This is a re-post from Onvia's State, Local and Education (SLED) Procurement Snapshot for Q1 - 2016

State, local and education (SLED) governments will face heightened budget pressures for the foreseeable future but for contractors, this will bring opportunities for partnering.

By: Dan White, Senior Economist Moody’s Analytics

Coming out of the Great Recession, government agencies are finally ridding themselves of cyclical budget pressures, but are in short order being burdened by long-term structural issues reaching a critical mass. Revenue collections are no doubt improving, and in most cases surpass real pre-recession peaks. However, discretionary government spending, as well as hiring, are being constrained by mandatory pressures.

The 3 Top Pressures on Budgets

The 3 Top Pressures on Budgets - Onvia

Important services that we most readily associate with government and government jobs, like education, public safety and transportation, are being crowded out by several factors including a need for higher reserves, underfunded pensions and skyrocketing Medicaid costs. Unable to borrow for general operations, state and local government budgeting is a zero-sum game. Every dollar spent on reserves, pensions or Medicaid is a dollar not spent on construction, police or in the classroom.

To ensure that an adequate amount of public services are rendered, state and local governments will have to rely on innovation and collaboration with the private sector to make things happen.

Structural forces will continue to limit the pace of discretionary spending in the years to come, but also create new opportunities for public-private cooperation as policymakers are forced to provide the same services with less resources.

Reserve Funding: State Agencies Leading the Charge

The first, and most temporal, of these structural forces is the lack of adequate reserves. Long-term changes in state and local government fiscal structures have made public budgets more sensitive to changes in the business cycle than ever before. One of the reasons the Great Recession was followed by a slow recovery was the inability of most states and local governments to remain stable, let alone act in a counter-cyclical manner. As revenues declined and mandatory spending ballooned during and after the recession, most agencies found themselves unprepared for any downturn, let alone one the magnitude of the Great Recession. This caused most to implement deep cuts or tax increases at times their economies could least absorb them, exacerbating an already weak national recovery.

States in particular have taken notice of this weakness in their fiscal positions, and a number are taking steps to address their lack of reserves through volatility and stress testing. A study Moody’s Analytics performed testing state fiscal positions found that the average state would need roughly 8.5% of their annual spending put away in reserve to survive a moderate recession for one year without having to cut spending or raise taxes. In fiscal year 2016, states in the aggregate budgeted less than 5% of their spending to reserves when controlling for the large permanent funds in Alaska and Texas.

While this gap does not necessitate a wholesale saving spree by all governments in the next fiscal year, it underlines the fact that states and local governments will devote more resources to testing and filling reserve funds in the run-up to the next recession, whenever that might be.

Underfunded Pensions: State and Local Agencies Seeking Long-Term Solutions

States and local governments face growing imbalances in their pension systems. While hyperbolic headlines have garnered a lot of attention about a handful of governments, most public pension funds are not in any immediate danger of insolvency. They do, however, face strong demographic challenges in that fewer workers will be supporting a larger number of retirees in the years ahead. Thus, even states and local governments who have been diligent with their post-employment benefits will be paying more money into their pension funds.

For those states who have been less diligent, the years ahead will be spent paying down the large unfunded liabilities that have already been accrued. This has proven difficult for those already grappling with tight budgets, and has been a key factor in the amount of late or last minute state budgets in fiscal 2016. These are long-term problems in need of long-term solutions, and the length and ferocity of budget debate in many of the most troubled states and municipalities reflects that reality.

Increase in Medicaid Budgets: The Biggest Challenge

While the need for higher reserves and underfunded pensions play a big role in crowding out important services, no influence has done more to upend the zero-sum budget game than Medicaid. In the last 30 years Medicaid has risen from 9.9% of state budgets to 19.1% today, increasing faster than any other state government program. As program spending accelerates at a faster rate than tax revenues, that share of total spending will only increase at the expense of other important programs.

The most optimistic of those projections, from the Centers for Medicare and Medicaid Services, expects state spending on Medicaid to grow at more than 6% annually from 2016 through 2023. For context, state tax revenues historically grow at just over 5% per year.

That creates a gap in funding of more than 1% per year that must be filled by money that would otherwise go to areas like teachers, police officers or construction projects. Using other less sanguine forecasts, including our own, that gap may be as wide as 2%-3%.

Contractors Can Help Facilitate State and Local Efficiency Gains Through Public-Private Partnerships

Even in those states and local governments best positioned to handle the fiscal challenges before them, policymakers will continue to have to innovate ways to do more with less.

There is no question governments have already been forced to make gains in staff productivity and efficiency — for example, state governments employ fewer workers per capita than they have in more than 30 years while they spend nearly 175% more real dollars per-capita than they did 30 years ago given increased needs. But further gains will be needed to address these three budget pressures, which is where the private sector can help.

The new fiscal reality facing state and local policymakers is one in which traditional government services make up a much smaller share of overall spending. To ensure that an adequate amount of public services are rendered, state and local governments will have to rely on innovation and collaboration with the private sector to make things happen.

This includes more contracting and public-private partnerships in helping to stretch the public dollar further, while still providing necessary public services to residents.

In many ways, the ability of state and local governments to provide vital public services to their residents will depend on the ability of the private sector to offer innovative solutions. Vendor and contractor assistance to help facilitate those efficiencies in transportation, healthcare, public safety, and IT, just to name a few, will be a key factor in determining which governments are the most successful and which communities are the most livable.