Category Archives: Federalism

Does statehood trigger Leviathan? A case study of New Mexico and Arizona

I was recently asked to review, “The Fiscal Case Against Statehood: Accounting for Statehood in New Mexico and Arizona, by Dr. Stephanie Moussalli for EH.net (the Economic History Association).

I highly recommend the book for scholars of public choice, economic history and accounting/public finance.

As one who spends lots of time reading  state and local financial reports in the context of public choice, I was very impressed with Moussalli’s insights and tenacity. In her research she dives into the historical accounts of territorial New Mexico and Arizona to answer two questions.  Firstly, did statehood (which arrived in 1912) lead to a “Leviathan effect” causing government spending to grow. And secondly, as a result of statehood, did accounting improve?

The answer to these questions is yes. Statehood did trigger a Leviathan effect for these Southwestern states –  findings that have implications for current policy – in particular the sovereignty debates surrounding Puerto Rico and Quebec. And the accounts did improve as a result of statehood, an outcome that controls for the fact that this occurred during the height of the Progressive era and its drive for public accountability.

A provocative implication of her findings that cuts against the received wisdom:  Are the improved accounting techniques that come with statehood a necessary tool for more ambitious spending programs? Does accounting transparency come with a price?

What makes this an engaging study is Moussalli’s persistence and creativity in bringing light to a literature void. She stakes out new research territory, and brings a public choice-infused approach to what might otherwise be bland accounting records. She rightly sees in the historical ledgers the traces of the political and social choices of individuals; and the inescapable record of their decisions. In her words, “people say one thing and do another.” The accounts speak in a way that historical narrative does not.

For more read the review.

 

Credit Warnings, Debt Financing and Dipping into Cash Reserves

As 2013 comes to an end recent news brings attention to the structural budgetary problems and worsening fiscal picture facing several governments: New Jersey, New York City, Puerto Rico and Maryland.

First there was a warning from Moody’s for the Garden State. On Monday New Jersey’s credit outlook was changed to negative. The ratings agency cited rising public employee benefit costs and insufficient revenues. New Jersey is alongside Illinois for the state with the shortest time horizon until the system is Pay-As-You-Go. On a risk-free basis the gap between pension assets and liabilities is roughly $171 billion according to State Budget Solutions, leaving the system only 33 percent funded. This year the New Jersey contributed $1.7 billion to the system. But previous analysis suggests New Jersey will need to pay out $10 billion annually in a few years representing one-third of the current budget.

New Jersey isn’t alone. The biggest structural threat to government budgets is the unrecognized risk in employee pension plans and the purely unfunded status of health care benefits. Mayor Michael Bloomberg, in his final speech as New York City’s Mayor, pointed to the “labor-electoral complex” which prevents employee benefit reform as the single greatest threat to the city’s financial health. In 12 years the cost of employee benefits has increased 500 percent from $1.5 billion to $8.2 billion. Those costs are certain to grow presenting the next generation with a massive debt that will siphon money away from city services.

Public employee pensions and debt are also crippling Puerto Rico which has dipped into cash reserves to repay a $400 million short-term loan. The Wall Street Journal reports that the government planned to sell bonds, but retreated since the island’s bond values have, “plunged in value,” due to investor fears over economic malaise and the territory’s existing large debt load which stands at $87 billion, or $23,000 per resident.

This should serve as a warning to other states that continue to finance budget growth with debt while understating employee benefit costs. Maryland’s Spending Affordability Committee is recommending a 4 percent budget increase and a hike in the state’s debt limit from $75 million to 1.16 billion in 2014. Early estimates by the legislative fiscal office anticipate structural deficits of $300 million over the next two years – a situation that has plagued Maryland for well over a decade. The fiscal office has advised against increased debt, noting that over the last five years, GO bonds have been, “used as a source of replacement funding for transfers of cash” from dedicated funds projects such as the Chesapeake Bay Restoration Fund.

 

Medicaid Expansion: State Policy Challenges

Dr. Robert Graboyes, Mercatus scholar and expert on the Affordable Care Act, recently discussed the law’s impacts on Medicaid and challenges facing states considering Medicaid expansion on Mercatus’ Inside State and Local Policy podcast. In 20 minutes, Dr. Graboyes discusses principles legislators may consider while attempting to improve opportunities for health, strengthen the healthcare system, and why the two might not be the same mission.

Obama Administration will bailout Detroit

The Obama administration announced today it plans to send Detroit $320 million to “aid in its recovery,” according to The Hill.

The dollars come from existing federal money that is being re-purposed. It includes $24 million to rehabilitate buses and install safety cameras, $1.35 million for a community policing program, and the underwriting of 150 new firefighters. There are also funds for streets lights, police bike patrol, $3 million to hire new police, dollars for urban revitalization, and $25.4 million for demolition. A few months ago the administration said Detroit would have to work with creditors to resolve its bankruptcy issues. The city owes its creditors $18.5 billion.

Another example of how Detroit ended up in this awful position is highlighted in yesterday’s New York Times report of how Detroit City Council members skimmed $2 billion off of the pension system’ “excess earnings” to give employees ‘extra payments’ that had nothing to do with their pension benefits. This practice which spanned a 23 year period was justified as follows, quoting the NYT:

“People were having a hard time, living hand-to-mouth, and we thought we would give them some extra,” Ms. Bassett said.

Of all the nonpension payments, she said, 54 percent went to active workers, 14 percent went to retirees and 32 percent went to the city, which used its share to lower its annual contributions to the fund. The excess payments were often made near the end of the year, when recipients needed money for the holidays, or to heat their homes.

Of course the practice sounds wrong. Except it’s really another example of what happens when pensions value their liabilities based on asset returns. Detroit gave workers these “excess earnings.” New Jersey and scores of other states believed they were overfunded also and they “skipped payments” when the market was hot in the 1990s and early 2000s. The accounting gave them the illusion that this would all work out in the end. It is a dangerous fiction that these pension systems operate under.

That illusion of “overfunding in boom years” flows from the practice – discussed often in this blog – of discounting liabilities based on expected asset returns.The math really matters. For a long discussion, see here. 

How much damage has this accounting assumption and all the behaviors that flow from it caused? For Detroit – a significant amount. The city reports its pensions are underfunded by $634 million. It’s actually $9 billion underfunded on a market basis. 

I am not entirely surprised by the bailout, which sounds like a mini-stimulus via federal municipal grant programs. And I openly wonder what it portends for other cities that find themselves looking at similarly dire economic and financial situations.

Lessons from North Carolina’s proposed budget

In today’s Room for Debate at The New York Times, I discuss what’s good and what is worrying about North Carolina’s proposed biennial budget.

The good: a doubling of the state’s Rainy Day Fund and end to the estate tax. But a big controversy surrounds the legislature this week. Lawmakers decided to cut unemployment benefits by one-third. This move disqualifies the state from receiving additional emergency unemployment insurance funds from the federal government, affecting 170,000 jobless in the state.

The issue points to the perennial calls for reform to the federal-state Unemployment Insurance (UI) program. North Carolina is one of many states that must pay the federal government back what it has borrowed to offer extended benefits to its residents, or face higher payroll taxes. Their choices are tough ones to make: raise the state payroll tax (or taxable wage base) and replenish the trust fund – which has its own effects on the economy and the workforce – or cut benefits. A better solution is to re-think our approach to social insurance, something economists, such as Harvard’s Martin Feldstein, have been highlighting the structural flaws of UI since the 1970s.

n.b. update: a reader rightly notes at the NYT – the states must pay back the money they’ve borrowed from the federal government to continue paying benefits. But they don’t have to pay back the temporary EUC program. 

Local control over transportation: good in principle but not being practiced

State and local governments know their transportation needs better than Washington D.C. But that doesn’t mean that state and local governments are necessarily more efficient or less prone to public choice problems when it comes to funding projects, and some of that is due to the intertwined funding streams that make up a transportation budget.

Emily Goff at The Heritage Foundation finds two such examples in the recent transportation bills passed in Virginia and Maryland.

Both Virginia Governor Bob McDonnell and Maryland Governor Martin O’Malley propose raising taxes to fund new transit projects. In Virginia the state will eliminate the gas tax and replace it with an increase in the sales tax. This is a move away from a user-based tax to a more general source of taxation, severing the connection between those who use the roads and those who pay. The gas tax is related to road use; sales taxes are barely related. There is a much greater chance of political diversion of sales tax revenues to subsidized transit projects: trolleys, trains and bike paths, rather than using revenues for road improvements.

Maryland reduces the gas tax by five cents to 18.5 cents per gallon and imposes a new wholesale tax on motor fuels.

How’s the money being spent? In Virginia 42 percent of the new sales tax revenues will go to mass transit with the rest going to highway maintenance. As Goff notes this means lower -income southwestern Virginians will subsidize transit for affluent northern Virginians every time they make a nonfood purchase.

As an example, consider Arlington’s $1 million dollar bus stop. Arlingtonians chipped in $200,000 and the rest came from the Virginia Department of Transportation (VDOT). It’s likely with a move to the sales tax, we’ll see more of this. And indeed, according to Arlington Now, there’s a plan for 24 more bus stops to compliment the proposed Columbia Pike streetcar, a light rail project that is the subject of a lively local debate.

Revenue diversions to big-ticket transit projects are also incentivized by the states trying to come up with enough money to secure federal grants for Metrorail extensions (Virginia’s Silver Line to Dulles Airport and Maryland’s Purple Line to New Carrolton).

Truly modernizing and improving roads and mass transit could be better achieved by following a few principles.

  • First, phase out federal transit grants which encourage states to pursue politically-influenced and costly projects that don’t always address commuters’ needs. (See the rapid bus versus light rail debate).
  • Secondly, Virginia and Maryland should move their revenue system back towards user-fees for road improvements. This is increasingly possible with technology and a Vehicle Miles Tax (VMT), which the GAO finds is “more equitable and efficient” than the gas tax.
  • And lastly, improve transit funding. One way this can be done is through increasing farebox recovery rates. The idea is to get transit fares in line with the rest of the world.

Interestingly, Paris, Madrid, and Tokyo have built rail systems at a fraction of the cost of heavily-subsidized projects in New York, Boston, and San Francisco. Stephen Smith, writing at Bloomberg, highlights that a big part of the problem in the U.S. are antiquated procurement laws that limit bidders on transit projects and push up costs. These legal restrictions amount to real money. French rail operator SNCF estimated it could cut $30 billion off of the proposed $68 billion California light rail project. California rejected the offer and is sticking with the pricier lead contractor.

 

 

 

 

Virginia’s transportation plan under the microscope

Last week Virginia Governor Bob McDonnell shared his plan to address the state’s transportation needs. The big news is that the Governor wants to eliminate Virginia’s gas tax of 17.5 cents/gallon. This revenue would be replaced with an increase in the state’s sales tax from 5 percent to 5.8 percent. This along with a transfer of $812 million from the general fund, a $15 increase in the car registration fee, a $100 fee on alternative fuel vehicles and the promise of federal revenues should Congress pass legislation to tax online sales brings the total amount of revenue projected to fund Virginia’s transportation to $3.1 billion.

As the Tax Foundation points out, more than half of this relies on a transfer from the state’s general fund, and on Congressional legislation that has not yet passed.

Virginia plans to spend $4.9 billion on transportation. As currently structured, the gas tax only brings in $961 million. There are a few reasons why. First, Virginia hasn’t indexed the gas tax to inflation since 1986. It’s currently worth 40 cents on the dollar. In today’s dollars 17.5 cents is worth about 8 cents. Secondly, while there are more drivers in Virginia, cars are also more fuel efficient and more of those cars (91,000) are alternative fuel. In 2013, the gas tax isn’t bringing in the same amount of revenue as it once did.

But that doesn’t mean that switching from a user-based tax to a general tax isn’t problematic. Two concerns are transparency and fairness. Switching from (an imperfect) user-based fee to a broader tax breaks the link between those who use the roads and those who pay, shorting an important feedback mechanism. Another issue is fairness. Moving from a gas tax to a sales tax leads to cross-subsidization. Those who don’t drive pay for others’ road usage.

The proposal has received a fair amount of criticism with other approaches suggested. Randal O’Toole at Cato likes the idea of Vehicle Miles Travelled (VMT) which would track the number of miles driven via an EZ-Pass type technology billing the user directly for road usage. It would probably take at least a decade to fully implement. And, some have strong libertarian objections. Joseph Henchman at the Tax Foundation proposes a mix of indexing the gas tax to inflation, increased tolls, and levying a local transportation sales tax on NOVA drivers.

The plan opens up Virginia’s 2013 legislative session and is sure to receive a fair amount of discussion among legislators.

Eileen Norcross on News Channel 8 Capital Insider discussing Virginia and the fiscal cliff

Last week I appeared on NewsChannel 8’s Capital Insider to discuss how the fiscal cliff affects Virginia. There are several potential effects depending on what the final package looks like. Let’s assume the deductions for the Child Care Tax Credit, EITC, and capital depreciation go away. This means, according to The Pew Center, where the state’s tax code is linked to the federal (like Virginia) tax revenues will increase. That’s because removing income tax deductions increases Adjusted Gross Income (AGI) on the individual’s income tax filing (or on the corporation’s filing) thus the income on which the government may levy tax increases. According to fellow Mercatus scholar, Jason Fichtner, that could amount to millions of dollars for a state.

On the federal budget side of the equation,the $109 billion in potential reductions is now equally shared between defense and non-defense spending. Of concern is the extent to which the region’s economy is dependent on this for employment. Nearly 20 percent of the region’s economy is linked to federal spending. Two points: The cuts are reductions in the rate of growth in spending. For defense spending, they are relatively small cuts representing a return to 2007 spending levels as Veronique points out. So, these reductions not likely to bring about the major shakeup in the regional economy that some fear. Secondly, the fact that these cuts are causing worry is well-taken. It highlights the importance of diversification in an economy.

Where revenues, or GDP, or employment in a region is too closely tied to one industry, a very large and sudden change in that industry can spell trouble. An analogy: New Jersey’s and New York’s dependence on financial industry revenues via their income tax structure led to a revenue shock when the market crashed in 2008, as the New York Fed notes.

On transportation spending there are some good proposals on the table in the legislature and the executive. Some involve raising the gas tax (which hasn’t been increased since 1986), and others involve tolls. The best way to raise transportation revenues is via taxes or fees that are linked to those using the roads. Now is no time to start punching more holes in the tax code to give breaks to favored industries (even if they are making Academy-award quality films) or to encourage particular activities.

Virginia’s in a good starting position to handle what may be in store for the US over the coming years. Virginia has a relatively flat tax structure with low rates. It has a good regulatory environment. This is one reason why people and businesses have located here.

Keep the tax and regulatory rules fair and non-discriminatory and let the entrepreneurs discover the opportunities. Don’t develop an appetite for debt financing. A tax system  is meant to collect revenues and not engineer individual or corporate behavior. Today, Virginia beats all of its neighbors in terms of economic freedom by a long shot. The goal for Virginia policymakers: keep it this way.

Here’s the clip

Giving Illinois local governments control over their workers’ pensions

The Chicago Tribune makes a “modest proposal” this week. Discouraged by the inaction of the Illinois General Assembly on state-wide pension reform, the editorial board supports the idea that costs for teacher pensions should be shifted and shared with local governments. Republicans, fearful of property tax hikes, don’t like the notion. But the Tribune makes a good point: the cost shift should be accompanied with the ability of local governments to directly negotiate with their employees minus the influence of Springfield. It’s an interesting idea.

Ultimately, pension reform must proceed according to certain principles that clarify the following:

a) What is the true and full value of the benefit? The market valuation principle.

b) How do you incentivize such a system to properly value, steward, and fund benefits? The principal-agent problem.

c) How do you connect the full employee wage/benefit bill with taxpayers who enjoy the services? The fiscal illusion problem.

Right now, it’s a mess. Government accounting is a still a jumble. (But the real value is always knowable via market valuation.) No entity currently has the incentive to properly value and fund these systems. And in fact, we continue to see risk-taking and the shifting of assets into alternative investments, the issuance of Pension Obligation Bonds, and the deferral of reforms. Politicians have a short-term horizon.

And then there is the problem of “disjointed finance.”

Take the case of New Jersey. Local governments negotiate with their employees over wages. But pension policy is set by the state. New Jersey municipalities get an annual bill to fund their employee pensions based on the state actuary’s calculations. Local officials don’t have any sense of what those obligations look like going forward. The state’s annual funding calculations low-ball what is needed to fund the benefits. Could it be that such opacity leads local governments to offer wage enhancements, or hiring increases, that translate into total compensation packages that they can’t afford?

The Chicago Tribune’s idea only works if Illinois local governments accurately calculate what is needed on an annual basis to fund the pensions they negotiate with their workers and to have a full assessment of the value of compensation packages over time. How is market valuation incentivized? Perhaps Moody’s move to calculate pensions based on a corporate bond yield will have an effect. Or perhaps plans need to be managed by a third-party, as Roman Hardgrave and I suggest in our 2011 paper. 

Tying local costs to local taxpayers is a good idea. Another phenomenon the pension problem has revealed is gradual separation of taxing and spending in American public finance over the course of the past half century. That has produced a growing fiscal illusion in finance – where things seem less expensive than they actually are since the costs are spread over larger groups of taxpayers. Local costs are spread among state taxpayers, and now the worry is that state pension costs and debts will be spread across national taxpayers. At least, it’s been suggested.

In his 2012 budget, Governor Quinn alluded to a federal government guarantee  of Illinois’ pension debt. It’s not a popular idea with Congress at the moment. But it appears to have been part of the political calculations of those who are responsible designing and enforcing the rules that guide Illinois’ budget and determine pension policy.

 

 

 

 

The Problem with States’ Rights

This week, Eileen Norcross hosted a fiscal federalism symposium, bringing together scholars of various disciplines to discuss some of the challenges that our system of federalism faces today. Part of the discussion centered around Michael Greve’s new book The Upside-Down Constitution.

One of his key points is a reminder of the reason federalists believed that states’ rights are important. We shouldn’t care about states’ rights for the sake of states’ rights — states are merely groups of residents. Rather, we should care about people’s rights, and how these can be better protected in a federalist system than under a centralized government. This distinction sometimes gets lost when people advocate states’ rights rather than states’ enumerated powers. The problem with advocating states’ rights is that this nuance paves the way for states to collude rather than to compete.

A clear example of this collusion happened in 1984 when Congress passed the National Minimum Drinking Age Act. Because setting a drinking age does not fall under the federal government’s enumerated powers, when Congress wanted to change the rules in this area, it had to bargain using tax dollars. States that kept a drinking age in place below 21 would have lost 10-percent of their federal highway funding dollars.

While this may sound like the federal government is coercing the states, it’s key to remember that the goal of federalism is individuals’ rights. With the National Minimum Drinking Age Act, the states and federal government colluded to bring an end to competition in policy. This Act made state policy in this area the same, taking away Americans’ opportunity to choose to live in states with lower drinking ages.

When multiple levels of government pay for a given service, such as roads, many opportunities arise for this type of collusion, leading to the growth of government and the erosion of competition between governments. A competitive federalism means both that governments have incentives to provide the policy environments that their residents want and that people will have greater variety of policy climates to choose from. If the drinking age is an important issue to a family, competitive federalism could provide them with the option of living in a city or state with a higher or lower minimum age.

In the coming year, we hope to pursue research exploring what institutions limit competition within American federalism and what institutions prevent collusion between the federal, state, and local jurisdictions.