes. Similar to the growth in sales  taxes, individual income taxes grew at an average rate of 2 percent  per year, but reflected a wider range of growth from 1997 to 2017.  Individual income taxes grew slower than state GDP in 26 states  and slower than 1 percent per year in six states. From 2008 to  2017, growth in individual income taxes slowed to an average rate  of 0.3 percent per year—representing a more than 3-percentage- point slower growth rate compared to the period from 1997 to 2007.

Table 4 shows that public welfare grants to state and local  governments—which include Medicaid—grew faster than state GDP in 47  states. Public welfare grants grew faster than 3 percent per year in 45  states from 1997 to 2017. During this period, public welfare grants grew in  all states at an average rate of 4.6 percent per year, ranging from 1.8  percent to 9.5 percent per year. Grant funding for education and  highways grew faster than state GDP at an average annual rate of 2.6  percent and 2.4 percent, respectively. Although a relatively small share of  federal grants, natural resources grants had the largest average annual  growth rate—4.9 percent—and grew faster than state GDP in 37 states  from 1997 to 2017.

Federal grants grew faster than own-source revenue overall and in a  majority of states from 1997 to 2017. Figure 5 compares the rate of  growth in own-source revenue to the rate of growth in federal grant  revenue during the period. Figure 5 shows that, for the majority of states,  revenue from federal grants grew faster than own-source revenue.

State Rainy Day Fund Balances Fluctuated During the Past 20 Years and Experienced Consistent Growth Since 2010

State rainy day fund balances fluctuated as a median percentage of  general fund expenditures from 1998 to 2018 and experienced consistent  increases since 2010. Rainy day funds include state budget stabilization  or reserve funds that state governments may use to supplement general  fund spending during a revenue downturn or other unanticipated shortfall.  Every state has some type of rainy day fund, though deposit and  withdrawal rules vary considerably.

Robust rainy day fund balances alone do not necessarily indicate strong  fiscal positions, but they are one of the primary mechanisms available to  states to offset a budget gap, along with spending reductions or tax  increases. However, these funds will not necessarily relieve longer-term  structural fiscal pressures.

Median state rainy day fund balances as a percentage of total general  fund expenditures increased to their highest level in the last 20 years in  2018. Figure 6 shows that states’ median rainy day fund balances  increased from 1.6 percent of general fund expenditures in 2010 to 6.4  percent in 2018. Further, the median balance of state rainy day funds  declined significantly after each of the last two recessions, while states  gradually restored their balances each time.

From 2016 to 2018, the majority of states maintained rainy day fund  balances in excess of 5 percent of their general fund expenditures. The  number of states with rainy day fund balances that exceeded 5 percent of  their general fund expenditures doubled from 1998 to 2018, from 16  states in 1998 to 32 states in 2018 (see figure 7). Specifically, nearly half  of the states maintained rainy day fund balances greater than 5 percent  and less than 10 percent of their general fund expenditures in 2018. Six  states had rainy day fund balances equal to 1 percent or less of their  general fund expenditures, down from 11 states in 1998.

Experts Identified Federal Policies and Other Considerations That Affect State and Local Governments’ Fiscal Conditions

Experts we interviewed identified a range of federal policies and other  considerations that could affect the fiscal condition of state and local  governments. While there are other issues that affect the state and local  sector’s fiscal condition, this section focuses on the issues that emerged  most frequently during the interviews related to the effects of federal  policies on the sector’s fiscal condition, and the fiscal pressures facing  states and localities that could require a federal policy response to ensure  effective delivery of federal programs implemented by these  governments. Those issues include: health care, federal budget  uncertainty, physical infrastructure, tax policy, and natural disasters.

Health care. Most experts agreed that health care costs and, in  particular, Medicaid, have placed fiscal stress on state and local  governments. A number of experts expressed concerns about the long- term sustainability of Medicaid and the states’ ability to meet future  demand, given current demographic trends and expectations for  escalating enrollment. As we discussed earlier, Medicaid has been the  fastest growing category of state spending and, based on our simulations,  is expected to rise faster than GDP during the next 50 years.

Some experts noted that growth in Medicaid affects states’ fiscal  conditions as it has become a larger portion of states’ budgets. They  pointed out that even though states have experienced a recent leveling  off in Medicaid enrollment, states have also experienced a faster rate of  growth in spending. Two experts attributed this growth largely to the aged  and disabled enrollment groups that account for a larger share of program  spending.

A number of experts said that states that expanded their Medicaid  programs have seen the largest increases in enrollment—driven by adults  who are newly eligible for the program. CMS’s Office of the Actuary  projected that Medicaid enrollment is expected to grow by as many as  13.3 million newly eligible adults by 2026—as additional states may  expand their Medicaid programs to cover certain low-income adults under  the Patient Protection and Affordable Care Act (PPACA). The  Congressional Budget Office also reported that Medicaid spending  increased 36 percent from fiscal years 2015 to 2019, largely because of  state Medicaid expansions. As of January 2020, 36 states and the  District of Columbia expanded eligibility for their Medicaid programs under  PPACA.

Some experts noted that, while enrollment has grown for the expansion  states, the federal government bears responsibility for a large portion of  the costs. Specifically, the federal government reimbursed 100 percent of  the costs of the expanded population beginning in 2014. The federal  reimbursement then decreased to 94 percent in 2018, and to 90 percent  in 2020. One expert told us that states had the benefit of anticipating the  decrease in funding and the corresponding increase in the state share of  the costs.

At the same time, a number of experts generally agreed that states are  not financially positioned to meet the future demands of Medicaid during a  recession or economic downturn, given projected increases in enrollment.  In particular, experts pointed to the costs of recession-related Medicaid  enrollment increases and the resulting fiscal pressures this would place  on federal and state governments to fund Medicaid obligations. One  expert shared concerns related to the uncertainty of federal funding  should a recession occur.

Two experts also pointed to the pressures local governments, and more  specifically, county governments, face from implementation of certain  federal health care policies. Specifically, these experts pointed to the  health care costs that county governments must incur as a result of local  jails housing pretrial inmates who have medical needs and require  treatment. Federal law prohibits the use of federal health benefits by  inmates who are pending trial. Thus, to the extent that an inmate cannot  afford to pay the costs of health care services, counties must assume the  related health care expenses for providing the necessary treatment for  the inmate without reimbursement for those expenses.

Federal budget uncertainty. A number of experts told us that states  continue to grapple with uncertainty stemming from unpredictability in the  amount of federal assistance and timing of federal appropriations— including continuing resolutions and federal government shutdowns—and  effects on states’ ability to plan and implement programs.

Some experts raised concerns related to the federal government’s current  fiscal condition and the potential effects on state and local governments.  Specifically, experts noted that states are aware of the federal  government’s current fiscal condition—including federal debt and deficit  levels—and the level of support the federal government may or may not  choose to provide in the event of an economic downturn or recession, as  it has during past recessions. In light of the uncertainty, some states have  engaged in “stress tests” of their own budgets using various revenue and  expenditure scenarios to determine if they are in sufficient fiscal health to  weather a mild-to-severe recession.

Moody’s Analytics reported in 2019 that, based on the results of stress  tests it performed on all fifty states, 28 states have the level of cash  reserves necessary to manage a moderate recession without having to  raise taxes or cut spending. Some experts further noted that state and  local governments that have not been able to strengthen their cash  reserves could undergo more severe fiscal stress in an economic  downturn and require a greater level of assistance.

Some experts also raised concerns related to the effects of federal  government shutdowns and continuing resolutions on state and local  governments and their ability to plan for and implement federally-funded  programs. In all but 4 of the last 42 years, Congress has passed  continuing resolutions to keep government services in operation until an  agreement is reached on final appropriations bills. In some years, when  new appropriations or a continuing resolution have not been enacted on  time, this lapse in appropriations—or funding gap—caused the  government to partially shut down, which halted some activities at federal  agencies until appropriations were passed.

A number of experts told us that interruptions in appropriations and  subsequent delays in federal grants caused by shutdowns, for example,  may require states to spend additional unbudgeted funds to ensure  continuity of services in certain federally-funded programs, such as food  and nutrition and transportation. According to one expert, not all state or  local governments are in a position to access those funds in a timely  manner. Furthermore, one expert noted the impacts of continuing  resolutions on local governments by compressing the time available for  federal grant applications. As a result, some applicants (e.g., cities or  other localities) may not apply or miss deadlines for certain federal grant  programs.

We and others have reported on the effects of government shutdowns  and its impact on some states. For example, we reported on the partial  shutdown of the federal government in October 2013, which lasted for a  period of 16 days due to a lapse in appropriations. Our report showed  that even if a state wanted to use its funds to continue services for a  federally-funded program, it might not have had sufficient liquid assets to  do so quickly.

At that time, at least 12 states publicly reported that funding for certain  grant programs was only confirmed through October, meaning the  funding may not have been available if the shutdown had continued into  November. Some of these states expected to discontinue certain  federally-funded programs or services if the shutdown had extended into  November, while others expressed uncertainty regarding how they would  have proceeded if the shutdown had been longer.

Physical infrastructure. Physical infrastructure at the state and local  government level includes a broad range of systems—including  highways, mass transit, rail, water, and sewer systems. A number of  experts pointed to concerns related to an aging infrastructure and the  fiscal pressures that infrastructure demands place on state and local  governments. The cost of repairing and upgrading the nation’s surface  transportation infrastructure to meet current and future demands is  estimated in the hundreds of billions of dollars. Further, our 2017 report  noted that estimates from the Environmental Protection Agency put  drinking water and wastewater infrastructure needs at approximately  $655 billion nationwide during the next 20 years.

State and local governments own a large portion of the nation’s physical  infrastructure, while the federal government provides support to the sector  in the form of grants, bonds, and loans. Funds made available from the  Highway Trust Fund are distributed to states in the form of grants for  eligible projects. The federal government also supports additional  infrastructure spending through tax-exempt or tax-credit bonds, which  provide a tax exclusion or tax credit to owners of municipal bonds issued  by state and local governments. Further, through various loan  programs, such as the Transportation Infrastructure Finance and  Innovation Act program, the government supports project financing.  State and local governments also generate revenues for transportation  projects through their own sources including user fees and taxes.

A number of experts shared concerns about the future of federal funding  for state and local surface transportation needs. One expert  acknowledged the benefits of highway grant programs provided through  the Fixing America’s Surface Transportation Act. However, this expert  also recognized that the act is set to expire in 2020 and its future, along  with other sources of federal funding through the Highway Trust Fund,  remains uncertain. We have also reported that traditional federal  funding sources for surface transportation, such as the Highway Trust  Fund, are eroding and the federal government lacks a long-term  sustainable strategy for funding surface transportation.

Moreover, experts noted that physical infrastructure needs represent only  one among many competing priorities for state and local government  spending. One expert expressed concern that the availability of state and  local discretionary spending on infrastructure needs and maintenance will  increasingly be affected by growing pressures from other mandatory  spending categories, such as Medicaid.

Many states have looked to modify or enhance other sources of revenue,  such as the gas tax, to help meet highway transportation costs. According  to the National Conference of State Legislatures (NCSL), since 2013, 31 states and the District of Columbia have enacted legislation that will or  may increase their motor fuel tax to support surface transportation costs.  Even so, two experts raised concerns about the viability of the gas tax as  a reliable revenue source since gasoline consumption has declined.  Further, NCSL reported that many states have received federal funding to  study and pilot user-based alternative mechanisms through the Surface  Transportation System Funding Alternative Program.

We and others have also reported that some states have recognized the  need for an alternative funding mechanism to meet future revenue  demands. Some options that states have considered or implemented  include tying gas tax rates to inflation or population, taxes based on the  price of fuel, and taxing miles traveled instead of gas purchased—also  referred to as mileage-based user fees.

Further, experts pointed to the lack of a clearly articulated federal  highway infrastructure policy and the implications for state and local  governments. For example, one expert noted that states need the ability  to plan multiyear programs for large-scale transportation projects and that  an open dialogue about federal program implementation or renewal with  all three levels of government could help state and local governments  better plan for the future. This expert added that the uncertainty that state  and local governments experience could be reduced if the federal  government could better inform and communicate with state and local  governments regarding legislative policy developments and was willing to  engage in conversations with state and local governments.

Tax policy. Experts discussed selected provisions of the law commonly  known as the Tax Cuts and Jobs Act (TCJA) and other tax-related issues  that could exacerbate or help ease fiscal pressures for state and local  governments. Enacted in December 2017, TCJA included significant  changes to corporate and individual tax law, with implications for state  and local government tax collections. In particular, for individual  taxpayers, for tax years 2018 through 2025, tax rates were lowered for  nearly all income levels, some deductions from taxable income were  changed (personal exemptions were eliminated, while the standard  deduction was increased), and certain credits, such as the child tax credit,  were expanded.

A number of experts agreed that with just over 2 years since its passage,  it is still too early to fully assess the effect of TCJA’s provisions on state  and local government revenues. States are continuing to incorporate  some of the provisions of TCJA into their own tax codes. Some states  have adopted the federal definition of taxable income as a starting point  for state tax calculations, while other states use the federal definition of  adjusted gross income as a starting point. The choices states make  regarding their linkage to these definitions have implications for their state  tax revenues.

Further, because TCJA placed a $10,000 annual cap on the federal  deduction for taxpayers’ state and local taxes (SALT) from taxable  income beginning on January 1, 2018, some high-income taxpayers  prepaid their personal income and property taxes to take advantage of  the uncapped SALT deduction in 2017. As a result, some states  experienced an increase in revenues in late 2017. According to S&P  Global Ratings, the imposition of SALT caps incentivized many taxpayers  to accelerate their income tax payments into December 2017, but  consequently made December 2018 tax payments look smaller by  comparison. It also further reduced December 2018 payments by  lessening the incentive for many taxpayers to make early income tax  payments.

Most experts raised the TCJA’s elimination of advance refunding for tax- exempt municipal bonds as a potential source of fiscal stress for the state  and local government sector. State and local governments use these tax- exempt bonds to finance a broad range of projects and activities,  including public infrastructure. Prior to its elimination, the provision  allowed state and local governments to take advantage of favorable  interest rates to reduce borrowing costs, restructure debt, and free up  resources for other projects or investments. A number of experts  explained that the elimination of the provision could result in increasing  project costs—ultimately increasing infrastructure and debt costs over  time.

Some experts highlighted overall concerns about states’ eroding sales tax  base. For example, the country has transitioned to a more service-based  economy, due to changes in consumption. As services have begun to  represent a larger and growing share of GDP, there has been an erosion  of states’ sales tax bases.

In contrast, a number of experts pointed to the outcome of the U.S.  Supreme Court’s ruling in South Dakota v. Wayfair, Inc. and its potential  for stimulating growth in sales tax revenue. The Court in South Dakota  v. Wayfair, Inc. held that states could require out-of-state sellers to collect  and remit sales taxes on purchases made from those out-of-state sellers,  even if the seller does not have a substantial physical presence in the  taxing state. A number of experts noted that remote sales taxes will likely  increase state and local sales tax revenues, but that states are still  realizing the effects of the ruling on their revenues.

Following the U.S. Supreme Court’s decision, numerous states that levy a  sales tax and the District of Columbia have taken some kind of  action to enforce remote sales tax collections. According to NCSL, as of  January 2020, 43 states and the District of Columbia currently require  remote sales tax collection. Some states have taken legislative action to  change their state laws in response to the outcome of the Wayfair case,  while some collection efforts have been led by departments of  revenue if statutory authority was already provided. However, it is too  soon to determine the full effects of the Wayfair case on states’ sales tax  revenue.

Natural disasters. A number of experts pointed to the increasing fiscal  pressure that state and local governments are under and will continue to  face, given the increasing frequency, severity, and cost of natural  disasters. We and others have reported on the increasing trend in the  number of natural disasters and related costs. For example, in 2018  alone, there were 14 weather and climate disaster events with losses  exceeding $1 billion each across the United States with total costs of at  least $91 billion, according to the National Oceanic and Atmospheric  Administration. Further, disaster costs are projected to increase as  extreme weather events become more frequent and intense because of  climate change as observed and projected by the U.S. Global Change  Research Program and the National Academies.

A number of experts acknowledged that the federal government plays a  critical role in providing disaster assistance to state and local  governments and stressed the need for continued financial support.  Some experts discussed the importance of federal assistance since  states may need to pay for immediate disaster costs, such as debris  removal, out of current expenditures and may not have the funds  available to cover those costs. Local governments in particular are  generally the first responders in the event of a disaster, often times using  their own personnel and funding in these circumstances.

Some experts noted that these localities and communities may lack the  available cash reserves needed for disaster response-related resources,  such as public safety overtime and other types of public assistance. One  expert underscored the federal government’s role as an economic  stabilizer in providing assistance to local governments during disasters.

Given the increase in federal disaster spending, we and others have  underscored the importance of finding ways to address the growing costs  of natural disasters, citing investment in mitigation as one approach.  Some experts we interviewed also pointed to the importance of states’  adoption of mitigation strategies as a way to help states and localities  reduce the environmental and fiscal effects of natural disasters. For  example, the Pew Charitable Trusts reported in 2020 that a number of  states and localities are looking to invest in infrastructure projects that will  help mitigate the potential effects of disasters before they occur.

For example, according to Pew Charitable Trusts, one state plans to limit  development and move residents out of areas most prone to flooding,  while improving infrastructure in communities on higher ground that are  likely to receive displaced populations from neighboring towns. Another  state plans to invest its federal funds in flood control, removing homes  from high-risk areas and helping local governments pay for projects.  Further, one locality plans to spend $500 million on infrastructure  upgrades over the next few years, after its residents voted to authorize a  bond to address flooding and other concerns.

Further, one expert stressed the importance of the Disaster Recovery  Reform Act of 2018 (DRRA) in developing state and local mitigation  programs, in addition to strengthening federal, state, and local  relationships in disaster response and recovery efforts. Among other  things, the act increases the federal investment in predisaster mitigation,  increases reimbursement caps for state and local governments on a  range of disaster costs, and allows state and local governments to  administer housing assistance grants. We reported in 2019 that it is too  early to tell what effect implementation of DRRA will have on state and  local resilience.

In addition, economic literature we reviewed highlighted the potential  long-term implications of natural disasters and climate change on state  and local governments’ municipal bond ratings. For example, credit rating  firms—Fitch Ratings, Moody’s Investors Service, and S&P Global  Ratings—indicated that they are considering the effects of climate change  in their credit analyses of state and local governments. Specifically, S&P  Global Ratings has identified risk factors related to the environment,  among other credit risk factors, such as extreme weather events and  flooding that can affect an issuer’s ability to meet full and timely debt  service.

We are sending copies of this report to the appropriate congressional  committees and other interested parties. In addition, the report will be  available at no charge on the GAO website at http://www.gao.gov.

If you or your staff members have any questions about this report, please  contact me at (202) 512-6806 or sagerm@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix II.

Appendix I: Objectives, Scope, and Methodology

This report examines fiscal pressures for state and local governments.  Specifically, the objectives of our review were to (1) examine recent  trends in state and local government expenditures and revenues; and (2)  synthesize expert views regarding the effect of federal policy on state and  local government fiscal pressures.

To describe recent trends in state and local government expenditures and  revenues, we analyzed categories of aggregate data on state and local  expenditures and revenues using inflation-adjusted data from the Bureau  of Economic Analysis’s (BEA) National Income and Product Accounts  (NIPA) from 1998 to 2018. We analyzed changes in the shares of state  and local expenditures and revenues as a percent of total expenditures  and revenues respectively from 1998 to 2018. We determined that the  NIPA data were the most recent available data for the purpose of  examining aggregate state and local government revenue and  expenditure trends. The NIPA data do not always match state and local  government budget data due to methodological differences between how  BEA calculates NIPA data and how state and local governments compute  their budget data. We also reviewed our prior reports and those of others  to identify what is known about these trends and the factors that affect  them.

To analyze trends in state and local government revenues and  expenditures among states, we used the U.S. Census Bureau (Bureau)  government finance data and gross domestic product (GDP) price index  data from BEA to calculate inflation-adjusted values of selected  expenditure and revenue categories for each state (including the District  of Columbia) and for the United States for 1997 to 2017. Data for 1997,  2002, 2007, 2012, and 2017 are based on the Bureau’s Census of  Governments, which surveys all state and local governments in the  United States. Data for the other years are based on the Bureau’s Annual  Survey of Government Finances. In these years, local government  finance statistics are based in part on a sample of local governments in  the United States. We determined that the Bureau’s data were the most  comprehensive for the purpose of examining trends in state and local  government expenditures and revenues. However, due in part to  definitional differences among the states, such as those of coverage  (what constitutes a government entity) or measurement (cash or accrual  accounting), the data cannot be used as financial statements to measure  a government’s fiscal condition or to calculate a surplus or deficit. We  assessed the reliability of the data we used for this analysis and  determined that BEA NIPA and the Bureau’s data were sufficiently  reliable for our purposes. Our data reliability assessment included  reviewing relevant documentation, interviewing knowledgeable BEA and  Bureau officials, and reviewing the data to identify obvious errors or  outliers.

We examined patterns between state and local government revenue  growth and growth in overall state and local government spending using  data from the Bureau. For each state and the District of Columbia, we  assessed how fast each expenditure and revenue category grew between  1997 and 2017 and calculated the average annualized growth rate based  on year-to-year changes for each selected expenditure and revenue  category. For each expenditure and revenue growth rate calculation, we  identified the U.S. average annualized growth rate and the minimum and  maximum growth rates across states.

Because changes in the levels of expenditure and revenue categories  can be affected by changes in state fiscal capacity—such as increased  tax revenues due to population growth—we compared the average  annual compound growth rate for each category of spending and  revenues to the average annual compound growth rate in state gross  domestic product (GDP). We chose state GDP as a proxy for each state’s  resources or fiscal capacity. We determined state GDP to be the most  appropriate representation of a state’s total resources or fiscal capacity.  To compare the growth in these categories relative to growth in each  state’s resources, we compared the growth rate for each selected  expenditure and revenue category to the growth rate in each state’s GDP  resources from 1997 to 2017. When expenditures in a state are growing  faster than GDP, the share of the state’s resources that are dedicated to  state and local government services is growing. Over the long run, such  growth could create a fiscal pressure. This analysis also identified the  number of states where growth in a category was (1) greater than GDP  for that state or (2) less than GDP for that state.

We also examined patterns between state and local revenue growth and  growth in state and local spending and federal grants using data from the  Bureau. For each state and the District of Columbia, we plotted the  average annual growth rate in general revenues against the average  annual growth rate in general expenditures from 1997 to 2017. We then  counted the number of states in which spending grew faster, slower, and  at the same rate as general revenues. We also analyzed growth in own- source revenues against growth in federal grant revenues using the same  approach. We then counted the number of states in which own-source  revenue grew faster, slower, and at the same rate as federal grants.

To identify expenditure categories in the Bureau’s data, we selected all of  the Bureau’s general expenditure categories. We included other  expenditure categories, such as interest on debt and salaries and wages  to document their low growth rates. We included insurance benefits and  repayments because of its high growth rate and its inclusion of pension  benefits, which experts identified as a growing expense in some states.

As part of our analysis of trends in state and local government  expenditures, we analyzed data from the National Association of State  Budget Officers (NASBO) on state rainy day fund balances and general  fund expenditures. NASBO’s Fiscal Survey of States surveys state  budget officers in 50 states on general fund receipts, expenditures,  annual tax and revenue changes, and balance data, which includes rainy  day fund balances. We calculated state rainy day fund balances as a  percentage of state general fund expenditures among states from 1998 to  2018. We then plotted the median state rainy day fund balances for each  year from 1998 to 2018. We assessed the reliability of the data we used  for this analysis and determined that NASBO’s data were sufficiently  reliable for our purposes. Our data reliability assessment included  reviewing relevant documentation and consulting knowledgeable officials  about the data.

To obtain expert views regarding the effect of federal policy on state and  local government fiscal pressures, we conducted a series of structured  interviews by telephone or in person with a nongeneralizable sample of  individuals representing organizations with recognized expertise in state  and local budgeting and finance economics, public policy, and  intergovernmental issues. To select these experts, we reviewed their  published or other publicly available work, professional affiliations, or  recommendations by other experts. These considerations informed  whether the experts we selected would be knowledgeable or have  expertise related to state and local government fiscal and  intergovernmental issues. We identified three categories of experts and  selected individuals within each category. These three categories  included: (1) officials representing state and local government  organizations; (2) providers of financial and credit risk information, such  as credit rating agencies; and (3) researchers representing think tanks  with expertise in state and local government finance, including taxes,  budgeting, and intergovernmental relations. We spoke with  representatives from the following 17 organizations as part of our  structured interviews:  1.  The Council of State Governments  2.  Federal Funds Information for States  4.  International City/County Management Association  5.  Moody’s Analytics  6.  National Association of Counties  7.  National Association of State Auditors, Comptrollers, and Treasurers  8.  National Association of State Budget Officers  9.  National Conference of State Legislatures  10. National Governors Association  11. National League of Cities  12. Pew Charitable Trusts  13. S&P Global Ratings  15. Urban-Brookings Tax Policy Center  16. The United States Conference of Mayors  The results from the structured interviews are not generalizable and  represent the opinions of the individuals from the 17 organizations we  interviewed. However, we took steps to obtain opinions from experts with  different types of expertise and perspectives. For each question in the  structured interview, we coded, organized, and analyzed the responses to  develop common themes among the responses, based on the issues that  emerged most frequently. We use the terms “a number of,” “some,” and  “most” to describe the number of experts who responded on a particular  issue. We defined “a number of” or “some” as three or more experts and  “most” as nine or more experts. To provide context on these themes and  supplement our understanding of this information, we reviewed related  research, literature from those interviewed and other organizations,  including ourselves, and included relevant examples as appropriate.

We conducted this performance audit from January 2019 to March 2020  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Appendix II: GAO Contact and Staff Acknowledgments

In addition to the contact named above, Brenda Rabinowitz (Assistant  Director), Keith O’Brien (Analyst-in-Charge), Colin Ashwood, and Dylan  Stagner made key contributions to this report. David Dornisch, J. Andrew  Howard, Courtney LaFountain, Silda Nikaj, Robert Robinson, Ardith  Spence, and Frank Todisco also provided support.

We examined state and local government spending and revenue trends. From 1998–2018, state and local government spending increased by about $1.1 trillion to about $2.8 trillion. Revenues increased by about $1 trillion, to about $2.6 trillion.

Health spending had the largest increase, rising to 24% of all spending in 2018

Federal grants were the fastest growing source of revenue

We also gathered experts’ views on how federal policy affects state and local governments’ fiscal conditions. Experts identified potential effects of federal policies related to health care, natural disasters, aging infrastructure, and more.