Tag Archives: Illinois

Red ink flows in state-run prepaid tuition programs

In three years the Prepaid Alabama College Tuition Program (PACT) will run dry. The State Treasurer reports PACT which pays $100 million in tuition a year, has $347 million in investments remaining. To fulfill its obligations to all 40,000 participants over the next 20 years, PACT needs an additional $843.9 million. The state Supreme Court recently struck down a potential solution put forth by the legislature: cap payouts to 2010 tuition levels and have beneficiaries make up the difference. The remedy didn’t pass scrutiny due to a 2010 law that promises PACT be 100 percent funded.

PACT worked for about 20 years until hit with the combination of unrelenting tuition inflation and a bear market which halved the plan’s investments.

Unfortunately, Alabama isn’t the only state with a prepaid program in the red. The Wall Street Journal reports South Carolina’s plan expects to run out of funds in 2017. Tennessee’s budget seeks an infusion of $15 million into its program. And West Virginia recently transferred funds from an unclaimed-property program to shore up its struggling prepaid plan.

In remarkably bad shape is IllinoisCrain’s Chicago Business finds that Illinois’ 12-year old $1.1 billion prepaid plan has the largest shortfall in the entire nation. Worse still, plan managers are making up for losses by embracing a huge amount of risk. In 2011, 47 percent of Illinois’ prepaid tuition plan was shifted into alternatives and investment expectations set at 8.75 percent. An expectation that far outstrips any other prepaid plan by a long-shot. (Florida has the country’s largest prepaid tuition plan and operates with an expected return of 4.3 percent on plan investments).

This year the agency that runs the prepaid program, the Illinois Student Assistance Commission ,has dropped that return assumption to 7.5 percent.  According to its actuarial report College Illinois! has enough money to pay out tuition for a few more years.

Prepaid plans are a type of 529 plan (the other is the college savings program) that allow parents to purchase contracts (or credits) for their children’s education.  The prepaid tuition plan locks-in tuition for the current year for eligible in-state colleges. Contributions are invested and benefits paid from those funds. To remain well-funded asset performance must track or exceed tuition increases. Given the rapid increase in college tuition which on average has increased 5.6 percent per year over the rate of inflation in just the past decade, it’s easy to see why so many plans have gone bust.

PACT participants who may not recoup their initial investments are understandably upset, “everything about the way the plan was promoted implied it was backed by the state.”

But, just how good is the state’s guarantee?

That is often in the fine-print. The WSJ finds three levels of guarantee in operation. 1) Full Faith and Credit – the state promises to pay for shortfalls if the fund goes dry. (Washington, Texas, Ohio, Mississippi and Florida)  2) Legislative appropriation – the legislature must consider an appropriation to cover shortfalls. (Illinois, Maryland, Virginia, South Carolina and West Virginia)  and 3) Fund Assets – the plan is solely backed by the assets in the plan. (Alabama, Michigan, Nevada, Pennsylvania, and Tennessee.)

Alabama’s PACT participants found they had little recourse in 2009.  Since the state doesn’t guarantee payment of tuition,they were technically out of luck. However, after a series of demonstrations and hearings in 2010 the Alabama legislature granted a $548 million bailout, tiding the plan over for the next three years. And then what? The state legislature filed a bill last week to tweak the previous solution to the court’s liking. It is again proposing to cap tuition payouts at 2010 levels.

Strangely, in spite of the risk present in pre-paid tuition plans they continue to provide a “flight to safety” for some investors. Last year growth in pre-paid plans outstripped growth in 529 college savings plans. The lure of higher returns attracts some who are banking on the ability of governments to keep their promise to pay it out regardless of market performance or the fine-print.

Don’t Bailout the States

Last week the Illinois House adopted HR 0720 which was part of a growing effort to remove the possibility of a federal bailout for the states. The synopsis of the House Resolution reads:

Urges the federal government to take no action to redeem, assume, or guarantee State debt; and the Secretary of the Treasury should report to Congress negotiations to engage in actions that would result in an outlay of Federal funds on behalf of creditors to a State.

Senior Director of Government Affairs at the Illinois Policy Institute, Collin Hitt, offered committee testimony on the resolution. While writing about his testimony, Collin correctly argues that

Illinois’ problems are its own. Illinois has the tools to fix its finances. The state is seeing record reviews. Pension reform and Medicaid reform are possible, and there are concrete ideas to fix these debt-ridden programs. The prospect of a federal bailout only forestalls those solutions. If a federal bailout is considered imminent – or even possible – then the urgency to actually solve our problems ourselves is diminished. This resolution sends a message throughout state government that a bailout is not a solution that the State of Illinois can plan on.

That last part is absolutely essential, as it gets at a serious issue currently taking place in Illinois and other troubled states across the U.S. When politicians and law makers are dealing with a state that is on the brink of fiscal collapse they have two options: 1) make lasting intuitional and structural reform or 2) avoid significant reform and hope that most of the issues fix themselves. As a federal bailout becomes more likely, however, avoiding reform becomes politically easier. This, therefore, becomes a race to the bottom scenario where the states that end up in the worst fiscal shape are “rewarded” with a federal bailout… A very bad incentive structure and a scary road to head down.

Hopefully HR 0720 gains more traction and Illinois and begins to change the growing federal bailout expectations. If it is successful, other states should surely follow.

Virginia and New Jersey wrangle over taxes, spending and pensions

In the past week Virginia and New Jersey have put together their proposed budgets. One thing they have in common: how much to set aside for pension benefits, and how to pay for it? Governor McDonnell of Virginia proposes less spending on education than is sought by the House and Senate. The Governor wants to fund spending with increased fees. The Senate prefers an increase in the gas tax.

Virginia operates with a biennial budget and McDonnell’s two-year $85 billion spending proposal is the largest spending plan in the state’s history. Of the $438 million proposed for education, $342 million is earmarked for teacher’s pensions. Governor McDonnell will make the annual payment (more or less) as calculated by state actuaries and proposes increasing the employee contribution to 6 percent. The Senate rejects increased employee contributions. The House, by contrast, thinks the Governor should go further with structural pension reforms.

In New Jersey Governor Christie will make 2/7ths of the full contribution to New Jersey’s pension system. It’s too little, too late and the needed contribution is already terribly underestimated. In addition Christie’s $32.1 billion budget represents a spending increase of 8.2 percent over last year. There are proposed spending increases for K-12 education and universities, but also cuts to municipal aid for distressed cities, including Camden which has been almost entirely dependent on state aid for decades. It appears optimistic revenue projections figure into the proposal. The Governor proposes a 10 percent cut in income taxes across the board and a restoration of the Earned Income Tax Credit (EITC).

The structural problems in New Jersey’s fiscal landscape remain. And these structural problems are apparent in many other states. It is not a problem easily solved. The means of financing schools – bound up with income taxes, state aid and their effect on property taxes and spending, instituted in 1976, remains in place. Factor in the resistance of governments to confront the real costs associated with employee pensions – a problem shared by all states and  many municipalities. The present problem is that recovering revenues may lead states to feel comfortable again. But that would be misplaced. Instead, lawmakers would do well to view their state’s long-term fiscal trends without the aid of rose-colored glasses.


Hamilton’s Paradox

I recently finished reading Jonathan Rodden’s 2006 book Hamilton’s Paradox: The Promise and Peril of Fiscal Federalism. The book provides a fascinating analysis of fiscal federalism that combines theory, qualitative and quantitative analysis, and contemporary case studies.

Rodden begins by detailing the potential promises and perils of fiscal federalism. He states that the promise of federalism is straightforward: “decentralized, multitiered systems of government are likely to give citizens more of what they want from government at lower cost than more centralized alternatives.” The perils of federalism, although less examined in the literature, are rooted in the idea that “In decentralized federations, politically fragmented central governments may find it difficult to solve coordination problems and provide federation-wide collective goods. As in the private sector, public institutions only produce desirable outcomes when incentives are properly structured” (p. 5).

In Chapter 3 Rodden provides a very interesting history of federalism and federal bailouts in the U.S. Specifically, he discusses the federal assumption of state debt that took place in 1790, the rapid growth in state borrowing in the early 1800s, the nine states that defaulted in 1841 and 1842 (Maryland, Pennsylvania, Arkansas, Florida, Illinois, Indiana, Louisiana, Michigan, and Mississippi), and the constitutional debt limitations that many states adopted in the 1840s and 1850s.

Most interesting is the game theory model Rodden develops in the second half of Chapter 3. Specifically, it’s a dynamic game of incomplete information that takes place between the central government and a single subnational government. Information is incomplete because subnational governments don’t know exactly how the central government will behave in the event of fiscal crisis. That is, the central government will either allow the subnational government to default (resolute type) or will provide a bailout (irresolute type).

The fist move of the game occurs when a subnational government experiences a fiscal shock with lasting effects (i.e. recession). In response to the fiscal shock it can either adjust immediately or refuse to deal with the shock by borrowing, with the long term hope of receiving a bailout. The path that the subnational government takes is a function of, among other things, the expected probability of the central government being resolute or irresolute (the complete game is much more detailed than the brief description provided here).

Rodden utilizes this game as he develops each of the case studies provided later in the book. The case studies involve comparing and contrasting the events that have taken place in Germany and Brazil. In the 1990’s two states in Germany received formal bailouts by the federal government (the Bund). During the same time, however, bailouts were distributed to virtually every state in Brazil. In Chapters 7 and 8 Rodden carefully details the structures of government in these two countries and outlines the reasons their outcomes were so different.

Two of the many important conclusions that Rodden makes in this book are (1)

when free to borrow, growing transfer dependence is associated with increasing deficits, both among federated units and local governments (p. 116)

and (2)

The central government must not only allow subnational governments significant tax autonomy and disentangle its books from those of the subnational governments, but it must demonstrate through costly action that it will not assume subnational liabilities when times get tough (p. 267)

This brief review of Hamilton’s Paradox only covered a few of the many important topics that the Rodden details in the book. I strongly recommend this book for anyone interested in fiscal federalism.

New Education Funding in Illinois Goes to Pensions

Neighborhood Effects readers know that Illinois’s pension problems are much worse than reported. According to the state’s numbers, Illinois’s unfunded pension liabilities amount to roughly $85 billion but as Eileen Norcross and I have argued, the amount is actually closer to $173 billion.

There have been many discussions regarding pension reform in Illinois during the past few months and, unsurprisingly, little has been accomplished. In fact, an article in Statehouse News earlier this week provided evidence that Illinois is continuing to deliberately avoid dealing with the problem by providing temporary quick fixes and banking on the idea that the state’s pension problems will simply disappear when the economy recovers.

According to the article in Statehouse, Illinois’s

12 percent increase in higher education spending this year isn’t going to benefit students. Instead, the additional funding for fiscal 2012 is going into the State Universities Retirement System, or SURS, to address its underfunded pension program…. The dramatic increase in the amount of money being given to SURS, and the other state pension systems, seeks to make up for decades of chronic underfunding by governors and legislators, and shrinking returns on investments because of the stagnant economy.

Education costs are increasing across the country. Students in Illinois paid 30 percent more for a year of college education at a university in 2011 than they did in 2007. Instead of using the additional 12 percent in higher education funds to curb these increasing costs, the state put the money towards its SURS system. This fiscal year students in Illinois are dealing with the consequences of the state’s failure to properly manage its pension system. As pension costs continue to grow in Illinois, the state will likely continue putting more money into the system – which means less money will be available for other areas of the budget.

In related pension news in Illinois, the Daily Herald provided the following quote from Hanover Park Village President Rodney Craig:

We have a fear that at the end of the day the pensions won’t be there

Without serious structural pension reform, Mr. Craig’s fear will most certainly become a reality. Labeling Illinois’s recent pension quick fix as a disappointment would be an understatement. This is nowhere near the type of reform that needs to happen in Illinois. If the state legislature wants to ensure fiscal stability in the future of Illinois’s pension system then they must start by removing the constitutional protection of pension benefits, reducing the rate of accrual for current employees, increasing current employee contributions, closing the current defined benefit plans and moving all employees to a defined contribution plan.


Tax Foundation Releases New State Business Tax Climate Index

On Wednesday the Tax Foundation released the updated State Business Tax Climate Index by Mark Robyn. Wyoming, South Dakota, and Nevada ranked highest on the index because they have low overall tax burdens and tax policies that introduce minimal distortions to business behavior.

The three states at the bottom of the ranking — New Jersey, New York, and California — were also the worst-ranked states last year. Unsurprisingly, these three states are also experiencing domestic outmigration as individuals and businesses leave for locations with lower tax burdens. A study by Jed Kolko, David Neumark, and Marisol Cuella Mejia demonstrates that the SBTCI is one of the most accurate indexes for predicting economic outcomes.


Illinois had the largest change in ranking over last year’s, dropping 12 spots. Robyn writes on the importance of tax policy in business decisions:

Anecdotes about the impact of state tax systems on business investment are plentiful. In Illinois early last decade, hundreds of millions of dollars of capital investments were delayed when then-Governor Blagojevich proposed a hefty gross receipts tax. Only when the legislature resoundingly defeated the bill did the investment resume. In 2005, California-based Intel decided to build a multi-billion dollar chip-making facility in Arizona due to its favorable corporate income tax system. In 2010 Northrup Grumman chose to move its headquarters to Virginia over Maryland, citing the better business tax climate. Anecdotes such as these reinforce what we know from economic theory: taxes matter to businesses, and those places with the most competitive tax systems will reap the benefits of business-friendly tax climates.

The Tax Foundation is not alone in finding these states relatively lacking in economic freedom. Indexes developed by the Mercatus Center and the American Legislative Exchange Council also ranked these states as among the least economically competitive in the country.

While lawmakers may be tempted to try to improve their states’ rankings in these types of indexes with special business tax breaks or increasing state spending, all three studies demonstrate that the best way to improve a state’s competitiveness ranking is to provide a climate of low, stable taxes that do not favor specific industries.


What Illinois’s Credit Rating Downgrade Really Means

Last week Moody’s Investment Service downgraded Illinois’s credit rating from A2 to A1, thus labeling the state’s debt as the riskiest in the nation. There seems to be some confusion, however, on what this downgrade means for state borrowing, how it will affect taxpayers, and how it will impact the state’s fiscal future.

To put this downgrade into perspective, it’s important to consider that it came just a few days before the state had planned to borrow $800 million to pay for roads, schools, and bridges. Many individuals predicted that this downgrade would make it more expensive for the state to follow through with its planned bonds sale. Illinois Treasure Dan Rutherford estimated that the downgrade would likely cost the state an additional $65 million in order to issue the $800 million in bonds. Bloomberg predicted that Illinois would face borrowing costs more than quadruple the average that it has paid over the past ten years.

But if the rating downgrade was supposed to make borrowing more expensive, how then was Illinois able to secure historically low interest rates in its bond sale this week?

This is precisely the source of much of the confusion and there are a few things that need to be considered. First and foremost, it’s important to point out that a credit downgrade does not necessarily increase the cost of borrowing (as we saw when the cost of borrowing decreased after the U.S treasury was downgraded). A downgrade is just that, a grade. It’s an assessment by a credit rating agency.  A downgrade will generally only change lending terms if it teaches the lenders something new. For example, if lenders (i.e. bond buyers) know that Illinois is flunking math, then they have already built that into their lending habits – the information is “baked into the price.” It’s well known that Illinois is in poor fiscal shape and thus this downgrade did not surprise lenders.

Another thing that needs to be considered is the fact that interest rates on all bonds are currently very low which certainly helped the state obtain the low rate. Additionally, as the Wall Street Journal points out, the relative scarcity of new bonds in the municipal bond market this year aided the reception of Illinois’s $800 million bond sale. And finally, it’s true that Illinois secured historically low rates on its recent bond sale but, more importantly, it’s also true that the state may have secured even lower rates if its credit rating would have been higher. In other words, even though the state was able to borrow at relatively low rates, the borrowing may have been more expensive than it would have otherwise been in the absence of a rating downgrade.

Adding to the confusion, Governor Quinn described the state’s downgrade as an “outlier decision.” It’s difficult to label this downgrade as an outlier, however, considering that Illinois has had its credit rating downgraded nine times in three years.

Not only was the downgrade not an outlier but there is simply no reason to believe that the state’s credit is going to improve in the near future. Given Illinois’s habitual utilization of budgetary gimmicks, its customary practice of issuing debt to avoid making necessary budget cuts and its vastly underfunded pension system – it’s likely that the state’s credit rating will continue to decrease unless Quinn and the state legislature start making serious institutional reform.

Most importantly, this downgrade could mean that Illinois taxpayers will now get less bang for their buck. As legislators continue to push off significant reform, borrowing costs will likely continue to increase and more taxpayer dollars will be going towards interest payments instead of building schools and roads. Paying more money for fewer services is something Illinoisans can simply not afford – especially in the wake of last year’s tax hike which increased the average family’s state tax bill by $1,594.

So to clear up any confusion, what Illinois’s recent credit downgrade really means is that the state’s long run borrowing costs may be higher than they would have otherwise been, Illinois taxpayers are now paying more for less, and Illinois’s fiscal future will suffer if the state continues to hold the riskiest debt in the nation.

State finances going into 2012

In 2012, municipal bonds are unlikely to return at same levels as 2011

Investment analysts worry that without further fiscal action Illinois bonds will underperform the market in the coming year.

On January 1, many new laws go into effect in the states. The National Conference of State Legislatures has a rundown.

According to the U.S. Census the 100 largest public pension plans declined 8.5 percent in the third quarter of 2011.

The $237 billion drop in public pension plans is the biggest drop since the crash of 2008


More Corporate Tax Deals in Illinois: Was This Really a Win?

Illinois’s fall veto session was a disappointment – little was addressed and even less was achieved. In attempts to make up for their lack of achievement, Illinois lawmakers reconvened early last week to revisit a corporate tax relief package. Specifically, this session was meant to address the recent threats to leave the state coming from some of Illinois’s largest corporations. After a two day session, lawmakers approved a $330 million tax package that will supposedly prevent CME Group Inc. and Sears Holdings from leaving Illinois.

Governor Quinn described this legislative action as a win-win situation by telling reporters that this was a

win for workers and a win for employers in Illinois… what we did here the last two days is a part of making Illinois a good place to do business and a good place to work

But was this a win for Illinois? Not really…

In the case of Sears, it is important to look at the reason the company chose Illinois as a location to do business in the first place. Illinois has been the home of the Sears headquarters for more than 125 years. Interestingly enough, in 1989 Sears had announced plans to abandon its corporate headquarters in Chicago and relocate to another state. Illinois law makers, however, were able to convince the company to stay via the provision of $178 million in state and local subsidies (déjà vu?).

This method of convincing companies to stay in or relocate to a specific state via the provision of large subsidies and tax breaks is often referred to as industrial recruitment. Despite Governor Quinn’s statement, industrial recruitment is one of the least effective ways to make a state a better place to do business.

As Robert Turner makes clear, when utilizing this approach, states generally lack the knowledge regarding how willing a business is to move or stay, how large the subsidy needs to be, and how much tax revenue the relocation will create. This necessarily means that a state cannot conduct an accurate cost-benefit analysis when creating the subsidy and thus, by definition, cannot make an efficient policy decision in this situation.

Ultimately, when states participate in this industrial recruitment method, it results in a prisoner’s dilemma type situation where states overbid for firms that end up bringing fewer jobs and less tax revenue than planned. The industrial recruitment process, therefore, generally ends up being a negative sum game.

It took $178 million to keep Sears the first time around and now Illinois is fronting a portion of the new $330 million tax package to convince the company to stick around for a while longer. Is it not yet clear that this is a fundamentally flawed method of fostering business activity?

A more efficient (not to mention, more equitable) approach would be to create a business climate which fosters all businesses rather than one that picks winners and losers.  Allowing people a measure of economic freedom with low, stable, and non-discriminatory taxation and simple, non-burdensome regulation would be a true win-win.


Why Do Some States Face Steep Borrowing Costs?

One of the interesting—and alarming—developments in state finance over the last few years is the spread between borrowing costs among the states. Unsurprisingly, the borrowing costs of all states jumped during the financial crisis and recession. But as the (anemic) recovery began, the borrowing costs of many states eased while those of some states like California and Illinois remained high.

A paper by Daniel Nadler and Sounman Hong of the Harvard Kennedy School offers one explanation:

Political-institutional factors—such as the political composition of state legislatures, and interstate variations in public sector labor environments, such as union strength, and collective bargaining rights—can explain a significant proportion of interstate variation in bankruptcy risk. We find that, controlling for multiple economic variables, states with weaker unions, weaker collective bargaining rights, and fewer Democratic state legislators pay less in borrowing costs absolutely, and less in borrowing costs at similar levels of unexpected budget deficits, than do states with stronger unions and a higher proportion of Democrats.

As this summary puts it:

According to the study, a 20 percentage point difference in the share of the public-sector workforce that is unionized is associated with an additional increase in state borrowing costs of 40.4 basis points.