Features

The Monster Eating Our States and Cities

To feed the pension beast, state and local governments are starving education and infrastructure. But yes, something can be done.

By Richard Vague

Tagged EconomicsPensions

With a GDP of $19 trillion, America is the richest country in the world. However, the IMD World Competitiveness Center recently ranked our education system as 24th out of 61 countries, and the American Society of Civil Engineers recently rated our infrastructure—the roads, bridges, and water systems that were once the envy of the world—as a D+.

These failings are so often cited that we have become numb to them. If our education and infrastructure systems, which are largely managed and paid for by state and local governments, were improving, these poor ratings would be easier to tolerate. But the opposite is true.

We all know that the federal budget is under tremendous pressure, but the budgets of states, cities, and other local governments (SLGs) are under even greater pressure. This pressure will not ease for a generation, if then. The inescapable consequence is that the funding of education and infrastructure will continue to be under immense pressure for as far into the future as we can realistically see.

The issue is this—for years SLGs’ expenses have been relatively constant as a percent of GDP, yet their pension and Medicaid costs have been skyrocketing, crowding out investment in education and infrastructure. It will take a radical, perhaps even heretical, new approach to these expenses to restore our ability to properly invest in these two areas.

A Brief Overview of State and Local Budgets

Federal budget expenses, which are endlessly scrutinized, are currently about $4.2 trillion or 23 percent of GDP. The expenses of SLGs, when added together, come to a half again that amount (net of federal subsidies and pass-throughs)—another $2.1 trillion or 11.5 percent of GDP. This is a massive amount that deserves almost as much scrutiny as federal spending. Together, federal, state, and local governments spend 34 percent of our national income.

Surprisingly, over the last 30 years, SLG budgets have been relatively flat in relation to GDP, at roughly 12 percent. (Federal expenses have ranged, in that period, from highs of 24 percent under President Reagan and 26.5 percent after the 2008 financial crisis under President Obama, toc a low of 19 percent under President Clinton.) Because total SLG spending has been roughly constant compared to GDP, the issues in SLG spending have been issues of mix—increases in relative spending in one area have been offset by decreases in relative spending in another area.

How do SLGs spend their money? Most is spent on education —$890 billion, or 34 percent of all spending. That is followed by $666 billion, or 26 percent spent on social benefits, including Medicaid. Next comes “economic affairs,” mainly highways, transportation, and other infrastructure, at $334 billion, or 13 percent. Chart 1 provides an overview. All these numbers are before the receipt of federal grants or reimbursements of $531 billion—including $340 billion for Medicaid.

CHART 1

Source- BEA; Pension Contributions- Census

Importantly, approximately 75 percent of all spending on infrastructure and education comes from SLGs. If you want to fix schools, roads, bridges, or water systems, the place to go is to SLGs. Even the hopes of the current Administration for an incremental $1 trillion in infrastructure investment places much of that burden onto SLGs.

However, as a practical matter, SLGs are more limited than the federal government in how much they can spend and invest. Many states are required, by their own laws, to maintain a balanced budget, and even if this restriction did not exist, states have a constraint on debt issuance that means they need to stay closer to a balanced budget. That constraint is the lower debt ratings and higher interest costs that too much debt issuance would bring. Currently, all SLG debt totals $3 trillion. That’s about 17 percent of GDP, not that much higher than where it stood in 1970. In that same timeframe, federal debt has skyrocketed from 38 percent to 108 percent of GDP, a whopping $20 trillion total. Yet federal debt has maintained its pristine credit rating. Why are SLGs constrained in how much debt they can issue when the federal government is not? Largely because, through its Treasury and the Federal Reserve, the U.S. government can “print” money, while SLGs can’t and therefore have to live within their means. This makes the pressure on SLG expenditures more immediate, real, and painful.

As mentioned, the combined expenses of SLGs have been relatively flat at roughly 12 percent of GDP for the last 30 years. If that is true, then, again, why are they under so much budget pressure? Carefully examining these expenses over an extended time frame shows that there are two pressure points where expenses have been increasing at a problematically high pace—Medicaid and public pension costs. (See Chart 2.) As a percent of GDP, Medicaid costs have increased by an equivalent of $52 billion and pension costs by $61 billion in the past 15 years, for a combined impact of $113 billion. Since overall expenses have been roughly flat, that means $113 billion a year in spending has had to be taken away from other categories. Medicaid costs were increasing rapidly even before the ACA. What’s worse, it is probable that in ten more years, based on both our own estimates and the Congressional Budget Office’s projections, these pension and Medicaid expenses will have increased by the equivalent of another $100 to $150 billion. This will crowd out yet more funding for other programs unless taxes or fees are dramatically increased. (Medicaid cuts have recently been proposed by the Republican Party, along with an overall repeal of the ACA. Although none of these initiatives have yet succeeded, Medicaid cost increases would likely remain a problem under any of them, not to mention the substitute costs states would likely incur if Medicaid were curbed.)

There is risk in attributing to a single SLG any of the trends observed for the whole, and of course the trends we highlight in this article are not true of all SLGs. But directionally they should be helpful in illuminating trends and issues that are impacting a significant number of them.

This article focuses primarily on the pension expense problem, but will offer a few words on Medicaid as well.

CHART 2

Source: BEA; Pension Contributions- Census

What expenses have been crowded out? What expenses have declined the most as a percent of total SLG spending during this period? The answer is both capital spending, which is primarily infrastructure, and education. (See Chart 3.) On a relative basis in ratio to GDP, education spending is down $40 billion and capital outlays are down $56 billion over this same 15-year period. Notably, these are the very areas where we have regressed so markedly in comparison to our own historical standards and to the rest of the world.

CHART 3

Source: BEA, Census

Before I go further, I would point out that education, infrastructure, pensions, and health care for the poor (Medicaid) are as important and as emotionally charged as any government policies I could mention. As I have examined the budgets of SLGs, been confronted by these trends, and then shared these finding with various audiences, I have encountered pushback from those who hope and believe that we should not, and do not, need to curtail spending in any of these areas.

Given this, I must quickly set forth that I am in wholehearted favor of strong investment in education, health care, and infrastructure. And I fully support defined benefit pensions for existing public employees. Our public-sector workers are crucially important, healing, protecting, teaching, and serving all of us. But this article is about finances. It is about what things cost today and what they are almost certain to cost in the future, and what the implications of that are likely to be.

Of course, SLGs can overcome this expense limitation by raising taxes and fees. But there are 50 states and hundreds of cities, almost all of which are constantly and energetically trying to “poach” businesses away from other cities and states. As a result, the strategy of raising taxes is fraught with the risk of driving away businesses and households to those other cities and states. Further, the Republican Party, for which it is a central tenet to keep governments small and taxes low, controls 60 percent of state legislatures. The net of this is that the remedy of significantly higher taxes and fees is currently unlikely, leaving intact the problem of diminishing education and infrastructure investment.

State and Local Pension Costs

Pension benefits paid have been increasing at 6.3 percent per annum over the last ten years, almost double the rate of economic growth. And the “employer contributions” of SLGs have had to increase as well, rising by 8 percent per annum over the last five years. Pension costs are rising because of increased pension benefits and an aging workforce. In New York’s State Teachers Retirement System, employer contributions have had to increase by $2.6 billion in 2015 versus 2001, as pension benefit payouts have grown by 120 percent. And New York is one of the few states with well-funded pension plans.

For many years, a large number of SLGs have simply not been making the employer contributions they should have been making.

Unlike New York, most SLGs pensions are underfunded, so what was already a budget issue for those few states with well-funded pension plans has become an even more intense problem for those with underfunded plans.
According to data from the Federal Reserve, in aggregate, the SLG pensions funding ratio is only 67 percent, which means they are underfunded by a whopping $1.9 trillion. That’s equal to 10 percent of GDP. This is explained by the fact that, for many years, a large number of SLGs have simply not been making the employer contributions they should have been making.

CHART 4

Source- PEW Charitable Trusts

In one small but representative example of pension underfunding, the city of Philadelphia has a $8 billion annual “all funds” budget and an overall pension obligation of $11 billion, but only $4.5 billion of this obligation has been funded. The numbers make the story painfully clear. There is simply no way to increase employer contributions from a $8 billion general operating budget enough to make up a $6.5 billion deficit without radically impacting other expenses or adding a major new tax burden—even if you have years to do it.

So why haven’t SLGs been required to make the high level of contributions that would have truly kept these pensions fully funded? The short answer is that they have, to a large extent, been able to make their own rules. And in the context of perennial and increasing budget challenges, they and their actuaries have made overly optimistic pension forecasts which have resulted in lower-than-needed pension contributions.

Decades ago, corporations often found themselves in a similar position, but many of their practices were reformed under the 1974 Employee Retirement Income Security Act (ERISA), from which SLG pensions were exempted. In the years since then, SLG pensions have become broadly underfunding. (See Chart 3.) During this time, some SLG pensions have been criticized for poor management—including paying unduly high investment-management fees and allowing questionable practices such as “pay to play”—whereby political contributions are parlayed into lucrative pension money management contracts,

Though exempt from ERISA, there are a number of more recent laws and regulations that have gradually increased the urgency with which SLGs are now trying to address these pension deficits. These include the Pension Protection Act of 2006 and a Government Accounting Standards Board (GASB) pronouncement that mandates that SLGs make a more overt disclosure of pension underfunding in their financial statements. This GASB pronouncement makes it much more likely that rating agencies will take these unfunded positions into account when rating the debt of these SLGs, impacting both the rates SLGs pay on their debts and the amount of new debt they are able to issue. There are also state laws, state-level court cases, and pension boards which govern and influence the management of these pensions. Further, there are provisions regarding pension funding in the SLG union contracts themselves.

All this has increased the pressure on SLGs to make larger pension contributions, which simply makes it more likely that other non-pension categories of spending will get less.

CHART 5

Source: Federal Reserve

To try and keep up with rising pension costs and address pension underfunding, SLGs, in aggregate, have increased “employer contributions” by 8 percent per annum during the last decade—which means they contributed a total of $76 billion more in 2015 as compared to ten years before—for a total employer contribution of $132 billion in 2015. Yet even with this rather massive increase, they continue to lose ground and, in aggregate, the SLG pension funding ratio has plummeted from 92 percent in 2006 to 67 percent in 2016. Even though contributions have been rising, they have not been increasing nearly enough to keep pace with growing pension liabilities.

The numbers for 2015 illustrate the dilemma. In aggregate during 2015, SLGs made employer contributions of $132 billion, up by $45 billion over the same contribution just five years earlier. Add to that employee contributions of another $48 billion, and investment returns which were $169 billion, all against a $286 billion in benefit payouts. So far so good. However, pension liabilities increased by $262 billion, so the overall pension funding gap increased by $200 billion in that period. Indeed, it is a daunting equation.

CHART 6

Going forward, even if SLGs increase employer contribution levels by 8 percent per year, which is far greater than the rate of GDP growth, I estimate that the funded ratio will not improve from the current 67 percent ratio. In fact, it may even decline. I estimate that it will take an additional $100 to $200 billion each year over the next 20 years beyond recent aggregate employer contribution levels to reach the fully funded level. In other words, it’s a fiasco.

How did we get in this mess? Well, it didn’t take long. These pensions were actually more than fully funded as recently as 2000. That happy circumstance came after the extraordinary bull market that accompanied the first Internet boom of the late 1990s. As of January of 1999, stocks had gained an incredible 28 percent per year over the prior four years. The Internet revolution had seemingly ushered in a new era in stock performance—at least in the minds of pension managers and actuaries. To them, the pension investment return projections of 5 to 8 percent that had historically been used in establishing required employer contributions seemed unnecessarily tame, and SLGs aggressively raised these forecasts. The sky was the limit.

In the wake of this heady period, many SLGs significantly increased pension benefits to their employees. Then came the inevitable correction. In the ten-year period through January 2009, stocks declined by 30 percent, decimating the forecasts of pension managers. That, when paired with the large increases in benefits that had been granted, yielded the ugly underfunding we see today. While the investment return assumptions that led to this seem naïve in hindsight, at the time, sweetening pension benefits seemed like a no cost bargaining chip in union negotiations.

Facing this funding challenge, for those cities in the very worst shape, bankruptcy is an option. This was shown in the bankruptcy of Detroit, where the general retirement fund reached a low of 53 percent funded and was a major part of the financial dilemma. But states can’t declare bankruptcy, and state pensions are 82 percent of all SLG pensions.

Why, then, aren’t SLGs renegotiating with employee unions to reduce benefits? Actually, these discussions are occurring widely, but the unions fiercely defend these pension benefit gains and generally have significant political clout, so the modifications have been small.

Can SLGs address this underfunding problem by pursuing higher return investments? They have certainly tried. Historically, pensions have invested conservatively, investing primarily in bonds, stocks, and cash. But large funding deficits have caused many SLG pensions to consider alternative investments that hold the hope of higher returns, including hedge funds. But those alternatives have largely not met these higher return expectations and thus have not reduced the funding deficit.

Stuck between Scylla and Charybdis, many SLGs are doing as much as is politically feasible and, in an already challenging budget environment, battling to modify pension benefits and increase pension contributions. Many of these efforts and attempts are bold and admirable—moving some component of plans to a defined contribution structure, which I’ll discuss below, or introducing some other creative form of risk-sharing and benefit reduction. These SLGs are then coupling these changes with brave assumptions on investment returns, benefit payouts, and increased employer contributions to create new long-term pension forecasts which show funding reaching acceptably high levels. And then they are declaring victory.

We have seen a number of these new forecasts. However, when we have examined them ourselves, we have come to much less optimistic conclusions. As an example, Philadelphia, with a funded ratio of 45 percent, now forecasts that its pension liabilities will be at 93 percent funded by 2035. But to achieve that, it forecasts an investment return of over 7.7 percent per annum, instead of the roughly 5 percent that has actually been achieved by most pension managers over the last decade or the roughly 4 percent return Philadelphia achieved over the last 5 years. If Philadelphia had used 5.5 percent instead of 7.7 percent in its projections, its funded ratio in 2035 would have been 62 percent instead of 93 percent. Add in slightly less positive assumptions about employer contributions and benefit payouts and the funded ratio in 2035 could fall below 50 percent. Philadelphia is not unique as regards this issue.

The Kentucky Teachers Retirement System takes this optimism in reporting a step further and actually publishes two different funded ratios for the same period. The first fulfills their GASB reporting requirement and shows a 35 percent current funding ratio. The second is produced for the Kentucky legislature and shows a 54 percent funding ratio.

These pension changes and optimistic forecasts serve an important related purpose. Credit ratings analysts will be less concerned about the impact of pension underfunding on a given city or state’s overall credit rating if there is a plausible plan to achieve a high level of funding over a 10 to 20 years time horizon. There is an incentive to put forward an optimistic forecast.

So, while the efforts of SLGs to make changes to their contributions and other program aspects have helped, they have not solved the problem. Instead, for the most part, the net impact of these efforts in a given city or state has been to push back the problem by a few years.

The aggregate national numbers for SLG expenses paint a picture that is bleak but clear. If the net annual SLG expense budget is $2.1 trillion, and every bit of that is spoken for every year, how in the world will SLGs ever make up a whopping $1.9 trillion pension funding deficit without compromising spending in key areas, even if they have decades to do it?

Which brings us to the one thing that, ironically, may be the biggest problem of all—almost none of these pension funds will actually run dry any time soon. Even New Jersey, which has been criticized for poor pension funding and management practices, has $84 billion in its collective funds, enough to sustain benefit payouts for as much as 20 years with no additional employer contributions. Because of this, an emergency that would prompt truly radical change to these programs simply doesn’t exist. And so the pattern I have just described will continue to repeat itself.

The house is not on fire, but the foundation is crumbling.

What Can Be Done?

First, a little background.

Conventional pension plans, including most SLG pension plans, have almost all been defined benefit (DB) plans. With these, the employer (and often the employee) makes regular contributions to employees’ pensions, and, after retirement, the employee gets a pre-determined monthly payment (e.g. 70 percent of their highest salary level), usually for the rest of their lives. The employee gets this “defined benefit” no matter how successful or unsuccessful the investment of the pension funds has been. Though a highly popular benefit provided by large corporations to their employees in the decades after World War II, the majority of corporations have abandoned this type of plan because it has proven to be difficult to manage financially. A corporation may have made all the required contributions and yet face a crisis in a given year by having to make an unexpected and extraordinarily large pension contribution because of changes in interest rates, changes in projected life expectancy, poor investment performance, or other factors. The long-term nature of pensions means that small changes in trends or key assumptions, when considered over the decades-long timelines of these plans, can result in huge and unwelcome changes in the current required pension contribution.

The house is not on fire, but the foundation is crumbling.

Further, if, at a given company, the benefits of a pension plan are high relative to the amount contributed, these plans depend on a continually rising employee headcount to remain fully funded, and quickly develop problems with funded levels if hiring slows down or declines.

Given these issues, the vast majority of corporations have replaced these “defined benefit” (DB) pensions with programs such as 401ks that are considered “defined contribution” (DC) plans. With these, the employee, often in conjunction with the employer, makes regular contributions to the plan. The ultimate retirement benefit paid to employees is a function of how much is contributed and the actual investment returns on those funds. The employee assumes the risk of changes in investment performance and other factors. Some have protested that it is unwise to move these risks to the employee, since many are not sophisticated enough to manage their own retirement funds. Yet I am assuming that protections and aids can be legislated to minimize these problems. It should be noted that having the risk reside with the SLGs instead of with the employees has not been without its own downside—the education and infrastructure downside to taxpayers described in this article.

These defined contribution plans have none of the volatility and accounting surprises associated with DB plans, and they have almost none of the employer underfunding problems either. There is no possible mystery or ambiguity as to how much a given employer needs to contribute. They either make these contributions or they don’t.

By and large, however, the employees of SLGs have remained on DB plans and therefore pension liabilities continue to skyrocket, increasing by an average of $232 billion a year over the past five years—and we have the $1.9 trillion pension funding gap to show for it. Further, since they have remained on DB plans, they remain subject to this volatility and the propensity to underfund.

As a first step to fixing the problem and preventing further funding abuses, SLGs should convert to DC plans for any employees they hire in the future. Initiatives to do this have been taken in many cities and states with some initial success, but not without concerted opposition and numerous legal, contractual, and regulatory barriers to its achievement. Make no mistake, these DC plans can be structured to be as generous as a DB plan. Furthermore, when corporations have moved from DB plans to DC plans, they have kept existing employees on DB plans, and that would be done here as well. Unless this—or something very close to it—is done, the already-formidable pension problem will simply compound and the costs will become even more overwhelming.

A recommendation that employees hired in the future be given DC plans instead of DB plans should come as no surprise. The vast majority of corporations have long since concluded that DB plans were not feasible and made that change. The problems related to existing increases in payouts and existing underfunding will not vanish even if new employees are placed on DC plans. But since no new employees will be added to these DB plans, at least the problem will be capped.

Once capped, pension plan liability growth would begin moderating over time. But moving to DC plans is only a first step, since SLGs will still need to increase employer contributions or make other changes to address the benefit obligations already embedded. As mentioned above, by my estimate, these could reach an additional $100 to $200 billion each year above current contribution levels. It will be enormously difficult for SLGs to increase contributions to these levels, so we will need to take additional steps—steps that bridge the funding gap for those employees still in DB plans, but also leave enough room in SLG budgets for increased investment in other SLG priorities.

I have three radical suggestions on how this funding gap could be bridged. Each is controversial. But I would strongly suggest they be considered—if only to spark more ideas and debate— since this problem will continue to compound unless we address it head on:

1. Federal Funding Guarantee
The federal government could assume responsibility for the unfunded liabilities of those SLGs in need. The federal government has the capacity to do this. In this scenario, the SLGs would continue to make employer contributions for the 67 percent portion of pensions already funded, using the investment income on pension funds to pay benefits, and paying any portion not covered by investment funds out of other funds. The Federal government would then pay the pension benefits on the 33 percent of SLG pensions that are unfunded, an amount we would estimate as roughly $90 billion for 2017. This would free that level of funds in SLG budgets, allowing them to accelerate investment in education and infrastructure, revitalizing our nation’s performance in those areas, and igniting a jobs revolution as well.

Suffice to say, that is an enormous amount of money—which unfortunately reflects the magnitude of the problem. Given that the federal government is wrestling with its own $20 trillion in debt and its own annual deficits, this scenario is highly unlikely. This brings us to the two proposals below, which both provide a solution without the same onerous current expense consequences.

But first a dose of heresy. Why do we need to fully pre-fund our future SLG pension obligations? I ask this question only in light of the $1.9 trillion size of the pension funding deficit and the acuteness of the need in education and infrastructure. I would hasten to note that this particular heresy depends on pensions being converted to DC plans for futures hires and thus capping future liability—I would not dare make these suggestions otherwise. The answer is this: the reason to pre-fund retirement obligations in the form of a pension fund is to guarantee that the funds will be there when the pensioner retires. It’s a credit guarantee. But it isn’t a given that we have to have the credit guarantee for state pensions that a fully funded pension provides. After all, states (which are 82 percent of all SLG pension dollars) can’t declare bankruptcy, and the full taxing authority of the states serves as a guarantee that pensions will be paid.

A fully funded pension is a form of credit guarantee absolutely necessary for private sector pensions that may not be needed for the public sector. Furthermore, a guaranty from the Federal government, which would entail no direct cost to the Federal government, could be employed if further credit assurance were somehow needed. By pre-funding future SLG pension obligations, we have locked up $3.9 trillion in these funds—the 67 percent that is funded—that could instead be used for investment. If future pension obligations don’t need to be fully funded, then SLGs don’t need to try to make the arduous climb back from being 67 percent funded to being 100 percent funded. The annual cost difference between the two is enormous.

2. Lower Funding Requirements

In this approach, SLG’s would abandon their attempt to achieve a fully funded ratio, and instead simply maintain their current funded ratio. If, for example, a given SLG was at a 60 percent funded ratio, it would no longer even attempt to return to a 100 percent funded level, but instead would make an iron-clad commitment to stay at a 60 percent funded level (and do this through operations rather than by issuing debt). In our view, for many SLGs, it will be hard enough to simply stay at the current funded ratio. This may very well still require big increases in current employer contributions, but at least that SLG could abandon the even bigger increases required to get the fund back to 100 percent. By our calculation, this would reduce the current annual aggregate SLG employer contribution requirement by over $100 billion each year over the next twenty years from the level truly required to become fully funded. This would free this sum for a tremendous increase in productive, job creating investment. After that 20-year period, since all new employees will have been hired into DC plans, liabilities will be smaller than they otherwise would have been, and therefore benefits paid in the year 2037 forward will likely be readily manageable.

(I believe that even though SLGs purport that they will achieve a 100 percent funding level through time, in reality many will not. Instead, they are using overly optimistic payout and return assumptions and will do well just to maintain their current funding ratios)

3. Even Lower Funding Requirements

If a state truly doesn’t need full funding as a credit guarantee, why even aim for the 60 percent funding level mentioned above? Thus an even more radical variation on Option 2 above would be to allow the funded ratio to decline through time to some minimum threshold—e.g. 30 percent—over a strictly defined period of time—say 20 years—and then make an iron-clad commitment to stay at that 30 percent thereafter. (Someone more radical than I might even suggest a lower threshold). The 30 percent would serve as a credit reserve. In addition, as suggested above, a federal guarantee could added if required. This more radical version would eliminate the current annual aggregate SLG employer contribution requirement for the next twenty years, freeing an even greater sum for productive, job creating investment in areas like infrastructure and education. Employer contributions should be manageable after that as described for Option 2 above.

Both #2 and #3 face objections and a daunting gauntlet of legal and regulatory obstacles and would require any numbers of changes. I have reviewed the sources of these obstacles briefly above—state law, IRS law, court decisions, GASB pronouncements, union contracts, and more. But because this is a multi-trillion dollar issue, and the alternative is a continued long-term erosion of other needed SLG investment, they are worth considering nonetheless.

Conceptually, both #1 and #2 suffer from an element of unfairness, since states that have been responsible in maintaining high levels of funding would receive no greater benefit than profligate states. Option 3 has the distinct advantage of a greater reward for states that have been responsible, since their reduction in required employer contributions would be far greater than for those that haven’t.

Option 3 could be a radical, era-redefining breakthrough for what has heretofore been an intractable, unsolvable problem.

What Can Be Done About Rising Medicaid Expenses?

The Medicaid cost issue is every bit as difficult. The crucial thing to note is that the CBO is forecasting that the program’s costs will rise at a rate of 5.5 percent per year through 2025 when the economy itself is projected to grow at 3 percent or less per year. If true, it could crowd out an even greater portion of other SLG spending. This cost projection may be optimistic, since these costs were rising an average of 7 percent in the decade before the ACA.

There is an avalanche of activity by insurers, hospitals, and other health-care providers aimed at reducing health-care expenses, and overall, progress is being made in addressing high costs. Further, as I have examined healthcare systems in Europe and Asia, I am increasingly convinced that substantial breakthroughs in healthcare expenses are possible. We have among the highest per capita costs and among the least favorable healthcare outcomes. As the cliché goes, if we put a man on the moon, surely we can make substantial improvements in healthcare costs. We will likely achieve these in ways not currently contemplated by either Republicans or Democrats.

Yet any such progress is hard-pressed to overcome a colossal obstacle—Americans are getting older and the percent living at or under the poverty line remains stubbornly high. An estimated 80 percent of health-care costs are associated with just four disease categories—cancer, heart disease, diabetes and Alzheimer’s—and as we age, the frequency of these diseases inevitably increases.

An estimated 80 percent of health-care costs are associated with just four disease categories—cancer, heart disease, diabetes and Alzheimer’s.

We will not be able to make radical, breakthrough reductions in health-care costs until we make substantial progress toward cures in those four areas. It is within our grasp to do so, but only through concerted, well-funded academic medical research. Yet, astonishingly, we have been reducing federal support for this research in real dollars. If we look over any long time horizon, there will be a direct link between federal spending on research for cures and our ability to curb the rising trend in Medicaid and health-care costs.

States will be wrestling with rising Medicaid costs for years to come.

The pension expenses of state, cities, and other local governments, along with that portion of Medicaid expenses borne by those same governments, are growing faster than the economy, and this has been crowding out expenditures in other key areas, most notably education and infrastructure. Absent large tax increases or some other bold strategies, this will continue unabated.

The financial consequences of this are increasingly clear. And while we have grown accustomed to the behavior of our federal government, whereby tough choices among competing expenditures are routinely avoided with the result of huge annual deficits and $20 trillion in accumulated debt, SLGs are much more fiscally limited, and so these hard choices can less readily be escaped.

The infrastructure and education systems of SLGs are slowly being starved of critical investment. Unless SLGs find a way to slow the march of pension and Medicaid expenses, the years will turn into decades and the quality of our infrastructure and education will continue to erode.

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Richard Vague is the author of The Next Economic Disaster, managing partner at Gabriel Investments, and chair of The Governor's Woods Foundation. He was formerly CEO of Energy Plus, Juniper Financial, and First USA Bank.

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