Category Archives: Tax and Budget

Banking on risky investments is no way to guarantee a public pension

Over the past several years I’ve spent a lot of time studying public pension systems. That’s involved diving into the economics and actuarial literature, reading through many individual plan reports, and analyzing the trends in those systems in the context of the principles of financial economics. Why do this? It isn’t just a public finance problem. Twenty million Americans participate in these plans. If research points to systematic structural weaknesses in public sector plans, that under the right conditions, can lead to plan failure, then it is an imperative to point it out and recommend solutions to ensure that retirees receive the pensions they’ve been promised without placing unnecessary burdens on taxpayers or forcing painful budget tradeoffs at the worst possible time: during a recession.

The only way to protect pensions is to accurately assess their true value and funded status and then contribute what is needed to pay out those benefits. Unfortunately, the story of US public sector pension is that they are built on investment risk and accounting illusions.

Pension finance is not without controversy. Misunderstandings can arise in part due to the very different approaches taken by financial economists and traditionally trained actuaries over how to most appropriately value pension liabilities and assets, as well as the nature of investment risk.

However, some of the conflict is due to the implications of the pension literature. Applying the economic approach to valuing pension fund liabilities reveals trillions more in obligations and far bigger funding gaps for states and cities. It shows how public sector plans have exposed themselves to an unwise amount of investment risk effectively linking guaranteed pension payments to market volatility and putting taxpayers on the hook for losses. Some state and local governments have responded to this debate either through small accounting reforms or policy changes meant to shore up pension systems. These reforms are not necessarily sufficient but it’s a tacit recognition that the math really matters.

There are some plans that continue to staunchly defend a “More investment risk = safe and guaranteed pension with no downsides” approach. And at least one system has gone on the offense against any suggestion that increasing investment risk in a government-guaranteed pension system amounts to gambling with employees’ pension benefits.

In May 2014 I authored a paper that made the case for economic accounting and better funding for Alabama’s three state-run pension plans.[1] My study was featured in The Advisor in July 2014, the newsletter the Retirement Systems of Alabama (RSA) provides to its members.[2] One article written by “RSA staff” purports to debunk my paper, but ends up missing the implications of both the literature and my analysis.

The RSA staff’s main complaint revolves around one sentence in which I cite a peer-reviewed 2010 study in the National Tax Journal by Joshua Rauh entitled, “Are State Public Pension Plans Sustainable?[3] Rauh finds that, without policy changes, Alabama might run out of assets to pay benefits by 2023, necessitating the move to a pay as you go system. To be sure, that is a sobering claim.

The RSA staff argues that the runout date calculated by Rauh is based on “bad data” from 2006, when Alabama offered a 3.5 percent ad hoc Cost of Living Adjustment (COLA). It further contends the runout date is based on the assumption of a risk-free discount rate and asset values from 2009, and this all unfairly inflates liabilities and cherry-picks a low-point for asset values. In addition, Rauh assumes that the plan only pays for normal costs going forward (not for past benefits), in keeping with the contribution behavior of most plans at the time of the study.

The first two claims by the RSA staff are incorrect. In the “run-out dates” paper, Rauh’s data is assembled from, “the individual plans and the Center for Retirement Research on a plan-by-plan basis.”[4] This dataset was originally developed for a previous peer-reviewed paper with Robert Novy-Marx entitled, “Public Pension Promises: How Big Are They and What Are They Worth?” which drew from the individual Comprehensive Annual Financial Reports (CAFRs) of 116 state-sponsored pension plans.[5] Nine data items were taken from the pension plan CAFRs that were available as of December 31, 2008. (The FY 2008 CAFR contains data for 2007 that the authors project to 2009). These CAFR-derived items are:

  • the plans’ stated liability
  • its state-chosen discount rate
  • the actuarial method (EAN or PUC)
  • a benefit factor
  • a Cost of Living Adjustment
  • an inflation assumption
  • the share of active workers in the plan;
  • the share of retired workers in the plan; and
  • the dollar amount of benefits paid in the most recent year.

The third item – the actuarial method – was drawn from both the CAFR and information from the Center for Retirement Research at Boston College as of 2006.[6]

Novy-Marx and Rauh estimated a total of $42 billion projected liabilities as of June 2009 for all three of Alabama’s plans. [7] The authors’ estimate closely matches the reported value of $41.6 billion in September 30, 2009 in RSA’s FY 2010 CAFR. Novy-Marx and Rauh re-calculate the value of state promised pension liabilities when valued based on risk-free Treasury bonds. They find that Alabama’s total liabilities of $42 billion increase to $61.8 billion when discounted using the risk-free Treasury rate.

Their paper triggered a lot of attention. Clearly, the finding that GASB 25 was leading state plans to obscure the true size of their pension liabilities generates a lot of follow-up questions, such as, “When will they run out of money?”

In a subsequent paper Rauh (2010) tackles this very question. His assumptions are key to interpreting the run out date. Beginning with the data that he and Novy-Marx assembled, Rauh models the cash flows of these pension plans under the rate of return assumed by the plan itself, in the case of Alabama: 8 percent. A further assumption is made that future contributions to the plan will be equal in value to the benefits earned by employees in that year, “an assumption broadly in keeping with states’ recent contribution behavior.”[8] If the state fully funds benefits as they are accrued how long will the assets last under the assumption that the plans earn 8 percent each year?

Under an 8 percent discount rate with no COLA, and only funding the normal cost, Rauh projects that the RSA will run out of assets in 2023. The implication is that state contributions will have to increase, placing a greater demand on state budgets, necessitating increased taxes or cuts to spending. One thing going in Alabama’s favor is that they have a history of making the full contribution each year. However, this contribution amount is calculated under optimistic assumptions that I demonstrate in the paper are based on assuming a large amount of investment risk. And that is where the danger lies.

Contrary to the RSA staff’s claim:

  • There is no COLA assumption in Rauh’s 2010 run-out date study
  • The run out date of 2023 is based on a discount rate of 8 percent.

The RSA staff is correct to note that Rauh’s calculation is based on only paying the normal cost. Since Alabama has a history of making the full annual contribution this will help the system to forestall a run-out. The question is by how much, by how many years? As long as the RSA assumes an 8 percent discount rate and embraces a risky investment strategy they are operating under an accounting illusion that leads them to low-ball the annual contribution needed to fund the system.

If the market has a great run over the next decade with returns exceeding 8 percent per year and the RSA continues to to pay 100 percent of the ARC under these conditions it would stay solvent. The RSA points to the fact that between 2009 and today its assets have grown by 46 percent, or $35 billion. [9]

But there’s another problem. The RSA’s funded status continues its decade-long drop. Let’s look at Alabama’s assets, liabilities, and funded status of the plan between 2008 and 2013 (the most recent data available) taken from the plan CAFRs, with no adjustments to the data. The trend is clear. Liabilities are growing faster than the assets. Funding ratios are falling.

For Teachers’ Retirement System (TRS) over the period the total actuarial value of assets fell by six percent from $20.8 billion to $19.6 billion, while total liabilities grew from $26 billion to $29 billion (11 percent), leaving the system with a funded ratio of 66 percent.

Table 1. Teachers Retirement System Actuarial Accrued Liability and Actuarial Assets (2008-2013) Adjusted for Inflation

($ mil) 2008 2009 2010 2011 2012 2013 % change 2008-2014
TRS Liabilities $26,804 $27,537 $28,299 $28,776 $28,251 $29,665 11%
TRS Assets  $20,812 $20,582 $20,132 $19,430 $18,786 $19,629 -6%

Source: Comprehensive Annual Financial Report (CAFR) for Retirement System of Alabama (RSA) FY 2009-2014.

The same story can be told of the Employees Retirement System (ERS). Assets fell by 4 percent as liabilities grew by 11 percent over the period. The ERS is currently funded at 65 percent, down from 77 percent in 2009. Four years of increased returns have not reversed the decline.

Table 2. Employees’ Retirement System Actuarial Accrued Liabilities and Actuarial Assets 2008-2013

($ mil) 2008 2009 2010 2011 2012 2013 % change 2008-2014
ERS Liabilities $13,078 $13,756 $14,248 $14,366 $13,884 $14,536 11%
ERS Assets $9,905 $9,928 $9,739 $9,456 $9,116 $9,546 -4%

Source: Comprehensive Annual Financial Report (CAFR) for Retirement System of Alabama (RSA) FY 2009-2014

The Judicial Retirement Fund (JRF) had the steepest increase in liabilities. Assets fell by 6 percent and liabilities grew by 28 percent. JRF is the most weakly funded at 58 percent.

Table 1. Judicial Retirement System Actuarial Accrued Liability and Actuarial Assets (2008-2013) Adjusted for Inflation

($ mil) 2008 2009 2010 2011 2012 2013 % change 2008-2014
JRF Liabilities $323 $340 $358 $393 $380 $414 28%
JRF Assets $259 $252 $246 $235 $234 $243 -6%

Source: Comprehensive Annual Financial Report (CAFR) for Retirement System of Alabama (RSA) FY 2009-2014

Looking back at the decade shows an even more dramatic trend. These systems began 2003 with funding levels of 90 percent. They have fallen every year since to their current levels of between 66 percent and 58 percent.

The RSA has stated in the past that 80 percent funding is good enough and that investing assets in a risky portfolio currently comprised of 70 percent equities will enable the system to comfortably meet its obligations. But as these funding trends show a volatile portfolio comes with a downside. The assets may be back to where they were five years ago, but in the meantime, liabilities continue their steady growth.

The next observation the RSA staff makes is that these numbers are too bleak since they are based on 2009 asset values. Since then the assets have grown by 11 percent on average over the period. To be sure, once you exclude 2008, things look better. But that’s a bit like excluding the F when you calculate your average grade for the semester. Ignoring the downturn doesn’t mean it didn’t happen or that it didn’t erode the assets. It takes exceptional and sustained performance to make up for it.

The five and 10-year period tell a less bullish story.

Annualized returns for the RSA for the Fiscal Year ended September 30, 2013. (p. 60)

Total Portfolio 1 year Last 3 Years Last 5 Years Last 10 Years
TRS 14.93% 11.45% 6.68% 6.29%
ERS 14.6% 11.4% 6.17% 5.97%
JFR 14.05% 10.89% 8.74% 7.06%

While investments have rebounded for the RSA, plan funding status is falling despite increased contributions. Since 2012 employers and most employees are making bigger contributions to these plans. Alabama now operates a Two-tiered pension system. Tier 1 TRS and ERS employees (those hired before January 1, 2013) saw their individual contributions rates increase from 5 percent of pay in 2011 to 7.5 percent of pay in 2013. JRF members, firefighters, police officers and correctional officers contribution rates increased from 6 percent in 2011 to 8.25 percent of pay in 2013. Tier II members (those hired after January 1, 2013) will have lower contribution rates and diminished benefits. Both tiers will give something up.

Employers are also contributing more. The state’s contributions have increased. For the TRS (Tier 1 employees), the state’s contribution has risen from 6.3 percent of payroll in 2000 to 11.7 percent in 2014. Employer contributions for the ERS (Tier 1) rose from 4 percent to 12 percent of payroll over the same period. JRF has the largest employer contribution “In 2000, the state contribution to the JRF was 21 percent of payroll. It reached 35% by 2014.”

Rauh’s 2010 study points to a trend worth monitoring. Funding levels are dropping. Assets are not growing fast enough to keep up with the growth in liabilities necessitating more revenues, higher contributions or some other action. Yet the RSA staff points to its recent returns of 11%, as if that is something the RSA can sustain. The stock market does reward risk-taking with high returns in bull markets, but at a cost of negative returns in recession years like 2008. Increasing the risk of RSA assets to chase high stock market returns is banking on something neither the RSA nor anyone else can guarantee.

Valuing a guaranteed pension based on the expected returns of risky and volatile assets increases the chance of a funding shortfall. It is likely that Alabama will find it will need more revenue to fund the RSA. Already inadequate funding levels are falling. The investment portfolio is heavily exposed to market risk. And contribution rates are rising.

The RSA staff’s response to my research is part of a more general problem. Many of those responsible for public sector pensions think that investment risk can be ignored or it can just be passed on to taxpayers. The point of this entire body of literature drives home one theme consistently: public sector pension accounting flaunts the established principles of finance by claiming that there is no price for assuming investment risk. Financial theory can be abstract. But recent history gives us a demonstration of these core principles. Many pensions systems, the RSA included, have ignored the lessons of the Great Recession and are exposing pensions to even more investment risk.

[1] Eileen Norcross, “Pension Reform in Alabama: A Case for Economic Accounting,” in Improving Lives in Alabama: A Vision for Economic Freedom and Prosperity, The Johnson Center at Troy University, May 2014 (https://nebula.wsimg.com/35b439dc51fd0dae2bd46e38024dadd2?AccessKeyId=F0B126F45D4E1A4094F7&disposition=0&alloworigin=1)

[2] “Troy University Report on RSA has Erroneous Assumptions,” by RSA Staff, The Advisor, July 2014 (http://www.rsa-al.gov/uploads/files/Advisor_July2014.pdf)

[3] Joshua Rauh, “Are State Public Pension Plans Sustainable? Why the Federal Government Should Worry about State Pension Liabilities,” National Tax Journal 63(3) p. 585-601, May 2010. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1596679)

[4] Ibid, p. 6 and p. 9.

[5] Robert Novy-Marx and Joshua Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?” Journal of Finance 66 (4), 1211-1249, 2011 (http://www.jstor.org/stable/29789814?seq=1#page_scan_tab_contents)

[6] Ibid p. 1224, “The actuarial method (item 3) combines our own data collection with information from the state and local pension data made available by the Center for Retirement Research (2006.)

[7] Ibid, p. 1239

[8] Rauh, (2010) “Are Public Pensions Sustainable?” p. 2.

 

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.

State government spending hits new heights

There is a large literature in macroeconomics that examines the extent to which federal spending “crowds out” investment in the private sector. Basic theory and common sense lead to the conclusion that government spending must replace some private sector spending. After all, dollars are scarce – if the government taxes Paul and uses his money to build a road Paul necessarily has less money to invest in his landscaping business. In theory government spending on public goods like roads could be a net gain. This would occur if the additional value produced by spending one more dollar on roads was greater than the additional value produced by investing one more dollar in Paul’s landscaping business. But even in this scenario, Paul himself may be worse off – he’s one dollar poorer and he may not use the new road – and there is still a dead-weight loss due to the tax.

In reality, the federal government does a lot more than build roads, especially productive ones. In 2014, only 1.9% of federal income tax revenue was spent on transportation. And most of the other stuff that the government does is way less productive, like shuffling money around via entitlement programs – Medicare, Medicaid, and Social Security – and investing in businesses that later go bankrupt like Solyndra. So while it is possible that a dollar spent by the government is more productive than a dollar spent by a guy like Paul, in a country with America’s spending habits it’s unlikely to be the case.

The same crowding out that occurs at the federal level can occur at the state level. In fact, in many states state spending as a percentage of gross state product (GSP) exceeds federal spending as a percentage of GDP. The graph below shows state spending as a percentage of GSP for all 50 states and Washington D.C. in 1970, 1990, and 2012 (data). The red, dashed line is federal spending as a percentage of GDP in 2012 (21.9%).

state spending gsp graph

As shown in the graph, nearly every state increased their spending relative to GSP from 1970 – 2012 (triangles are above the X’s). Only one state, South Dakota, had lower spending relative to GSP in 2012 than in 1970. In 2012, 15 of the 50 states spent more as a percentage of GSP than the federal government spent as a percentage of GDP (states where the triangle is above the red, dashed line). In 1990 only two states, Arizona and Montana, spent at that level.

It used to be the case that state and local spending was primarily focused on classic government services like roads, water/sewer systems, police officers, firemen, and K-12 education. But state spending is increasingly looking similar to federal spending. Redistributive public welfare expenditures and pension expenditures have increased substantially since 1992. As an example, the tables below provide a breakdown of some key spending areas for two states, Ohio and Pennsylvania, in 1992 and 2012 (1992 data here, 2012 data here). The dollar per capita amounts are adjusted for inflation and are in 2009 dollars.

ohio spending table

penn spending table

As the tables show, spending on public welfare, hospitals, and health increased by 120% in Ohio and 86% in Pennsylvania from 1992 to 2012. Pension expenditures increased by 83% and 125% respectively. And contrary to what many politicians and media types say, funding for higher education – the large majority of state education spending is on higher education – increased dramatically during this time period; up 250% in Ohio and 199% in Pennsylvania. Meanwhile, funding for highways – the classic public good that politicians everywhere insist wouldn’t exist without them – has increased by a much smaller amount in both states.

The state spending increases of the recent past are being driven in large part by public welfare programs that redistribute money, pensions for government employees, and higher education. While one could argue that higher education spending is a productive public investment (Milton Friedman didn’t think so and I agree) it is hard to make a case that public welfare and pension payments are good investments. This alone doesn’t mean that society shouldn’t provide those things. Other factors like equity and economic security might be more important to some people than economic productivity. But this does make it unlikely that the marginal dollar spent by a state government today is as economically productive as that dollar spent in the private sector. Like federal spending, state spending is likely crowding out productive private investment, which will ultimately lower output and economic growth in the long run.

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.

More reasons why intergovernmental grants are harmful

In a recent blog post I explained how intergovernmental grants subsidize some businesses at the expense of others. But that is just one of several negative features of intergovernmental grants. They also make local governments less accountable for their fiscal decisions by allowing them to increase spending without increasing taxes. The Community Development Blog Grant (CDBG) money that local governments spend on city services or use to subsidize private businesses is provided by taxpayers from all over the country. Unlike locally raised money, when cities spend CDBG money they don’t have to first convince local voters to provide them with the funds. This lack of accountability often results in wasteful spending.

These grants also erode fiscal competition between cities and reduce the incentive to pursue policies that create economic growth. If local governments can receive funds for projects meant to bolster their tax base regardless of their fiscal policies, they have less of an incentive to create a fiscal environment that is conducive to economic growth. The feedback loop between growth promoting policies and actual economic growth is impaired when revenue can be generated independently of such policies e.g. by successfully applying for intergovernmental grants.

Some of the largest recipients of CDBG money are cities that have been declining since the 1950s. The graph below shows the total amount of CDBG dollars given to nine cities that were in the top 15 of the largest cities in the US by population in 1950. (Click on graphs to enlarge. Data used in the graphs are here.)

CDBGs 9 cities 1950

None of these cities were in the top 15 cities in 2014 and most of them have lost a substantial amount of people since 1950. In Detroit, Cleveland, St. Louis, and Buffalo the CDBG money has not reversed or even slowed their decline and yet the federal government continues to give these cities millions of dollars each year. The purpose of these grants is to create sustainable economic development in the recipient cities but it is difficult to argue that such development has occurred.

Contrast the amount of money given to the cities above with that of the cities below:

CDBGs 9 cities 2014

By 2014 the nine cities in the second graph had replaced the other cities in the top 15 largest US cities by population. Out of the nine cities in the second graph only one, San Antonio, has received $1 billion or more in CDBG funds. In comparison, every city in the first graph has received at least that much.

While there are a lot of factors that contribute to the decline of some cities and the rise of others (such as the general movement of the population towards warmer weather), these graphs are evidence that the CDBG program is incapable of saving Detroit, Buffalo, St. Louis, Cleveland, etc. from population and economic decline. Detroit alone has received nearly $3 billion in CDBG grants over the last 40 years yet still had to declare bankruptcy in 2013. St. Louis, Cleveland, Baltimore, Buffalo, and Milwaukee are other examples of cities that have received a relatively large amount of CDBG funding yet are still struggling with population decline and budget issues. Place-based, redistributive policies like the CDBG program misallocate resources from growing cities to declining cities and reduce the incentive for local governments to implement policies that encourage economic growth.

Moreover, if place-based subsidies, such as the CDBG program, do create some temporary local economic growth, there is evidence that this growth is merely shifted from other areas. In a study on the Tennessee Valley Authority, perhaps the most ambitious place-based program in the country’s history, economists Patrick Kline and Enrico Moretti (2014) found that the economic gains that accrued to the area covered by the TVA were completely offset by losses in other parts of the country. As they state, “Thus, we estimate that the spillovers in the TVA region were fully offset by the losses in the rest of the country…Notably, this finding casts doubt on the traditional big push rationale for spatially progressive subsidies.” This study is further evidence for what other economists have been saying for a long time: Subsidized economic growth in one area, if it occurs, comes at the expense of growth in other areas and does not grow the US economy as a whole.

Institutions matter, state legislative committee edition

Last week, Mercatus published a new working paper that I coauthored with Pavel Yakovlev of Duquesne University. It addresses an understudied institutional difference between states. Some state legislative chambers allow one committee to write both spending and taxing bills while others separate these functions into two separate committees.

This institutional difference first caught my eye a few years ago when Nick Tuszynski and I reviewed the literature on institutions and state spending. Among 16 different institutions that we looked at—from strict balanced budget requirements to term limits to “item reduction vetoes”—one stood out. Previous research by Mark Crain and Timothy Muris had found that states in which separate committees craft taxing and spending bills spend significantly less per capita than states in which a single committee was responsible for both kinds of bills. As you can see from the figure below (click to enlarge), the effect was estimated to be many times larger than that found for almost any other institution:

InstitutionsBut as large as this effect seems to be, the phenomenon has largely been ignored. To our knowledge, Crain and Muris are the only ones to have studied it. Their paper was now two decades old and was based on a relatively small sample of years from the 1980s.

As I wrote in yesterday’s Economics Intelligence column for US News:

To get a fresh look at the phenomenon, my colleagues and I consulted state statutes, legislative rules, committee websites and members’ offices. We created a unique data set that for some states spans 40 years. We took a cautious approach, coding taxing and spending functions as not separate in any chambers in which it was possible for a tax bill to come out of a spending committee and vice versa. We found that in 25 states, these functions are separate in both chambers, in 7 states they are separate in one chamber, and in the rest, these functions are separate in neither chamber.

To control for other confounding factors, we also gathered data on economic, demographic, and institutional differences between the states. Controlling for these factors, we found that separate taxing and spending committees are, indeed, associated with less spending. To be precise:

Other factors being equal, we find that those states with separate taxing and spending committees spend between $300 and $450 less per capita (between $790 and $1,200 less per household) than other states.

Our full paper is here, a summary is here, and my post at US News is here. Comments welcome.

State and local spending growth vs. GDP growth.

A few years ago, I produced a figure which showed inflation-adjusted state and local expenditures alongside inflation-adjusted private GDP.

It’s been some time since I made that chart and so I thought I might revisit the question. This time around, I compared state and local expenditures with overall GDP, not just private GDP.

The results are below (click to enlarge).

State and Local expenditures vs. GDPAfter adjusting for inflation, the economy is about 5.79 times its 1950 size. This is a good thing. It means more is being produced and more is available for consumption. And since the population has only doubled over this period, it means that per capita production is way up.

Over the same time period, however, state and local government expenditures have not just gone up 5 or 6 or even 8 times. Instead, after adjusting for inflation, state and local governments are spending about 12.79 times as much as they spent in 1950.

State and local governments, of course, depend entirely on the economy for their resources. As I put it when I produced the original chart, this is like a household whose income has grown about 6-fold but whose spending habits have grown nearly 13-fold.

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.

Some private sector pensions also face funding trouble

A new report by the Pension Benefit Guaranty Corp (PBGC) warns that while the market recovery has helped many multiemployer pension plans improve their funding there remain some plans that,”will not be able to raise contributions or reduce benefits sufficiently to avoid insolvency,” affecting between 1 and 1.5 million of ten million enrollees.

Multiemployer plans are defined as those which unions collectively bargained for, with multiple employers participating within an industry (e.g. building, construction, retail, trucking, mining and entertainment). They are also known as Taft-Hartley plans. Multiemployer plans grew out of the idea of offering pension benefits for unionized employees in transient kinds of work such as construction. These plans have been in trouble for awhile due to a variety of factors. Many plans have taken measures by increasing contributions and in a few cases cutting benefits according to GAO. But those steps have not been nearly enough to fix the growing shortfalls.

When a PBGC-insured pension plan goes insolvent beneficiaries are only guaranteed a fraction of their benefits. Those funds come from the premiums paid by remaining plans. The projected deficit for the ailing multiemployer plans range from $49.6 billion to $79.6 billion in 2022. By contrast the PBGC reports that single employer plans fare better with the current funding deficit of $27.4 billion narrowing to $7.6 billion by 2023.

Source: FY 2013 PBGC Projections Report

 

Delaware Senate votes to bail out three casinos

Delaware’s state senate has voted to redirect $10 billion in economic development funding to bail out three gambling casinos. The measure now goes to the House. Two reasons the casinos are failing: increased competition from Maryland and Pennsylvania and having to share a large chuck of revenue with the state. Lawmakers admit the bailout is only a “Band Aid,” and not enough to salvage the operations.

Supporters defend SB 220 as a jobs protection measure. But the real incentive is more likely the revenues involved. Lottery receipts are the fourth largest source of Delaware’s revenues at about 7 percent of the total bringing in $277 billion in 2013, right behind Income taxes, Franchise taxes, and Abandoned Property.

The casinos are certainly in trouble. According to Delaware Newszap.com Dover Downs Gaming & Entertainment saw a $1 million loss in Q1 2014 and is $46 million in debt. During that same first quarter the casino paid the state $16 million in revenue.

Revenue sharing between the state and the casinos has grown more onerous over the past 20 years. In 1997, the casino claimed 50.2 percent of the revenue and the state took 25.2 percent. In 2009, that split reversed, with the state claiming 43.5 percent of revenues and the casino keeping 37.8 percent.

The incentive for the bailout is fairly clear though the economic thinking is convoluted. Why not reduce the tax rate instead? Economist James Butkiewicz at the University of Delaware notes that as a voluntary tax it’s easy revenue and the state doesn’t have to raise taxes elsewhere.

But do casinos deliver for state coffers and economies?  Economists Douglas Walker (whose field is casino economics) and John Jackson find that while lotteries and horse racing tend to increase state revenues, casinos and greyhound racing tend to decrease it. Using recent data, Walker and Jackson find casinos have a positive economic impact. There are many other things to consider when thinking about the effects of casinos. As state creations there is ample opportunity for corruption and regulatory capture. Walker and Calcagno find just such a link in their paper in the journal Applied Economics (Dec 2013), “Casinos and Political Corruption in the United States: A Granger Causality Analysis.” And as a recent article by the WSJ notes oversaturation of casinos on the East Coast has also triggered an interstate “war” for revenues. Delaware’s gaming revenues are down 29 percent since 2011. A Delaware Casino Executive laments that the business model they are using is simply, “unworkable.”