As reports of fraudulent entitlement spending gain media attention and political traction, we explore what has led to its rapid rise, how federal and state governments are responding, and outline our view on the credit implications for the municipal market.
Fraud in Welfare Programs has Increased Sharply Post Pandemic
In response to COVID-19, federal entitlement spending increased dramatically. According to the Government Accountability Office, total budget authority grew from $4.7 trillion in 2019 to $7.4 trillion in 2020, followed by a $2.7 trillion increase a year later. The increase is attributable to both organic growth as more people became eligible for social services amidst the shutdown and special emergency spending like expanded unemployment insurance, stimulus payments and enhanced Medicaid funding. As governments prioritized distributing funds quickly over extended verification with systems that were never designed to operate at such scale, opportunities for organized fraud emerged.
Federal and State Investigations Predate Recent Media Attention but Have Accelerated as a Result
Investigations into misuse of funds began as early as 2020 at multiple levels of government and, in the past two years, have expanded beyond pandemic grants to other social welfare programs. More recently, a viral YouTube video on an alleged $110 million daycare fraud scheme in Minnesota has accelerated federal and state audits. While the scale of broader entitlement fraud within the state is as of yet unknown, one estimate sets the loss at $9 billion since 2018 which translates to about $1 billion a year, or less than 2% of the state’s current year spending. On January 5, the Department of Health and Human Services (HHS) announced a return to attendance-based billing and subsequently froze childcare funding for five states namely, California, Colorado, Illinois, Minnesota and New York. All 50 states are under review so additional funding freezes are possible.
Credit Implications for States are Neutral and Fundamentals Remain Strong
While the allegations of fraud are serious, we do not believe they will lead to widespread credit degradation and there has been no market reaction to date. The current freeze is temporary, and payments are expected to resume once the affected states verify their programs are no longer vulnerable to fraud. Even if they do not, the programs in question represent a very small portion of budgets for these states (on average 3% of federal receipts and 1% of total revenue) and states are under no obligation to backfill lost federal funding. Importantly, states approach this challenge from a position of strength, with reserves near all-time highs, growing tax collections, expanding economies, and increased debt capacity.
Nonetheless, we expect headlines will continue as federal probes into welfare programs intensify and expand in scope and target. We also acknowledge the likelihood that these audits will bring to light some degree of financial mishandling across states and entitlement programs along with the possibility of financial penalties. This approach is in keeping with broader trend of federal retrenchment that we have previously discussed. As has been the case with the higher education funding freezes and investigations, these cases will most likely play out over time and be resolved on a case-by-case basis. To the extent these investigations uncover inefficiencies and lead to enhanced program oversight, they could even be accretive to credit quality.