Category Archives: Debt

The use of locally-imposed selective taxes to fund public pension liabilities

Many eyes are on Kentucky policymakers as they grapple with finding a solution to their $40 billion state-reported unfunded public pension liability. As talks of a potential pension bill surface, various proposals have been made by legislators, but very few have gained traction. One such proposal stands out from the rest. A proposal that has since been shut down suggested imposing selective taxes on tobacco, prescription opiates, and outsourced labor to generate revenue to direct towards paying down the state’s pension debt. Despite its short-lived tenure, this selective tax proposal reflects a recent trend in pension funding reform; a trend that policymakers should be wary of. Implementing new taxes on select goods or services may seem like a good idea as it could, in theory, potentially raise additional revenues, but experience at the local level suggests otherwise.

In chapter 12 of a new Mercatus book on sin taxes, NYU professor Thad Calabrese examines the practice of locally-imposed selective taxes that are used to fund public pension liabilities and doesn’t find much evidence to support their continued usage.

Selective taxes are sales taxes that target specific goods and are also known as ‘sin taxes’ because of their popular usage in taxing less healthy goods such as cigarettes, junk food, or alcohol. In the examples that Calabrese examines, selective taxes are used to target insurance premiums as revenue sources for pensions.

Only a select few states have begun this practice – including Illinois, Pennsylvania, as well as municipalities in West Virginia and Missouri – but it may become more popular if courts begin to restrict the way in which current pension benefits can be modified. Once benefits are taken off the table as an avenue for reform, like in Illinois, policymakers will feel more pressure to find new revenue sources.

The proposal in Kentucky may seem appealing to policymakers, especially because of its potential to raise $600 million a year, but this estimate overlooks the unintended effects that such new taxes could facilitate. Thankfully, the proposal did not go through, but I think some time should be spent looking at what similar proposals have looked like at the local level, so that other states do not get tempted pick up where Kentucky left off.

Calabrese draws on the experiences in Pennsylvania and Illinois to examine how these taxes have operated, how the decoupling of setting and financing employee benefits tends to lead to these taxes, and how the use of these taxes is associated with significantly underfunded pension systems. Below I highlight Pennsylvania’s experience and caution against further usage of this mechanism for pension funding.

How it works (or doesn’t)

In 1895, Pennsylvania implemented a 2 percent tax on out-of-state fire and casualty insurance companies’ premiums on in-state property and then earmarked this for distribution to local governments to pay for pensions. Act 205 of 1984 replaced the original act in which the state of Pennsylvania allocated pension aid based on where the insured property was located and instead the new allocation was based on the number of public employees in a locality.

Calabrese explains how the funds were distributed:

“Each public employee was considered a ‘unit,’ and uniformed employees (such as police and fire) each represented two units. The pool of insurance tax revenue collected by the state was then divided by the sum of municipal units to arrive at a unit value. This distribution could subsidize local governments’ pension expenditures up to 100 percent of the annual cost. In 1985, this tax generated $62.3 million in revenues; as a result, each unit value was worth $1,146 – meaning that local governments received $1,146 for pension funding for each public employee and an additional $1,146 for pension funding for each uniformed public employee. Importantly, 75 percent of municipalities received enough funding from this revenue in 1985 to fully offset their pension costs.”

The new mechanism raised more funds, but it also unexpectedly raised costs. If a municipality had to contribute less than the $1,146 annually for a regular employee or $2,292 for a uniformed employee, for example, the municipality was essentially incentivized to increase benefits to public employees up to this limit, because local public employees would receive increased benefits at no direct budgetary cost to the municipality.

“…the tax likely increased insurance costs for residents and businesses (and then only a small fraction of the cost), but not directly for the government employer. Further, this system privileged benefits relative to other compensation, because these payments (borne at least statutorily by out-of-state companies) could only be used for financing pensions and not other forms of compensation.”

A tax originally implemented to fund pension costs statewide resulted in a system that encouraged more generous benefits.

Despite increased subsidies from the state, only 38 percent of municipalities received sufficient allocated funds from the pool to fully offset the costs of pensions. This was because annual pension contributions were growing at a faster rate than the rate at which the subsidy from the state insurance tax was growing.

To highlight a city with severely distressed pension plans, Philadelphia continued to struggle even following the implementation of the state insurance tax. The police pension plan, nonuniformed plan, and firefighter pension plan were all only 49, 47, and 45 percent funded, respectively. In 2009, the City Council passed a temporary 1 percentage point increase in their sales tax and when the temporary rate was renewed in 2014, any revenue in excess of $120 million was dedicated to the city’s pension plans. Additionally, the state permitted the city to pass a $2 per pack cigarette tax to fund a planned budget deficit for the school system; likely because its income tax capacity was largely exhausted.

Philadelphia’s new taxes technically generated new revenues, but they did little to improve the funding of the city’s pension plans.

The selective taxes implemented to fund pension liabilities in Pennsylvania were effectively a Band-Aid that was two small for the state’s pension funding problem, which in turn required the addition of more, insufficient pension Band-Aids. It merely created a public financing system that encouraged pension benefit growth which led to the passage of additional laws requiring certain pension funding levels. And when these funding levels were not met, even more laws were passed that provided temporary pension funding relief, which further grew liabilities for distressed municipalities.

Act 44 became law in 1993 and provided plan sponsors pension funding relief, but primarily by allowing sponsors to alter actuarial assumptions and thereby reduce required pension contributions. Another law delayed funding by manipulating how the required contribution was calculated, rather than providing any permanent fix.

Moving forward

Selective taxes for the purpose of funding pensions are still a relatively rare practice, but as pension liabilities grow and the landscape of reform options changes, it may become increasingly attractive to policymakers. As Calabrese has demonstrated in his book chapter, however, we should be wary of this avenue as it may only encourage the growth of pension liabilities without addressing the problem in any meaningful way. Reforming the structure of the pension plan or the level of benefits provided to current or future employees would provide the most long-term solution.

A solution with the long-term in mind and that doesn’t involve touching current beneficiaries includes moving future workers to defined contribution plans; plans that are better suited to keeping costs contained. The ballooning costs aren’t stemming solely from overly generous plan benefits, but more seriously are the result of their poor management and incentives for funding, only exacerbated by poor accounting practices. The problem is certainly complicated and moving towards the use of defined contribution plans wouldn’t eliminate all issues, but it would at least set governments on a more sustainable path.

At the very least, policymakers interested in long-term solutions should be cautioned against using selective taxes to fund pensions.

A public sector retirement plan for Millennials

According to the Center for Retirement Research, about 52 percent of households are “at risk of not having enough to maintain their living standards in retirement” and that the retirement landscape is making “the outlook for retiring Baby Boomers and Generation Xers far less sanguine than for current retirees.” This growing problem for younger generations is highlighted by the Economic Policy Institute’s finding that almost half of households headed by someone between the ages of 32 and 61 have nothing saved for retirement. A confluence of factors has led to a predicament for millennials as they try to prepare for retirement in a drastically changing job market.

The millennial generation has grown to be an integral part of the workforce, and private sector companies are increasing their efforts to understand what they value most a job. A Deloitte survey reveals that a good work/life balance, opportunities to progress/be leaders, flexibility, and a sense of meaning emerge as the most important factors when evaluating job opportunities. What’s more, millennials are not likely to stick around for a job that doesn’t meet this criteria. The same survey found that if given the choice during the next year, one in four millennials would quit his or her current employer to join a new organization or to do something different.

This flightiness appears to be a characteristic of many young people and to be happening in tandem with, if not contributing to, an increasingly transient job market. This phenomenon, corroborated by other surveys, demonstrates that more and more millennial workers are changing jobs at a higher rate than previous generations. It is not as common to stick with your first or second job until retirement, as it once was for Baby Boomers. The “loyalty challenge” facing companies, paired with changes in technology and culture, has in turn been transforming the landscape of retirement options.

As workers become more transient, companies are forced to provide more portable retirement plan options. During the past two decades, the private sector has done just that by transitioning from offering primarily defined benefit retirement plans to offering more defined contribution plans. This change is to be expected in part because of the flexibility it provides for beneficiaries. Defined contribution plans allow for workers to take their benefits more easily with them from job to job.

The public sector has not quite caught up to this trend. Public sector plans have had much more difficulty staying solvent and much of this is because of the prevalence of defined benefit plans. Mercatus scholars, along with many economists, have long criticized the poor incentive structure of these plans. If these aren’t reason enough for policymakers to offer defined contribution plans in their place, then maybe their changing workforces will.

Much of the debate over growing pension liabilities has focused on whether public sector compensation costs are fair either in comparison to other states or to the private sector. But much less has been said about what is fair across generations.

Most pension reform efforts at the state level target changes in benefits for younger employees while preserving the benefits of older workers. Although this is largely the result of legal and political constraints, such changes have the potential to force younger generations of public-sector workers to shoulder a disproportionate share of the cost of reforms, as their retirement benefits become more uncertain, thus violating a crucial criterion of “intergenerational equity” for pension reform.

Pension experts Robert Novy-Marx and Joshua Rauh reveal in a 2008 study that the intergenerational transfer of pension debt could be quite large. They predict a 50 percent chance of underfunding across the states amounting to more than $750 billion, even before adjusting for risk. In other words, if left alone, the pension bills of today are going to be handed to the generations of tomorrow.

A new Mercatus paper uncovers how similar intergenerational equity issues have developed in the state of Oregon. The author, legal scholar Scott Shepard, writes:

“…the system radically favors (generally older) workers who started before 1996 and 2003, respectively – not just in expected ways, like seniority pay bumps, but in deeply structural ways; earlier-hired employees simply get a significantly better pay-and-benefit package for every minute of their climb up the seniority ladder.”

Oregon’s pension system, along with many other states’ plans, started out offering extremely generous benefits, but as this has grown increasingly unsustainable, the state is being forced to deal with reality and reign in benefits for newer workers.

The unfair retirement landscape that this creates is largely the result of many past poor policy decisions and although this difference in benefits between age groups is far from intentional, how Oregon – and other states in similar positions – responds can be. Changing demographic trends may lend reason for public pension officials to consider moving towards defined contribution plan structures, or at least providing the option.

Shepard strongly urges Oregon to make this shift. He describes a number of benefits; from the perspective of the state, taxpayers, and future generations:

“First, payments must be made when due, rather than being shifted off to future generations. This may seem painful to present taxpayers, but the long-term effect is to ensure a more honest government, in that politicians cannot make promises that their (unrepresented) descendants end up paying for generations later, long after the promisors have reaped the political benefits of making unfunded promises, only to have retired from the scene when payment comes due. This inability to promise now and pay later has a corollary benefit of thwarting the impulse to make extravagant pension promises, as the payments come due immediately, rather than being foisted off on future generations.”

Offering defined contribution plans for workers can provide a more sustainable option that would prevent this equity issue from worsening.

In addition to the accountability and savings that offering a defined contribution option provides, like we have seen demonstrated in Utah and Michigan, this also has the potential to lead to higher worker satisfaction.

With millennials looking to save money for retirement through more portable means, policymakers will want to offer benefits packages that match these preferences. Private sector workers and some public – including Federal and public university – workers lie at the forefront of those benefiting from the defined contribution trend. Most state public plans, however, still fall behind, which has continuing implications for public plan solvency and intergenerational equity.

What’s going on with Alaska’s budget?

Alaska is facing another budget deficit this year – one of $3 billion – and many are skeptical that the process of closing this gap will be without hassle. The state faces declining oil prices and thinning reserves, forcing state legislators to rethink their previous budgeting strategies and to consider checking their spending appetites. This shouldn’t be a surprise to state legislators though – the budget process during the past two years ended in gridlock because of similar problems. And these issues have translated into credit downgrades from the three major credit agencies, each reflecting concern about the state’s trajectory if no significant improvements are made.

Despite these issues, residents have not been complaining, at least not until recently. Every fall, some earnings from Alaska’s Permanent Fund get distributed out to citizens – averaging about $1,100 per year since 1982. Last summer, Governor Walker used a partial veto to reduce the next dividend from $2,052 to $1,022. Although politically unpopular, these checks may be subject to even more cuts as a result of the current budget crisis.

The careful reader might notice that Alaska topped the list of the most fiscally healthy states in a 2016 Mercatus report that ranks the states according to their fiscal condition (using fiscal year 2014 data). For a state experiencing so much budget trouble, how could it be ranked so highly?

The short answer is that Alaska’s budget is incredibly unique.

On the one hand, the state has large amounts of cash, but on the other, it has large amounts of debt. Alaska’s cash levels are what secured its position in our ranking last year. Although holding onto cash is generally a good thing for state governments, there appears to be diminishing returns to doing so, especially if there is some structural reason that makes funds hard to access for paying off debt or for improving public services. It is yet to be seen how these factors will affect Alaska’s ranking in the next edition of our report.

Another reason why Alaska appeared to be doing well in our 2016 report is that the state’s problems – primarily spending growth and unsustainable revenue sources – are still catching up to them. Alaska has relied primarily on oil tax revenues and has funneled much of this revenue into restricted permanent trusts that cannot be accessed for general spending. When the Alaska Permanent Fund was created in the 1980s, oil prices were high and production was booming, so legislators didn’t really expect for this problem to occur. The state is now starting to experience the backlash of this lack of foresight.

The first figure below shows Alaska’s revenue and expenditure trends, drawing from the state’s Comprehensive Annual Financial Reports (CAFRs). At first look, you’ll see that revenues have generally outpaced spending, but not consistently. The state broke even in 2003 and revenues steadily outpaced expenditures until peaking at $1,266 billion in 2007. Revenues fell to an all-time low of $241 billion following the recession of 2008 and then fluctuated up and down before falling drastically again in fiscal year 2015.

alaska-revenues-exp4.5.17

The ups and downs of Alaska’s revenues reflect the extremely volatile nature of tax revenues, rents, and royalties that are generated from oil production. Rents and royalties make up 21 percent of Alaska’s total revenues and oil taxes 6 percent – these two combined actually come closer to 90 percent of the actual discretionary budget. Alaska has no personal income tax or sales tax, so there isn’t much room for other sources to make up for struggling revenues when oil prices decline.

Another major revenue source for the state are federal grants, at 32 percent of total revenues. Federal transfers are not exactly “free lunches” for state governments. Not only do they get funded by taxpayers, but they come with other costs as well. There is research that finds that as a state becomes more reliant on federal revenues, they tend to become less efficient, spending more and taxing more for the same level of services. For Alaska, this is especially concerning as it receives more federal dollars than any other state in per capita terms.

Federal transfers as an income stream have been more steady for Alaska than its oil revenues, but not necessarily more accessible. Federal funds are usually restricted for use for federal programs and therefore their use for balancing the budget is limited.

A revenue structure made up of volatile income streams and hard-to-access funds is enough by itself to make balancing the budget difficult. But Alaska’s expenditures also present cause for concern as they have been growing steadily, about 10 percent on average each year since 2002, compared with private sector growth of 6 percent.

In fiscal year 2015, education was the biggest spending category, at 28% of total expenditures. This was followed by health and human services (21%), transportation (11%), general government (10%), the Alaska Permanent Fund Dividend (9%), public protection (6%), and universities (5%). Spending for natural resources, development, and law and justice were all less than 5 percent.

The next figure illustrates the state’s biggest drivers of spending growth since 2002. Education and general government spending have grown the most significantly over the past several years. Alaska Permanent Fund spending has been the most variable, reflecting the cyclical nature of underlying oil market trends. Both transportation and health and human services have increased steadily since 2002, with the latter growing more significantly the past several years as a result of Medicaid expansion.

alaska-spendinggrowth4.5.17

Alaska’s spending is significantly higher than other states relative to its resource base. Spending as a proportion of state personal income was 31 percent in fiscal year 2015, much higher than the national average of 13 percent. A high level of spending, all else equal, isn’t necessarily a bad thing if you have the revenues to support it, but as we see from this year’s budget deficit, that isn’t the case for Alaska. The state is spending beyond the capacity of residents to pay for current service levels.

What should Alaska do?

This is a complicated situation so the answer isn’t simple or easy. The Alaska government website provides a Microsoft Excel model that allows you to try and provide your own set of solutions to balance the budget. After tinkering with the state provided numbers, it becomes clear that it is impossible to balance the deficit without some combination of spending cuts and changes to revenues or the Permanent Fund dividend.

On the revenue side, Alaska could improve by diversifying their income stream and/or broadening the tax base. Primarily taxing one group – in this case the oil industry – is inequitable and economically inefficient. Broadening the base would cause taxes to fall on all citizens more evenly and be less distortive to economic growth. Doing so would also smooth revenue production, making it more predictable and reliable for legislators.

When it comes to spending, it is understandably very difficult to decide what areas of the budget to cut, but a good place to start is to at least slow its growth. The best way to do this is by changing the institutional structure surrounding the political, legislative, and budgeting processes. One example would be improving Alaska’s tax and expenditure limit (TEL), as my colleague Matthew Mitchell recommends in his recent testimony. The state could also look into item-reduction vetoes and strict balanced-budget requirements, among other institutional reforms.

Ultimately, whatever steps Alaska’s legislators take to balance the budget this year will be painful. Hopefully the solution won’t involve ignoring the role that the institutional environment has played in getting them here. A narrow tax base reliant on volatile revenue sources, restricted funds, and growing spending are all factors that have led many to think that Alaska is and always will be “different.” But what constitutes sound public financial management is the same regardless of state. Although Alaska’s situation is unique, their susceptibility to fiscal stress absent any changes is not.

Solving the Public Pension Crisis

Last week I had the pleasure of attending a public policy conference that brought together many scholars who study public pensions to share what they have learned from their research. The crisis – growing unfunded pension liabilities and resulting fiscal distress for states and municipalities – laid as the foundation of the day. Hosted by GMU’s Law & Economics Center, the conference featured several panel discussions framed around different aspects of how to both diagnose the cause of this growing problem and hopefully find solutions to address the problem.

Professor Robert Inman of the University of Pennsylvania presented a helpful categorization of the different avenues to address the public pension crisis. He explained that as a reformer, you can either put stock in (1) courts, (2) markets, or (3) politics to solve the public policy problem. The next question is, which avenue is most effective at making pensions solvent while also keeping promises to beneficiaries?

First, take the courts. In municipal bankruptcy cases like that of Central Falls, Rhode Island; Stockton, California; and Detroit, Michigan, courts have ruled that reductions in benefits of current public workers and retirees are legally allowed. Until these rulings, however, it was thought to be almost impossible do such a thing. These cities employed reforms ranging from cutting payments to reducing current benefit formulas. By contrast, the state supreme court of Illinois has ruled similar cuts unconstitutional. It will be interesting to see how these conflicting legal precedents will affect future cases and what it will mean for the benefits of public workers.

However this legal discussion unfolds, it will certainly affect the courts as an avenue for solving the pension crisis. Strict rulings prevent states from cutting pension benefits of current workers, but they also require states to keep their promises, especially when it is politically hardest – during times of fiscal stress.

Times of fiscal stress are often prompted by a combination of factors. Growing unfunded liabilities, not enough cash in reserves, and poorly structured tax systems can all come together to really put policymakers in a tough spot and often leaves a large bill for taxpayers. A struggling economy on top of all of this can really exacerbate the situation. The main difference between the first three things and a struggling economy is that the latter is largely out of a policymaker’s control.

Despite this, many policymakers rely on the market to get them out of tough times. From the policymaker’s perspective “relying on the market” to solve the pension crisis usually means something different than what it means for an economist. This phrase for the policymaker usually entails reaping the benefits of more taxes generated from an economic boom or relying on high investment returns to improve the performance of pension funds.

Not only are the timing of economic booms fairly unpredictable, but they also don’t guarantee to solve all of your problems when they do occur. The growing city of Austin, Texas, for example, is facing budgetary pressures and only has enough money to pay for about two-thirds of the benefits workers have already earned, demonstrating that even good economic times don’t exempt you from pension problems.

The good news is that what we learn from market interactions can be transferred to the political sphere in order to increase our understanding. One lesson we learn from markets is that individuals respond to incentives and that the institutional structure in which they act influences how this occurs. The importance of incentives and rules doesn’t change when going from markets to politics, but the way they manifest does.

At the Law and Economics conference, Anthony Randazzo of the Reason Foundation explained how there is a tangled web of factors causing inappropriate pension funding behavior. These factors create misaligned incentives between fiduciaries and taxpayers. One way this has manifested is that the pension funding policy process has been captured by elected officials who are more concerned with near-term budget allocation than long-term solvency.

My colleague Eileen Norcross and her co-author Sheila Weinberg expanded more on the type of behavior that Randazzo spoke of. In their paper titled “A Judge in their Own Cause: GASB 67/68 and the continued mis-measurement of public sector liabilities” they review how policymakers are incentivized by state and local accounting guidelines to underreport the true value of their pension liabilities. Two new accounting rules were implemented in fiscal year 2015 in an attempt to improve this, but as Norcross and Weinberg’s findings suggest, they have not had their intended effects.

For example, there is evidence that one of the rules, GASB 67, is creating incentives for pension actuaries to project robust funding levels far into the future in order to avoid calculating and reporting large unfunded liabilities in the present.

They sum up the effects of both rules in their conclusion:

“Though these measures are justified in providing flexibility and practicality for governments, they only contribute to an artificial picture of state’s true fiscal results and thus affect important decisions on how states use resources.”

Their analysis demonstrates just how important it is to study the incentives present in both the measurement of and the governance of public pension funds. Luckily, there is also work being done that attempts to understand exactly what type of rules can improve incentives facing policymakers.

Another paper, presented by Professor Odd Stalebrink of Penn State, touched upon this by examining how governance structures affect the investment performance of public pension funds. He found that pension systems are more likely to meet their performance targets if they are governed by an institutional structure that (1) extends plan autonomy, (2) places emphasis on transparency, and (3) limits inefficient investment practices. In states that exhibit more corruption, however, Stalebrink noted that plans might actually be better off with less autonomy, while still focusing on transparency and improving efficiency.

The discussion of these papers along with many others at the conference underscored that pension problem in the states multifaceted one. The question of what avenue to employ reform efforts through does not have a simple answer. Growing unfunded pension liabilities are a result of many factors across market, political, and legal spheres. It only makes sense that effective solutions will revolve around an understanding of all three areas.

Proceedings of the conference will be published in a special symposium issue of Scalia Law School’s Journal of Law, Economics & Policy.

Eight years after the financial crisis: lessons from the most fiscally distressed cities

You’d think that eight years after the financial crisis, cities would have recovered. Instead, declining tax revenues following the economic downturn paired with growing liabilities have slowed recovery. Some cities exacerbated their situations with poor policy choices. Much could be learned by studying how city officials manage their finances in response to fiscal crises.

Detroit made history in 2013 when it became the largest city to declare bankruptcy after decades of financial struggle. Other cities like Stockton and San Bernardino in California had their own financial battles that also resulted in bankruptcy. Their policy decisions reflect the most extreme responses to fiscal crises.

You could probably count on both hands how many cities file for bankruptcy each year, but this is not an extremely telling statistic as cities often take many other steps to alleviate budget problems and view bankruptcy as a last resort. When times get tough, city officials often reduce payments into their pension systems, raise taxes – or when that doesn’t seem adequate – find themselves cutting services or laying off public workers.

It turns out that many municipalities weathered the 2008 recession without needing to take such extreme actions. Studying how these cities managed to recover more quickly than cities like Stockton provides interesting insight on what courses of action can help city officials better respond to fiscal distress.

A new Mercatus study examines the types of actions that public officials have taken under fiscal distress and then concludes with recommendations that could help future crises from occurring. Their empirical model finds that increased reserves, lower debt, and better tax structures all significantly improve a city’s fiscal health.

The authors, researchers Evgenia Gorina and Craig Maher, define fiscal distress as:

“the condition of local finances that does not permit the government to provide public services and meet its own operating needs to the extent to which these have been provided and met previously.”

In order to determine whether a city or county government is under fiscal distress, the authors study the actual actions taken by city officials between 2007 and 2012. Their approach is unique because it stands in contrast with previous literature that primarily looks to poorly performing financial indicators to measure fiscal distress. An example of such an indicator would be how much cash a government has on hand relative to its liabilities.

Although financial indicators can tell someone a lot about the fiscal condition of their locality, they are only a snapshot of financial resources on hand and don’t provide information on how previous policy choices got them to their current state. A robust analysis of a city’s financial health would require a deeper look. Looking at policy decisions as well as financial indicators can paint a more complete picture of just how financial resources are being managed.

The figure here displays the types of actions, or “fiscal distress episodes”, that the authors of the study found were the most common among cities in California, Michigan, and Pennsylvania. As expected, you’ll see that bankruptcy occurs much less frequently than other courses of action. The top three most common attempts to meet fundamental operating needs and service requirements during times of fiscal distress include (1) large across-the-board budget cuts or cuts in services, (2) blanket reduction in employee salaries, and (3) unusual tax rate or fee increases.

fiscal-distress-episodes

Another thing that becomes clear from this figure is that public workers and taxpayers appear to be adversely affected by the most common fiscal episodes. Cuts in services, reductions in employee salaries, large tax increases, and layoffs all place much of the distress on these groups. By contrast, actions like fund transfers, deferring capital projects, or late budget enactment don’t directly affect public workers or taxpayers (at least in the short term).

I decided to break down how episodes affected public workers and taxpayers for each state examined in the sample. 91% of California’s municipal fiscal distress episodes directly affected public employees or the provision of public services, while the remaining 9% indirectly affected them. Michigan and Pennsylvania followed with 85% and 66% of episodes, respectively, directly affecting public workers or taxpayers through cuts in services, tax increases, or layoffs.

Many of these actions surely happen in tandem with each other in more distressed cities, but it seems that more often than not, the burden falls heavily on public workers and taxpayers.

The city officials who had to make these hard decisions obviously did so under financially and politically intense circumstances; what many, including researchers like Gorina and Maher, consider to be a fiscal crisis. In fact, 32 percent of the communities across the three states in their sample experienced fiscal distress which, on its own, sheds light on the magnitude of the 2007-2009 recession. A large motivator of Gorina and Maher’s research is to understand what characteristics of the cities who more quickly rebounded from the Great Recession allowed them to prevent hitting fiscal crisis stage in the first place.

They do so by testing the effect of a city’s pre-existing fiscal condition on their likelihood to undergo fiscal distress. After controlling for things like government type, size, and local economic factors, they found that cities that had larger reserves and lower debt tended to weather the recession better relative to other cities. More specifically, declining general revenue balance as a percent of general expenditures and increases in debt as a share of total revenue both increase the odds of fiscal distress for a city.

Additionally, the authors found that cities with a greater reliance on property taxes managed to weather the recession better than governments reliant on other revenue sources. This suggests that revenue structure, not just the amount of revenue raised, is an important determinant of fiscal health.

No city wants to end up like Detroit or Scranton. Policymakers in these cities were forced to make hard choices that were politically unpopular; often harming public employees and taxpayers. Officials can look to Gorina and Maher’s research to understand how they can prevent ending up in such dire situations.

When approaching municipal finances, each city’s unique situation should of course be taken into consideration. This requires looking at each city’s economic history and financial practices, similar to what my colleagues have done for Scranton. Combining each city’s financial context with principles of sound financial management can surely help more cities find and maintain a healthy fiscal path.

Fixing decades of fiscal distress in Scranton, PA

In new Mercatus research, Adam Millsap and I and unpack the causes for almost a quarter of a century of fiscal distress in Scranton, Pennsylvania and offer some recommendations for how the city might go forward.

Since 1992, Scranton has been designated as a distressed municipality under Act 47, a law intended to help financially struggling towns and cities implement reforms. Scranton is now on its fifth Recovery plan, and while there are signs that the city is making improvements, it still has to contend with a legacy of structural, fiscal and economic problems.

We begin by putting Scranton in historical context. The city, located in northeastern Pennsylvania was once a thriving industrial hub, manufacturing coal, iron and providing T-rails for railroad tracks. By 1930, Scranton’s population peaked and the city’s economy began to change. Gas and oil replaced coal. The spread of the automobile and trucking diminished demand for railroad transport. By the 1960s Scranton was a smaller service-based economy with a declining population. Perhaps most relevant to its current fiscal situation is that the number of government workers increased as both the city’s population and tax base declined between 1969 and 1980.

An unrelenting increase in spending and weak revenues prompted the city to seek Act 47 designation kicking off two decades of attempts to reign in spending and change the city’s economic fortunes.

Our paper documents the various recovery plans and the reasons the measures they recommended either proved temporary, ineffective, or simply “didn’t stick.” A major obstacle to cost controls in the city are the hurdle of collective bargaining agreements with city police and firefighters, protected under Act 111, that proved to be more binding than Act 47 recovery plans.

The end result is that Scranton is facing rapidly rising employee costs for compensation, health care and pension benefits in addition to a $20 million back-pay award. These bills have led the city to pursue short-term fiscal relief in the form of debt issuance, sale-leaseback agreements and reduced pension contributions. The city’s tax structure has been described as antiquated relying mainly on Act 511 local taxes (business privilege and mercantile business tax, Local Services Tax (i.e. commuter tax)), property taxes and miscellaneous revenues and fees.

Tackling these problems requires structural reforms including 1) tax reform that does not penalize workers or businesses for locating in the city, 2) pension reform that includes allowing workers to move to a defined contribution plan and 3) removing any barrier to entrepreneurship that might prevent new businesses from locating in Scranton. In addition we recommend several state-level reforms to laws that have made it harder to Scranton to control its finances namely collective bargaining reform that removes benefits from negotiation; and eliminating “budget-helping” band-aids that mask the true cost of pensions. Such band-aids include state aid for municipal pension and allowing localities to temporarily reduce payments during tough economic times. Each of these has only helped to sustain fiscal illusion – giving the city an incomplete picture of the true cost of pensions.

To date Scranton has made some progress including planned asset monetizations to bring in revenues to cover the city’s bills. Paying down debts and closing deficits is crucial but not enough. For Pennsylvania’s distressed municipalities to thrive again reforms must replace poor fiscal institutions with ones that promote transparency, stability and prudence. This is the main way in which Scranton (and other Pennsylvania cities) can compete for businesses and residents: by offering government services at lower cost and eliminating penalties and barriers to locating, working and living in Scranton.

Local governments reluctant to issue new debt despite low interest rates

The Wall Street Journal reports that despite historically low interest rates municipal governments and voters don’t have the appetite for new debt. Municipal bond issuances have dropped to 20-year lows (1.6 percent) as governments pass on infrastructure improvements. There are a few reasons for that: weak tax revenues, fewer federal dollars, and competing budgetary pressures. As the article notes,

“Many struggling legislatures and city halls are instead focusing on underfunded employee pensions and rising Medicaid costs. Some cash-strapped areas, such as Puerto Rico and the city of Chicago, face high annual debt payments.”

The pressures governments face due to rising employee benefits is likely to continue. The low interest rate environment has already had a negative effect on public pensions. In pursuit of higher yields, investors have taken on more investment risk leaving plans open to market volatility. At the same time investments in bonds have not yielded much. WSJ reporter Timothy Martin writes that public pension returns are, “expected to drop to the lowest levels ever recorded,” with a 20-year annualized return of 7.4 percent for 2016.

The end result of this slide is to put pressure on municipal and state budgets to make up the difference, sometimes with significant tradeoffs.

The key problem for pensions is “baked into the cake,” by use of improper discounting. Linking the present value of guaranteed liabilities to the expected return on risky investments produces a distortion in how benefits are measured and funded. Public sector pensions got away with it during the market boom years. But in this market and bond environment an arcane actuarial assumption over how to select discount rates shows its centrality to the fiscal stability of governments and the pension plans they provide.

Properly funding a defined benefit plan requires solid average returns and some luck

Saving for retirement is something most workers do – either on their own or through an employer – and most are aware that the rate of return on their retirement investment matters. For example, if I save $100 today and it earns 10% per year in interest for the next 20 years I will have $672.75 at the end of 20 years. If the money earns 6% instead I will only have $320.71 at the end of 20 years.

Moreover, if I wanted to have $672 at the end of 20 years and the interest rate was only 6% I would have to save $209.54 today rather than $100. This demonstrates that the higher the interest rate is, the less money I will have to save today in order to have a specific amount of money in the future. This simple truth has important implications for pension funding.

For many years state pension plans assumed average returns of around 8% per year when calculating pension liabilities. Assuming this relatively high rate of return meant that pension plans required less contributions today in order to meet their future goals. But this also came with significant risk – if the average rate of return fell short of 8% then the pensions would not be able to pay out the benefits that were promised. This is demonstrated in the previous example; if a person wanted $672 after 20 years and assumed a 10% rate of return they would have only saved $100. However, if the rate of return turned out to be 6% per year instead of 10%, they would have ended up over $300 short of their goal ($672 – $320 = $352).

It turns out that an expected rate of return of 8% was unachievable and many pension plans are lowering their expected returns. This can generate large pension shortfalls, since a lower rate of return means that more money needed to be saved all along. In many states the budget is tight and it’s not clear where the additional money will come from, but there’s a good chance that taxpayers are going to have make up the difference.

Assuming too high of a return is an obvious problem. But there is a more subtle issue that doesn’t get as much attention yet generates similar results; even if a pension plan gets an 8% return on average, the plan may still fall short of its goal. This is because different returns have different effects on the actual amount of money over time. The chart below provides a simple example, where the goal is to accumulate $100,000 in 10 years.

Based on the $100,000 goal and an 8% yearly return one can calculate that (approximately) $6,400 must be contributed to the plan at the beginning of each year, which is the contribution amount I used. In each scenario in the table the average annual return is 8%, but not every plan returns 8% each year.

pension-avg-return-table2

Scenario 1 is the most straightforward; the plan actually earns 8% each year and the $100,000 goal is reached by year 10. But while this is the simplest scenario, it’s also the most unrealistic. Anyone who follows the stock market knows that it’s volatile – some years it’s up, some years it’s down. Standard pension accounting, however, assumes scenario 1 will occur even though that’s incredibly unlikely.

In scenario 2, the plan earns 8% in each of the first two years, then loses 15% the third year. After that returns are above average and plan actually exceeds its goal of $100,000 at the end of 10 years. In scenario 3 the plan earns 8% for the first 6 years, then 14%, before losing 15% in year 8. In this scenario, even the exceptional gains in years 9 and 10 are not enough to reach the $100,000 goal. And finally, in scenario 4 the gains fluctuate more often – there are some high return years in the beginning and the loss year is relatively late (year 7). In this scenario the plan ends up over $6,500 short of its $100,000 goal.

There are infinite ways a plan could get an 8% return on average, but these 4 examples demonstrate the different dollar amounts that can result even if the average return goal is met. In two of the scenarios (3 and 4) the plan falls short of its actual dollar goal and is underfunded even though it met its return goal. This exemplifies the inherent risk in any pension plan that promises a specific amount of money in some future period, as defined benefit plans do. As the previous example shows, even if the required contributions are made each year AND the plan’s average return goal is met, there is still a chance the plan will be underfunded.

The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans. Switching from defined benefit plans to defined contribution plans needs to be a part of the solution to public sector pension problems. Otherwise there’s a good chance that taxpayers will be required to pick up the tab when plans inevitably miss their funding goals.

 

Grants to Puerto Rico haven’t helped much

Greece’s monetary and fiscal issues have overshadowed a similar situation right in America’s own back yard: Puerto Rico. Puerto Rico’s governor recently called the commonwealth’s $72 billion in debt “unpayable” and this has made Puerto Rico’s bondholders more nervous than they already were. Puerto Rico’s bonds were previously downgraded to junk by the credit rating agencies and there is a lot of uncertainty surrounding Puerto Rico’s ability to honor its obligations to both bond holders and its own workers, as the commonwealth’s pension system is drastically underfunded.   A major default would likely impact residents of the mainland U.S., since according to Morningstar most of the debt is owned by U.S. mutual funds, hedge funds, and mainland Americans.

So how did Puerto Rico get into this situation? Like many other places, including Greece and several U.S. cities, the government of Puerto Rico routinely spent more than it collected in revenue and then borrowed to fill the gap as shown in the graph below from Puerto Rico’s Office of Management and Budget. Over a recent 13 year period (2000 – 2012) Puerto Rico ran a deficit each year and accrued $23 billion in debt.

Puerto rico govt spending

Puerto Rico has a lot in common with many struggling cities in the U.S. that followed a similar fiscal path, such as a high unemployment rate of 12.4%, a shrinking labor force, stagnant or declining median household income, population flight, and falling house prices. Only 46.1% of the population 16 and over was in the labor force in 2012 (compared to an average of nearly 64% in the US in 2012) and the population declined by 4.8% from 2010 to 2014. It is difficult to raise enough revenue to fund basic government services when less than half the population is employed and the most able-bodied workers are leaving the country.

Like other U.S. cities and states, Puerto Rico receives intergovernmental grants from the federal government. As I have explained before, these grants reduce the incentives for a local government to get its fiscal house in order and misallocate resources from relatively responsible, growing areas to less responsible, shrinking areas. As an example, since 1975 Puerto Rico has received nearly $2.7 billion in Community Development Block Grants (CDBG). San Juan, the capital of Puerto Rico, has received over $900 million. The graph below shows the total amount of CDBGs awarded to the major cities of Puerto Rico from 1975 – 2014.

Total CDBGs Puerto Rico

As shown in the graph San Juan has received the bulk of the grant dollars. The graph below shows the amount by year for various years between 1980 and 2014 for San Juan and Puerto Rico as a whole plotted on the left vertical axis (bar graphs). On the right vertical axis is the amount of CDBG dollars per capita (line graphs). San Juan is in orange and Puerto Rico is in blue.

CDBGs per capita, yr Puerto Rico

San Juan has consistently received more dollars per capita than the other areas of Puerto Rico. Both total dollars and dollars per capita have been declining since 1980, which is when the CDBG program was near its peak funding level. As part of the 2009 Recovery Act, San Juan received an additional $2.8 million dollars and Puerto Rico as a country received another $5.9 million on top of the $32 million already provided by the program (not shown on the graph).

It’s hard to look at all of this redistribution and not consider whether it did any good. After all, $2.7 billion later Puerto Rico’s economy is struggling and their fiscal situation looks grim. Grant dollars from programs like the CDBG program consistently fail to make a lasting impact on the recipient’s economy. There are structural problems holding Puerto Rico’s economy back, such as the Jones Act, which increases the costs of goods on the island by restricting intra-U.S.-shipping to U.S. ships, and the enforcement of the U.S. minimum wage, which is a significant cost to employers in a place where the median wage is much lower than on the mainland. Intergovernmental grants and transfers do nothing to solve these underlying structural problems. But despite this reality, millions of dollars are spent every year with no lasting benefit.

Paving over pension liabilities, again

Public sector pensions are subject to a variety of accounting and actuarial manipulations. A lot of the reason for the lack of funding discipline, I’ve argued, is in part due to the mal-incentives in the public sector to fully fund employee pensions. Discount rate assumptions, asset smoothing, and altering amortization schedules are three of the most common kinds of maneuvers used to make pension payments easier on the sponsor. Short-sighted politicians don’t always want to pay the full bill when they can use revenues for other things. The problem with these tactics is they can also lead to underfunding, basically kicking the can down the road.

Private sector plans are not immune to government-sanctioned accounting subterfuges. Last week’s Wall Street Journal reported on just one such technique.

President Obama recently signed a $10.8 billion transportation bill that also included a provision to allow companies to continue “pension smoothing” for 10 more months. The result is to lower the companies’ contribution to employee pension plans. It’s also a federal revenue device. Since pension payments are tax-deductible these companies will have slightly higher tax bills this year. Those taxes go to help fund federal transportation per the recently signed legislation.

A little bit less is put into private-sector pension plans and a little bit more is put into the government’s coffers.

The WSJ notes that the top 100 private pension plans could see their $44 billion required pension contribution reduced by 30 percent, adding an estimated $2.3 billion deficit to private pension plans. It’s poor discipline considering the variable condition of a lot of private plans which are backed by the Pension Benefit Guaranty Corporation (PBGC).

My colleague Jason Fichtner and I drew attention to these subtle accounting dodges triggered by last year’s transportation bill. In “Paving over Pension Liabilities,” we call out discount rate manipulation used by corporations and encouraged by Congress that basically has the same effect: redirecting a portion of the companies’ reduced pension payments to the federal government in order to finance transportation spending. The small reduction in corporate plans’ discount rate translates into an extra $8.8 billion for the federal government over 10 years.

The AFL-CIO isn’t worried about these gimmicks. They argue that pension smoothing makes life easier for the sponsor, and thus makes offering a defined benefit plan, “less daunting.” But such, “politically-opportunistic accounting,” (a term defined by economist Odd Stalebrink) is basically a means of covering up reality, like only paying a portion of your credit card bill or mortgage. Do it long enough and you’ll eventually forget how much those shopping sprees and your house actually cost.