States have large, understated implicit debts for unfunded pension liabilities, making their current net debt positions substantially worse than officially reported. And driven by increasing health care costs, state and local expenditures are growing faster than output. If spending trends continue and tax revenues remain near their historical levels relative to output, all 50 states will reach dangerous ratios of debt-to-GDP, and most will do so within 20 to 30 years.

While it will be politically difficult, states need to slow the growth of health care expenditures in order to avoid fiscal crisis. Also, the federal government will need to help states by changing some of its programs. It should consider converting Medicaid into block grants to states and then giving states substantial leeway to limit the rate of increase in program costs.