States of Hardship

Tuesday, March 29, 2011

The federal government’s disturbingly large present and prospective fiscal deficits receive much attention, and deservedly so. Yet the finances of many state and local governments are also in bad shape, and in many respects they are far more difficult to solve.

California offers a dramatic example. It has a current annual budget deficit of over $20 billion, which amounts to about 20 percent of its annual spending. My home state of Illinois is not far behind, with a fiscal deficit of about 20 percent of total spending. Nevada and other states run even bigger deficits. Many cities, like Chicago and New York, also face a dismal fiscal future. On the other hand, some states, including Texas, are in much better fiscal health, because they have had greater fiscal discipline or the Great Recession has had a smaller impact on their tax revenues.

Tax revenues will recover as the American economy recovers, and that will help reduce state and local deficits. But for many states, such as California and Illinois, the increased tax revenues from an economic recovery are unlikely to eliminate the deficits. These states have a structural gap between spending and revenues. They cannot easily cut spending because a sizable part of it goes to education, welfare, health, roads, and criminal justice—all categories with strong political support.

Nor is it easy for states and cities to greatly raise taxes. Taxpayer groups are generally well organized to lobby against tax increases. Moreover, competition among states and localities for companies and residents, and competition from untaxed online sales, puts a ceiling on how high taxes can be increased without badly hurting a state or local economy. Perhaps states that have relatively low income taxes—Illinois has a flat tax of 3 percent—can raise them a little, but states with high income taxes (the maximum in California already reaches almost 10 percent at moderate income levels) would find it hard. Raise income taxes too much and you encourage substantial out-migration of small businesses and richer individuals.

In states like California and Illinois, governments can’t easily cut spending because much of it goes to categories with strong political support.

As bad as their present fiscal situation is, the long-term picture for state and local government finance is worse. The vast, looming problem is the amount of unfunded liabilities for pensions and health care to retired government employees. Recent estimates place the present, or discounted, value of state and local government unfunded liabilities at over $3 trillion. This amounts to about 22 percent of American GDP, and it is more than 150 percent of annual state and local government spending. There are several reasons unfunded liabilities are so large.

Most state and local government employees can retire when they are still young, often after twenty to twenty-five years on the job. To make matters worse, these governments continue to use defined-benefit systems, in which the amounts paid to retired workers are only very loosely based on a worker’s contributions to the pension system. Retirement incomes depend mainly on earnings during the last few years of government employment. Earnings already tend to be much higher at older than at younger ages, and workers sometimes make the relevant earnings even higher by taking overtime pay shortly before retirement, and by other means.

Medical benefits to retired state and local government workers are another important determinant of unfunded liabilities. These benefits are usually generous, with low deductibles, co-payments, and premiums. Of the $3 trillion in unfunded liabilities, about 20 percent is from expected medical care, and the large remainder is from pensions. Since medical spending has been rising rapidly over time, the share of state and local liabilities due to medical spending is likely also to rise.

City governments could threaten the “nuclear option” of declaring bankruptcy, hoping that bankruptcy courts would reduce their unfunded retirement obligations.

Fiscal adjustment by states and cities is further complicated by heavy unionization. Whereas unionization in the private sector declined drastically during the past several decades to only about 7 percent of the private labor force, unionized state and local government employees grew dramatically, to about 40 percent of all those workers. Government unions, like the teachers’ unions, are powerful and entrenched, and would battle fiercely against efforts to greatly reduce any part of their total compensation.

The federal government also has immense unfunded medical and Social Security liabilities for retired workers, but unlike state and local governments, the federal government can help finance these liabilities in a pinch by effectively printing money through bonds that are directly or indirectly purchased by the Federal Reserve. The federal government can also raise taxes without worrying about the competition among states for businesses or richer individuals, although federal income and other taxes have sizable effects on incentives as well.

Despite the obstacles, state and local governments do have several options for getting their unfunded liabilities under control. They could delay retirement ages of most new employees, and even of many present employees, until they reach their sixties (employees doing strenuous physical work could retire earlier). They would thereby require their employees to retire at about the same age as most nongovernmental workers. In addition, they could begin to shift, as have many private employers, from defined-benefit retirement systems to defined-contribution systems. In the latter system, retirement benefits depend on the present value of pension taxes paid by each worker, accounting also for changes in returns on assets. Finally, state and local governments could force present and future retirees to pay for a larger fraction of their medical care.

Governments can oppose powerful unions if they have the strong support of the taxpayers who will be burdened with these unfunded obligations. City governments could even threaten the “nuclear option” of declaring bankruptcy, in the expectation that bankruptcy courts would reduce their unfunded retirement obligations.

One way or another, cities and states with the most serious unfunded liability problems would eventually be forced to either lower their spending or raise their taxes. Either choice would reduce their competitiveness against other localities. It’s hard to come away with much optimism for the economic futures of the states and cities with the biggest problems.