Category Archives: Public Choice

Today’s public policies exacerbate our differences

The evidence that land-use regulations harm potential migrants keeps piling up. A recent paper in the Journal of Urban Economics finds that young workers (age 22 – 26) of average ability who enter the labor force in a large city (metropolitan areas with a population > 1.5 million) earn a wage premium equal 22.9% after 5 years.

The author also finds that high-ability workers experience additional wage growth in large cities but not in small cities or rural areas. This leads to high-ability workers sorting themselves into large cities and contributes an additional 3.2% to the urban wage-growth premium.

These findings are consistent with several other papers that have analyzed the urban wage premium. Potential causes of the wage premium are faster human capital accumulation in denser, more populated places due to knowledge spillovers and more efficient labor markets that better match employers and employees.

The high cost of housing in San Francisco, D.C., New York and dozens of other cities is preventing many young people from earning more money and improving their lives. City officials and residents need to strike a better balance between maintaining the “charm” of their neighborhoods and affordability. This means less regulation and more building.

City vs. rural is only one of the many dichotomies pundits have been discussing since the 2016 election. Some of the other versions of “two Americas” are educated vs. non-educated, white collar vs. blue collar, and rich vs. poor. We can debate how much these differences matter, but to the extent that they are an issue for the country our public policies have reinforced the barriers that allow them to persist.

Occupational licensing makes it more difficult for blue-collar manufacturing workers to transition to middle-class service sector jobs. Federal loan subsidies have made four-year colleges artificially cheap to the detriment of people with only a high school education. Restrictive zoning has made it too expensive for many people to move to places with the best labor markets. And once you’re in a city, unless you’re in one of the best neighborhoods your fellow citizens often keep employers and providers of much needed consumer staples like Wal-Mart out, while using eminent domain to build their next playground.

Over time people have sorted themselves into different groups and then erected barriers to keep others out. Communities do it with land-use regulations, occupations do it with licensing and established firms do it with regulatory capture. If we want a more prosperous America that de-emphasizes our differences and provides people of all backgrounds with opportunity we need more “live and let live” and less “my way or the highway”.

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.

What else can the government do for America’s poor?

This year marks the 20th anniversary of the 1996 welfare reforms, which has generated some discussion about poverty in the U.S. I recently spoke to a group of high school students on this topic and about what reforms, if any, should be made to our means-tested welfare programs.

After reading several papers (e.g. here, here and here), the book Hillbilly Elegy, and reflecting on my own experiences I am not convinced the government is capable of doing much more.

History

President Lyndon Johnson declared “War on Poverty” in his 1964 state of the union address. Over the last 50 years there has been some progress but there are still approximately 43 million Americans living in poverty as defined by the U.S. Census Bureau.

Early on it looked as if poverty would be eradicated fairly quickly. In 1964, prior to the “War on Poverty”, the official poverty rate was 20%. It declined rapidly from 1965 to 1972, especially for the most impoverished groups as shown in the figure below (data from Table 1 in Haveman et al. , 2015). (Click to enlarge)

poverty-rate-1965-72

Since 1972 the poverty rate has remained fairly constant. It reached its lowest point in 1973—11.1%—but has since fluctuated between roughly 11% and 15%, largely in accordance with the business cycle. The number of people in poverty has increased, but that is unsurprising considering the relatively flat poverty rate coupled with a growing population.

census-poverty-rate-time-series-2015

Meanwhile, an alternative measure called the supplemental poverty measure (SPM) has declined, but it was still over 15% as of 2013, as shown below.

poverty-rate-time-series

The official poverty measure (OPM) only includes cash and cash benefits in its measure of a person’s resources, while the SPM includes tax credits and non-cash transfers (e.g. food stamps) as part of someone’s resources when determining their poverty status. The SPM also makes adjustments for local cost of living.

For example, the official poverty threshold for a single person under the age of 65 was $12,331 in 2015. But $12,331 can buy more in rural South Carolina than it can in Manhattan, primarily because of housing costs. The SPM takes these differences into account, although I am not sure it should for reasons I won’t get into here.

Regardless of the measure we look at, poverty is still higher than most people would probably expect considering the time and resources that have been expended trying to reduce it. This is especially true in high-poverty areas where poverty rates still exceed 33%.

A county-level map from the Census that uses the official poverty measure shows the distribution of poverty across the 48 contiguous states in 2014. White represents the least amount of poverty (3.2% to 11.4%) and dark pink the most (32.7% to 52.2%).

us-county-poverty-map

The most impoverished counties are in the south, Appalachia and rural west, though there are pockets of high-poverty counties in the plains states, central Michigan and northern Maine.

Why haven’t we made more progress on poverty? And is there more that government can do? I think these questions are intertwined. My answer to the first is it’s complicated and to the second I don’t think so.

Past efforts

The inability to reduce the official poverty rate below 10% doesn’t appear to be due to a lack of money. The figure below shows real per capita expenditures—sum of federal, state and local—on the top 84 (top line) and the top 10 (bottom line) means-tested welfare poverty programs since 1970. It is from Haveman et al. (2015).

real-expend-per-capita-on-poverty-programs

There has been substantial growth in both since the largest drop in poverty occurred in the late 1960s. If money was the primary issue one would expect better results over time.

So if the amount of money is not the issue what is? It could be that even though we are spending money, we aren’t spending it on the right things. The chart below shows real per capita spending on several different programs and is also from Haveman et al. (2015).

expend-per-cap-non-medicaid-pov-programs

Spending on direct cash-assistance programs—Aid for Families with Dependent Children (AFDC) and Temporary Assistance for Needy Families (TANF)—has fallen over time, while spending on programs designed to encourage work—Earned Income Tax Credit (EITC)—and on non-cash benefits like food stamps and housing aid increased.

In the mid-1970s welfare programs began shifting from primarily cash aid (AFDC, TANF) to work-based aid (EITC). Today the EITC and food stamps are the core programs of the anti-poverty effort.

It’s impossible to know whether this shift has resulted in more or less poverty than what would have occurred without it. We cannot reconstruct the counterfactual without going back in time. But many people think that more direct cash aid, in the spirit of AFDC, is what’s needed.

The difference today is that instead of means-tested direct cash aid, many are calling for a universal basic income or UBI. A UBI would provide each citizen, from Bill Gates to the poorest single mother, with a monthly cash payment, no strings attached. Prominent supporters of a UBI include libertarian-leaning Charles Murray and people on the left such as Matt Bruenig and Elizabeth Stoker.

Universal Basic Income?

The details of each UBI plan vary, but the basic appeal is the same: It would reduce the welfare bureaucracy, simplify the process for receiving aid, increase the incentive to work at the margin since it doesn’t phase out, treat low-income people like adults capable of making their own decisions and mechanically decrease poverty by giving people extra cash.

A similar proposal is a negative income tax (NIT), first popularized by Milton Friedman. The current EITC is a negative income tax conditional on work, since it is refundable i.e. eligible people receive the difference between their EITC and the taxes they owe. The NIT has its own problems, discussed in the link above, but it still has its supporters.

In theory I like a UBI. Economists in general tend to favor cash benefits over in-kind programs like vouchers and food stamps due to their simplicity and larger effects on recipient satisfaction or utility. In reality, however, a UBI of even $5,000 is very expensive and there are public choice considerations that many UBI supporters ignore, or at least downplay, that are real problems.

The political process can quickly turn an affordable UBI into an unaffordable one. It seems reasonable to expect that politicians trying to win elections will make UBI increases part of their platform, with each trying to outdo the other. There is little that can be done, short of a constitutional amendment (and even those can be changed), to ensure that political forces don’t alter the amount, recipient criteria or add additional programs on top of the UBI.

I think the history of the income tax demonstrates that a relatively low, simple UBI would quickly morph into a monstrosity. In 1913 there were 7 income tax brackets that applied to all taxpayers, and a worker needed to make more than $20K (equivalent to $487,733 in 2016) before he reached the second bracket of 2% (!). By 1927 there were 23 brackets and the second one, at 3%, kicked in at $4K ($55,500 in 2016) instead of $20K. And of course we are all aware of the current tax code’s problems. To chart a different course for the UBI is, in my opinion, a work of fantasy.

Final thoughts

Because of politics, I think an increase in the EITC (and reducing its error rate), for both working parents and single adults, coupled with criminal justice reform that reduces the number of non-violent felons—who have a hard time finding employment upon release—are preferable to a UBI.

I also support the abolition of the minimum wage, which harms the job prospects of low-skilled workers. If we are going to tie anti-poverty programs to work in order to encourage movement towards self-sufficiency, then we should make it as easy as possible to obtain paid employment. Eliminating the minimum wage and subsidizing income through the EITC is a fairer, more efficient way to reduce poverty.

Additionally, if a minimum standard of living is something that is supported by society than all of society should share the burden via tax-funded welfare programs. It is not philanthropic to force business owners to help the poor on behalf of the rest of us.

More economic growth would also help. Capitalism is responsible for lifting billions of people out of dire poverty in developing countries and the poverty rate in the U.S. falls during economic expansions (see previous poverty rate figures). Unfortunately, growth has been slow over the last 8 years and neither presidential candidate’s policies inspire much hope.

In fact, a good way for the government to help the poor is to reduce regulation and lower the corporate tax rate, which would help economic growth and increase wages.

Despite the relatively high official poverty rate in the U.S., poor people here live better than just about anywhere else in the world. Extreme poverty—think Haiti—doesn’t exist in the U.S. On a consumption rather than income basis, there’s evidence that the absolute poverty rate has fallen to about 4%.

Given the way government functions I don’t think there is much left for it to do. Its lack of local knowledge and resulting blunt, one size fits all solutions, coupled with its general inefficiency, makes it incapable of helping the unique cases that fall through the current social safety net.

Any additional progress will need to come from the bottom up and I will discuss this more in a future post.

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.

The cost disease and the privatization of government services

Many US municipalities are facing budget problems (see here, here, and here). The real cost of providing traditional public services like police, fire protection, and education is increasing, often at a rate that exceeds revenue growth. The graph below shows the real per-capita expenditure increase in five US cities from 1951 to 2006. (Data are from the census file IndFin_1967-2012.zip and are adjusted for inflation using the US GDP chained price index.)

real per cap spend

In 1951 none of the cities were spending more than $1,000 per person. In 2006 every city was spending well over that amount, with Buffalo spending almost $5,000 per person. Even Fresno, which had the smallest increase, increased per capita spending from $480 to $1,461 – an increase of 204%. Expenditure growth that exceeds revenue growth leads to budget deficits and can eventually result in cuts in services. Economist William Baumol attributes city spending growth to what is known as the “cost disease”.

In his 1967 paper, Baumol argues that municipalities will face rising costs of providing “public” goods and services over time as the relative productivity of labor declines in the industries controlled by local governments versus those of the private sector. As labor in the private sector becomes more productive over time due to increases in capital, wages will increase. Goods and services traditionally supplied by local governments such as police, fire protection, and education have not experienced similar increases in capital or productivity. K-12 education is a particularly good example of stagnation – a teacher from the 1950s would not confront much of a learning curve if they had to teach in a 21st century classroom. However, in order to attract competent and productive teachers, for example, local governments must increase wages to levels that are competitive with the wages that teachers could earn in the private sector. When this occurs, teacher’s wages increase even though their productivity does not. As a result, cities end up paying more money for the same amount of work. Baumol sums up the effect:

“The bulk of municipal services is, in fact, of this general stamp [non-progressive] and our model tells us clearly what can be expected as a result…inexorably and cumulatively, whether or not there is inflation, administrative mismanagement or malfeasance, municipal budgets will almost certainly continue to mount in the future, just as they have been doing in the past. This is a trend for which no man and no group should be blamed, for there is nothing than can be done to stop it.” (Baumol, 1967 p.423)

But is there really nothing than can be done to cure the cost disease? Baumol himself later acknowledged that innovation may yet occur in the relatively stagnant sectors of the economy such as education:

“…an activity which is, say, relatively stagnant need not stay so forever. It may be replaced by a more progressive substitute, or it may undergo an outburst of innovation previous thought very unlikely.” (Baumol et al. 1985, p.807).

The cure for the cost disease is that the stagnant, increasing-cost sectors need to undergo “an outburst of innovation”. But this raises the question; what has prevented this innovation from occurring thus far?

One thing that Baumol’s story ignores is public choice. Specifically, is the lack of labor-augmenting technology in the public-sector industries a characteristic of the public sector? The primary public sector industries have high rates of unionization and the primary goal of a labor union is to protect its dues-paying members. The chart below provides the union affiliation of workers for several occupations in 2013 and 2014.

union membership chart

In 2014, the protective service occupations and education, training, and library occupations, e.g. police officers and teachers, had relatively high union membership rates of 35%. Conversely, other high-skilled occupations such as management, computer and mathematical occupations, architecture and engineering occupations, and sales and office occupations had relatively low rates, ranging from 4.2% to 6.5% in 2014. Installation, maintenance, and repair occupations were in the middle at 14.6%, down from 16.1% in 2013.

The bottom part of the table shows the union membership rate of the public sector in general and of each level of government: federal, state, and local. The highest rate of unionization was at the local level, where approximately 42% of workers were members of a union in 2014, up from 41% in 2013. This is about 14 percentage points higher than the federal level and 12 percentage points higher than the state level. The union membership rate of the private sector in 2014 was only 6.6%.

In addition to the apathetic and sometimes hostile view unions have towards technological advancement and competition, union membership is also associated with higher wages, particularly at the local-government level. Economists Maury Gittleman and Brooks Piece of the Bureau of Labor statistics found that local-government workers have compensation costs 10 – 19% larger than similar private sector workers.

The table below shows the median weekly earnings in 2013 and 2014 for workers in the two most heavily unionized occupational categories; education, training, and library occupations and protective service occupations. In both occupation groups there is a substantial difference between the union and non-union weekly earnings. From the taxpayer’s perspective, higher earnings mean higher costs.

union median wage chart

There needs to be an incentive to expend resources in labor-saving technology for it to occur and it is not clear that this incentive exists in the public sector. In the public sector, taxpayers ultimately pay for the services they receive but these services are provided by an agent – the local politician(s) – who is expected to act on the taxpayer’s behalf when it comes to spending tax dollars. But in the public sector the agent/politician is accountable to both his employees and the general taxpayer since both groups vote on his performance. The general taxpayer wants the politician to cut costs and invest in labor-augmenting technology while the public-employee taxpayer wants to keep his job and earn more income. Since the public-employee unions are well organized compared to the general taxpayers it is easier for them to lobby their politicians/bosses in order to get their desired outcome, which ultimately means higher costs for the general taxpayer.

If Baumol’s cost disease is the primary factor responsible for the increasing cost of municipal government then there is not an easy remedy in the current environment. If the policing, firefighting, and education industries are unreceptive to labor-augmenting technology due to their high levels of unionization and near-monopoly status, one potential way to cure municipalities of the cost disease is privatization. In their 1996 paper, The Cost Disease and Government Growth: Qualifications to Baumol, economists J. Ferris and Edwin West state “Privatization could lead to significant changes in the structure of supply that result in “genuine” reductions in real costs” (p. 48).

Schools, police, and fire services are not true public goods and thus economic efficiency does not dictate that they are provided by a government entity. Schools in particular have been successfully built and operated by private funds for thousands of years. While there are fewer modern examples of privately operated police and fire departments, in theory both could be successfully privatized and historically fire departments were, though not always with great success. However, the failures of past private fire departments in places like New York City in the 19th century appear to be largely due to political corruption, an increase in political patronage, poorly designed incentives, and the failure of the rule of law rather than an inherent flaw in privatization. And today, many volunteer fire departments still exist. In 2013 69% of all firefighters were volunteers and 66% of all fire departments were all-volunteer.

The near-monopoly status of government provided education in many places and the actual monopoly of government provided police and fire protection makes these industries less susceptible to innovation. The government providers face little to no competition from private-sector alternatives, they are highly unionized and thus have little incentive to invest in labor-saving technology, and the importance of their output along with the aforementioned lack of competition allows them to pass cost increases on to taxpayers.

Market competition, limited union membership, and the profit-incentive are features of the private sector that are lacking in the public sector. Together these features encourage the use of labor-augmenting technology, which ultimately lowers costs and frees up resources, most notably labor, that can then be used on producing other goods and services. The higher productivity and lower costs that result from investments in productive capital also free up consumer dollars that can then be used to purchase additional goods and services from other industries.

Privatization of basic city services may be a little unnerving to some people, but ultimately it may be the only way to significantly bring down costs without cutting services. There are over 19,000 municipal governments in the US, which means there are over 19,000 groups of citizens that are capable of looking for new and innovative ways to provide the goods and services they rely on. In the private sector entrepreneurs continue to invent new things and find ways to make old things better and cheaper. I believe that if we allow entrepreneurs to apply their creativity to the public sector we will get similar outcomes.

An interesting development in state regulation of wine shipment

Can one state enforce another state’s laws that prohibit direct-to-consumer wine shipment from out-of-state retailers while allowing it by in-state retailers?  That’s the question posed in a recent New York case.

The New York State Liquor Authority has a rule that prohibits licensees from engaging in “improper conduct.”  The liquor regulator argues that direct shipments by retailers that violate other states’ laws constitute improper conduct.  It has fined, revoked licenses, and filed charges against New York retailers that it believes have shipped wine illegally to customers in other states. One retailer, Empire Wine, refused to settle and has sued the liquor authority in state court, claiming that the “improper conduct” rule is unconstitutionally vague and that the liquor authority cannot enforce other states’ laws that discriminate against interstate commerce.

Many states continue to prohibit direct shipment from out-of-state retailers. For example, 40 states do not allow New York retailers to ship directly to consumers.  This harms consumers, because it is usually out-of state-retailers, rather than wineries, that offer significant savings compared to in-state retailers. In a 2013 article published in the Journal of Empirical Legal Studies, Alan Wiseman and I identified two different anti-consumer effects of laws that allow out-of-state wineries to ship direct to consumer but prohibit out-of-state retailers from doing so. First, these laws deprive consumers of price savings from buying many bottles online: “Online retailers consistently offered price savings on much higher percentages of the bottles in each year—between 57 and 81 percent of the bottles when shipped via ground and between 32 and 48 percent when shipped via air. Excluding retailers from direct shipment thus substantially reduces—but does not completely eliminate—the price savings available from purchasing wine online.” Second, these laws reduce competitive pressure on bricks-and-mortar wine stores, since they exclude lower-priced out-of-state retailers from the local market. Thus, the laws likely harm consumers who buy from their local wine shops, not just consumers who want to buy online. (The published version of the paper is behind a paywall, but you can read the working paper version at SSRN.)

(Photo credit: http://srxawordonhealth.com/2011/07/11/exercise-in-a-bottle/)

 

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.

Strong words from the SEC on Public Sector Pensions

As state and local governments begin to pull back the curtain on the true value of their pension liabilities with the implementation of GASB 68, Daniel Gallagher, Commissioner of the SEC issued an important statement last week, noting in plain terms that how governments measure their liabilities would have serious repercussions in the private sector. Here’s part of the remarks worth considering:

 …for years, state and local governments have used lax governmental accounting standards to hide the yawning chasm in their balance sheets…

The riskiness of a pension obligation depends on state law.[32]  If pension obligations have the same preference as general obligation debt, then the municipality’s own municipal bond yield (generally around 5%) would be the proper discount rate.[33]  Or, if as we’ve seen from Detroit, pensions will be saved before all else, then we should use a default-free measure to discount the liability:  specifically, the Treasury zero-coupon yield curve.[34]  This would result in a discount rate in the low 3% range.

Obviously, the higher the discount rate, the lower the present value of the liability.  The difference between a discount rate in the range of seven percent and one in the range of three percent is in large part responsible for the hidden $3 trillion in unfunded liabilities that are currently going unreported.

This lack of transparency can amount to a fraud on municipal bond investors, and it does a disservice to state and local government workers and retirees by saving elected officials from making the hard choices either to fully fund the pension promises that were made to public employees,[35] or not to make the promises in the first place.

In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games.  And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions.  We should not treat municipalities any differently.”

GASB 68 asks that sponsors use a high- yield, tax exempt 20-year municipal GO bond only on the unfunded portion of the liability. This will reveal bigger funding gaps in public sector pension plans. But it does not reveal the full value of the liability since it allows sponsors to continue using the higher discount rates on the funded portion of the liability.

 In addition to using the new GASB standards, Commissioner Gallagher advises that governments should also disclose their pension liabilities on a risk-free basis. This would have the effect of showing the value of these promises on a ‘guaranteed-to-be-paid’ basis. Commissioner Gallagher’s suggestions are extremely sensible and a call to basic transparency in public sector liability reporting.

Ignoring the value of pension benefits is not going to make them cheaper to fund, and the longer a state waits to accurately measure the liabilities and payments, the worse it gets. Just ask New Jersey –  which is struggling to balance its budget and meet a fraction of a fraction of the required annual pension contribution to its state pension system. The situation is so dire that it could trigger yet another downgrade for the Garden State.

 

Is American Federalism conducive to liberty?

In new Mercatus research, Dr. Richard E. Wagner, Harris professor of Economics at George Mason University tackles a fascinating question: Is the American form of federalism supportive of liberty?

His answer is a qualified ‘yes.’ Under certain conditions, American federalism does support liberty, but that very same system can also be modified resulting in the expansion of political power relative to the liberty of citizens. The question of what results from the gradual constitutional transformation of the American federalist system is a salient one for not only students of government but also policymakers.

The important conditions that determine which form of federalism prevails (liberty-supporting or liberty-eroding) are rooted in competition among governments. Today we are experiencing a very different kind of federalism than the one instituted by the Founders. For the better part of a century, the US constitution has often been amended in a way to encourage collusion among the states thus undermining a key feature of a liberty-supporting federalism.

Restoring a liberty-supporting federalism first requires a deeper diagnosis of the American federalist system. Dr. Wagner develops that possibility through a very engaging synthesis of public choice theory, Austrian and new institutional economics.  Student of Dr. Wagner may be familiar with many of these concepts, developed in his public finance books including Deficits, Debt and Democracy (2012, Elgar). Rather than summarize the paper in today’s blog post, for now I encourage you to read the piece in full.

The “pension tapeworm” and Fiscal Federalism

In his annual report to shareholders, Warren Buffett cites the role that pension underfunding is playing in governments and markets:

“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made. During the next decade, you will read a lot of news –- bad news -– about public pension plans.”

He zones in on pension mathematics – “a mystery to most Americans” – as a possible reason for accelerating liabilities facing state and local governments including Puerto Rico, Detroit, New Jersey and Illinois. I might go further and state that pension mathematics remains a mystery to those with responsibility for, or interest in, these systems. It’s the number one reason why reforms have been halting and inadequate to meet the magnitude of the problem. But as has been mentioned on this blog before: the accounting will eventually catch up with the economics.

What that means is unrelenting pressure building in municipal budgets including major cities. MSN Money suggests the possibility of bankruptcy for Los Angeles, Chicago and New York City based on their growing health care and pension liabilities.

In the context of this recent news and open talk of big municipal bankruptcy, I found an interesting analysis by Paul E. Peterson and Daniel J. Nadler in “The Global Debt Crisis Haunting U.S. and European Federalism.”(Brookings Institution Press, 2014).

In their article, “Competitive Federalism Under Pressure,” they find a positive correlation between investors’ perception of default risk on state bonds and the unionization rate of the public sector workforce. While cautioning that there is much more at work influencing investors’ views, I think their findings are worth mentioning since one of the biggest obstacles to pension reform has been the reluctance of interested parties to confront the (actual) numbers.

More precisely, it leads to a situation like the one now being sorted out in federal bankruptcy court in Detroit. Pensioners have been told by Emergency Manager Kevyn Orr that if they are willing to enter into a “timely settlement” with the city and state, they may see their pensions reduced by less than the 10 to 30 percent now suggested. Meanwhile bondholders are looking at a haircut of up to 80 percent.

If this outcome holds for Detroit, then Peterson and Nadler’s findings help to illuminate the importance of collective bargaining rules on the structure of American federalism by changing the “rules of the game” in state and local finances. The big question for other cities and creditors: How will Detroit’s treatment of pensions versus bonds affect investors’ perception of credit risk in the municipal debt market?

But there are even bigger implications. It is the scenario of multiple (and major) municipal bankruptcies that might lead to federalism-altering policy interventions, Peterson and Nadler conclude their analysis with this observation:

[public sector] Collective bargaining has, “magnified the risk of state sovereign defaults, complicated the resolution of deficit problems that provoke such crises, heightened the likelihood of a federal intervention if such crises materializes, and set the conditions for a transformation of the country’s federal system.”