The latest report-card on the state of the state budgets paints a sobering picture.

The Parliamentary Budget Office’s National Fiscal Outlook, released last week, shows that the budget repair task across the nation is immense, with debt leaping past its pandemic-era peak.

Australia has a national debt problem – indeed as we discovered last week, a $1 trillion problem for the federal government alone.

But the ticking time bomb is actually a state problem, with their share of national debt forecast to almost double in a decade, from 20 per cent before the pandemic to around 38 per cent by 2029-30.

As a result, states are having to divert revenue away from delivering essential services to pay interest on this growing debt. Costs vary between the states, but NSW gives us a sense of its scale – its Audit Office found that in 2024-25, interest on debt cost the state budget $19.6 million a day.

The PBO’s National Fiscal Outlook, or NFO, offers us some reassurance. In 24 of 27 modelled future scenarios, the national budget position is projected to return to a more sustainable position, where debt as a share of the economy trends downwards.

But, in reality, the budget repair task is set to get much harder. The modelled path back to sustainability assumes governments repeat past performance. But known headwinds in the next decade, and those after it, will make that tougher to deliver.

The forecast surpluses states are banking on over the next few years are fragile. The war in the Middle East, stubborn inflation domestically, revenue volatility, and ever-growing service demand pressures, particularly for healthcare and disability care, mean the glide path back to a balanced budget is balanced on a knife edge.

And while governments might forecast surpluses, we see time and again that spending gets away from them.

Newly consolidated data that the PBO released alongside the NFO shows that the states consistently miss their expenditure forecasts and, as Grattan Institute has shown before, states have a “soft budgeting” problem when it comes to healthcare spending.  

Looking beyond the next four years, unavoidable further ageing of the population and the impacts of climate change make future surpluses harder still.

Federal Treasury’s last Intergenerational Report projected that by 2062-63, 23.4 per cent of the population will be 65 or older. This is almost one in four of us, up from one in 10 in the early 1980s.

A larger population of older Australians will place more pressure on health spending, which already accounts for the lion’s share of state budget outlays.

Climate change could bear down on budgets from both sides. Governments will spend more responding to more frequent and severe disasters and shielding essential infrastructure and services, while the slow burn of a warmer climate on the economy is likely to weigh on revenue.

Governments will also need to meet other shocks with almost no buffers to withstand them. And all the while they will be servicing a growing debt burden. Getting to the same surpluses we’ve achieved before will require more painful trade-offs than in the past.

To be clear, debt itself isn’t the problem, but debt should be used to finance productive investment.

Older generations should be paying their way, not leaving the bill to the kids.

As the NFO points out, the battle for state budget sustainability is complicated further by Australia’s relatively high vertical fiscal imbalance, where the states raise only 51 per cent of their revenue and rely on the federal government for the other half.

There is a way out.

First, the states need better budgeting practices. They need to do the hard work of continuously reviewing their spending and making the tough choices.

The savings from this work may be incremental, but they will add up over time. 

Part of the solution is good budget institutions. These include the processes that govern the annual budget cycle, fiscal rules that hold government to account, and independent organisations that help the public understand where the budget is at and where it is going.

The NFO is an important example of this.

But spending discipline won’t be enough. State governments need to ensure long-term revenue adequacy, where the costs of core spending and infrastructure responsibilities are matched with durable and efficient revenue sources. Right now, they are not.

The GST has a critical role to play here. It has potential to be a durable, efficient, and broad growth tax. But the current impasse on the GST distribution has meant that the national conversation has focused on how the GST is shared.

Until we settle this, we can’t have the more important conversation about making it do more.

State budgets, with the exception of Western Australia’s, are likely to get worse before they get better.  

But we have the choice to get ourselves out of this hole if we’re prepared, as a country, to face up to it.

Dr Aruna Sathanapally is CEO of the Grattan Institute. She is a former NSW barrister and senior public servant