December 19, 2010
State and Local Government: The Fiscal Crisis
State and Local Government: The Fiscal Crisis—Posner
In my post of August 29 of this year—"Is the Federal Government Broke?"—I pointed out that a realistic assessment of the federal government's finances, conducted in the first issue of a Morgan Stanley newsletter called Sovereign Subjects (published on August 25), and modeled on the kind of assessment required of private companies, concluded that the federal government probably is insolvent. A firm is insolvent when its liabilities exceed its assets. The major asset of the federal government is its taxing power, which is some fraction of Gross Domestic Product. Its liabilities include bonds and other contractual debt, entitlements such as social security and Medicare, and government services such as maintenance of highways and national defense. The so-called "entitlements" are not really contractual obligations because Congress can reduce or eliminate them, and likewise government services; but the political resistance to reducing let alone eliminating them could be as strong as the resistance to "restructuring" (a euphemism for defaulting on) government debt. And the taxing power is limited, not only by political opposition but also by the negative effect of heavy taxation on incentives to work and to invest, and by other economic distortions that heavy taxation creates.
Not that the federal government could be forced to declare bankruptcy. In a bankruptcy, the assets of the bankrupt firm are sold and the proceeds distributed among the creditors, or the creditors' claims are converted to equity and the creditors thus become the firm's owners, the shareholders being wiped out. Neither of these things can happen to the federal government. If it refuses to pay its contractual creditors—the individuals, firms and other private institutions, and foreign countries, that own Treasury securities or other federal debt—or if inflates the currency in order to reduce its real debt burden, it will find it difficult to borrow in the future without having to pay a very high interest rate, which will further deepen the federal government's insolvency. Inflation and default are only short-term measures for staving off financial disaster.
The federal government has at present a very large and growing deficit, and few ideas for reducing it that command widespread support. Many of our state and local governments also have huge deficits—Illinois, California, and New York are insolvent by the methodology of the Morgan Stanley study, and doubtless other states and a number of cities as well—but their fiscal situation is, I believe, less dire than that of the federal government.
Start with cities. Cities unlike states or the federal government can be forced to declare bankruptcy, and their assets can be sold to satisfy creditors. Cities (also towns, villages, and other municipal entities) often have income-producing assets attractive to creditors in bankruptcy. But it would be such a blow to municipal pride for a city to go broke and see its most valuable assets seized to pay its creditors, and would wreak such havoc on its ability to borrow in the future at reasonable interest rates, that city governments will do almost anything to avoid bankruptcy; and there is much they can do without encountering insuperable political opposition. Cities do not provide many entitlements. Rather, their costs are heavily concentrated in salaries and benefits of city employees, and these costs can be cut by salary reductions, reductions in pension and other benefit contributions, and layoffs. Infrastructure costs, such as road maintenance, can usually be reduced as well (by what is euphemistically referred to as "deferred maintenance"); and sales and property taxes can be raised to help close a gap between revenue and expenditures. Cities suffer but they cope.
The situation of the states differs in one crucial respect from that of municipalities: they cannot declare bankruptcy. And unlike the federal government, they cannot use inflation or devaluation to get out of a fiscal hole because they are not permitted to issue their own currency. In fact their situation is very similar to that of the nations of the eurozone. And we have seen that the eurozone nations that have been hardest hit by the economic crisis, notably Greece, Ireland, Portugal, and Spain, have taken effective and in some instances draconian measures to cut their costs, including entitlement costs. They have no choice, because they can't borrow money at affordable interest rates if creditors consider them insolvent or verging on insolvency.
Our states are in a similar but better position because, unlike the eurozone countries, they do not provide elaborate entitlements. Social security and Medicare, the two biggest U.S. entitlement programs, are entirely federal. Medicaid is shared, but a state could if it wanted abandon Medicaid. State expenditures are heavily concentrated on roads, higher education, and prisons, and expenditures on such services can be reduced, and state taxes raised, with limited political resistance because of the absence of alternatives. Nor do the states or cities bear the heavy costs of national security borne by the federal government, with its $700 billion annual defense budget.
The economic downturn caused a sharp decline in state tax revenues, which have been running about 12 percent below their pre-downturn levels. The result has been an aggregate state budget gap for fiscal 2011 of $130 billion and an estimated gap of $140 billion for fiscal 2012. About a third of these gaps will be filled by federal stimulus money. (These statistics are from Elizabeth McNicholl et al., "States Continue to Feel Recession's Impact," http://www.cbpp.org/cms/?fa=view&id=711.) That is not an ideal solution because it merely shifts debt from the state to the federal ledger. (See John B. Taylor, "A Zero Stimulus Impact," Dec. 9, 2010, http://misunderstoodfinance.blogspot.com/2010/12/zero-stimulus-impact.html.) And it still leaves big gaps in state budgets. But rather than running up huge deficits, as the federal government has been doing, the states have managed to close the budget gap for 2011 by a combination of raising taxes and reducing expenditures, and they will do so for 2012 as well—they have no choice. They are lucky not to! Because the federal government is not expected to default, it can borrow both from Americans and from foreigners at low interest rates, and so can continue to postpone the day of reckoning at which it will have to cut its expenditures. There is no similar confidence in state or city bonds. States and cities cannot long postpone the day of reckoning. The analogy of Greece and Ireland is compelling.
When times are good, low tax rates generate large public revenues, which politicians spend to make themselves popular. The result is waste, which can be cut in an economic downturn without inflicting unbearable political pain. Taxes can be raised as well, because the politicians can tell the people—and the people will believe them—that unlike the federal government they cannot use deficit spending to enable tax and expenditure rates to remain unchanged.
What is true and disturbing is that the weakness of government compared to private corporate accounting standards (the need for reform of government accounting is acute) fosters profligacy and makes adjustments to fiscal reality unnecessarily abrupt and painful. An illustrative problem for both state and cities is what might be called "indirect bankruptcy." I refer by that term to the sale of assets to obtain money for current expenditures. It is illustrated by the sale in the last few years by Chicago of two major income-producing City-owned assets: the Chicago Skyway and the system of parking fees and fines. The assets were sold for their market value, which is to say the present value of the earnings that they are anticipated to generate over their useful life. The City should have invested the proceeds of the sales in assets expected to generate a similar (ideally a higher) net income stream. Instead the City dissipated the proceeds on paying current expenses, nevertheless running up huge deficits with now less future income to pay them down.
Another example of bad government accounting at the state level is excessive pensions and other benefits for public employees. By assuming unrealistically that the value of a pension fund will increase at an annual rate of 8 percent, states are able to "fund" generous public pensions at low annual expenditure, since a contribution that compounds at 8 percent grows very rapidly. Still, public pensions can be renegotiated, or even defaulted, and the political pain is limited because public employees are not a dominant political bloc—in part because their high wages and especially their generous pension and medical benefits have made them unpopular in a period in which private employees are struggling—and because the generous federal entitlements buffer the pain to individuals of reduction in state and local expenditures.
At the local level, there is concern that many cities and other municipalities leave many of their liabilities off their books, and this concern has led to a fall in the price of municipal bonds (and hence an increase in the interest rates that municipalities have to pay on new bond issues). The financial situation of the municipalities may be more dire than that of the states, and the result may be a wave of municipal bankruptcies.
The fiscal situation of state and local government is serious from a macroeconomic standpoint because it adds to the nation's overall debt load, a load shared among individuals, families, cities, states, troubled businesses, and the federal government. This heavy debt load, by limiting the money available for consumption and production, is retarding the economic recovery and thus contributing to the continued high rate of employment. Nevertheless the fiscal situation of state and local government seems more manageable than that of the federal government.
The Dismal State of Long-Term State and Local Government Finance-Becker
The disturbingly large present and prospective fiscal deficits of the federal government receive much attention, and deservedly so. Yet the financial situations of many state and local government finances are also in bad shape, and in many respects they are far more difficult to solve than are the federal fiscal problems.
California provides a dramatic example. It has a current annual budget deficit of over $20 billion, which amounts to about 20% of its annual spending. My home state of Illinois is not far behind, with a fiscal deficit also of about 20% of total spending. States like Nevada even have much bigger deficits. Many cities, like Chicago and New York, also face dismal fiscal futures. Some states, like Texas, have much better fiscal health, either because they have had greater fiscal discipline, or because the Great Recession has a smaller impact on their tax revenues.
Tax revenues will recover as the American economy recovers, and that will help reduce state and local fiscal deficits. For many states, however, such as California and Illinois, the increased tax revenues from an economic recovery are unlikely to eliminate their deficits because they have a structural gap between spending and revenues. They cannot easily cut spending because a sizable fraction of their spending goes to education, welfare, health, roads, and criminal justice. All these activities have strong political support.
Nor is it easy for states and cities to greatly raise taxes. Taxpayer groups are generally well organized politically to lobby against their own taxes being raised. In addition, competition among states and localities for companies and residents, and competition from untaxed online sales, puts a ceiling on how much 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%- can raise them a little, but states that have high income taxes- the maximum rate in California already reaches almost 10% at moderate income levels- would find it difficult to raise income taxes by much without encouraging substantial out-migration of small businesses and richer individuals.
As bad as their present fiscal situation is, the long-term picture for state and local government finance is even more dismal. The vast looming problem is the huge level 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% of American GDP, and it is more than 150% of annual state and local government spending. Unfunded liabilities are so large because of several factors.
Most state and local government employees can retire when they are still young- often after 20-25 years of government employment. To make matters worse, these governments continue to use defined benefit systems, where the amounts paid to retired workers are only very loosely based on a worker's contributions to the pension system. Often, retirement incomes depend mainly on earnings during the last few years of government employment prior to retirement. Earnings 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 quite generous, with low deductibles and co-payments, and low premiums. Of the $3 trillion in unfunded liabilities, about 20% are liabilities 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 be rising over time.
Fiscal adjustment by states and cities is further complicated by the heavy unionization of their employees. Whereas unionization in the private sector declined drastically during the past several decades to only about 7% of the private labor force, unionized state and local government employees grew dramatically to about 40% of all these employees. 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 in a pinch help finance these liabilities 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.
Nevertheless, despite the obstacles, state and local governments do have several options that could help get their unfunded liabilities under better control. They could delay retirement ages of most new state and local employees, and even of many present employees, until they reach their sixties (employees doing strenuous physical work could retire earlier). That would simply be requiring their employees to retire at about the same ages as do most non-governmental workers. In addition, they can begin to convert, 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, states and local governments could force present and future retirees to pay for a larger fraction of the medical care that they receive.
Of course, the teachers union and other powerful state and local government unions will strongly resist efforts to substantially cut their generous retirement benefits. Governments can, however, fight back if they have strong support from the taxpayers who will be burdened with financing these unfunded obligations. If the governments were losing these political battles, cities but not states, as Posner indicates, could even threaten the "nuclear" option of declaring bankruptcy in the expectation that bankruptcy courts will reduce the size of their unfunded retirement obligations.
One way or another, cities and all states with the most serious unfunded liability problems would eventually be forced to either lower their spending or raise their taxes. Either way that would reduce their competitiveness against other states. It is hard to come away with much optimism for the economic futures of the states and cities with the greatest fiscal problems.