Tag Archives: Robert Inman

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.

The Backdoor Bailouts

The Washington Post reports:

States that have borrowed billions of dollars from the federal government to cover the soaring cost of unemployment benefits would get immediate relief from the Obama administration under a plan to suspend interest payments for the next two years.

According to White House Press Secretary Robert Gibbs, the President’s proposal, “prevents future state bailouts, because in the future, states are going to have to rationalize what they offer and how they pay for it.” I’m not convinced.

First, a little background:

The unemployment system is jointly administered by the states and the federal government. To finance the program, both states and the feds tax the first $7,000 of wages paid to each worker, while some states choose to tax income earned beyond that first $7,000.

As the Post reports:

In tough times, states routinely borrow from the federal government to pay benefits. But when states have an outstanding balance for at least two years, federal law triggers an automatic increase in the federal tax to repay the loan. Such tax hikes already have taken effect or are imminent in Michigan, Indiana and South Carolina.

What the Post doesn’t mention (but Bloomberg does), is: “From 2009 until this year, the loans had been interest-free under a provision of the economic-stimulus program.”

Now the President wants to go further, suspending any interest payments the states owe to the federal government for the next two years. In 2014, he would then change the tax base so that instead of taxing the first $7,000 of wages, the feds and the states would each tax the first $15,000. 

It is this aspect of the proposal that the press secretary, evidently, believes “prevents future state bailouts.” This might be true if we assume that policy makers won’t respond to the extra tax revenue by increasing spending. But more fundamentally, it seems to me that the press secretary is glossing over the fact that the first part of the plan—suspension of interest payments—is a bailout.

For historical context, I turned to Robert Inman. In the first chapter of Fiscal Decentralization and the Challenge of Hard Budget Constraints, he writes (p. 57):

The first major wave of lower government defaults occurred during the 1840s, when eight states (Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, and Pennsylvania) and the Territory of Florida defaulted.

Maryland Representative William Cost Johnson (you can’t make that name up!) led the effort. As Inman explains, the rest of Congress didn’t agree with Mr. Cost; they refused to bail out the states (p. 57):

Importantly, opponents of a bailout stressed the strategic implications of such a policy; bailouts would signal an accommodating central government and encourage future deficits, defaults, and ultimately inefficient local governments. Congress said no, and there have been no state defaults since.

This marked a turning point in federal-state relations: through recessions, depressions and countless state fiscal crises, the strong no-bailout rule has survived nearly two centuries.

This made the US federal system unique. Unlike local governments in other countries, US states could not run up huge bills and export the costs to their neighbors. As Inman explains, other countries are not so fortunate to have such a strong no-bailout rule (p. 35):

The recent financial crises in Argentina and Brazil, largely precipitated by excessive local government borrowing, are prominent recent examples of how a fiscally irresponsible local sector can impose significant economic costs on a national economy.

The strong no-bailout rule in the US, however, has not prevented the federal government from increasing its role in state finance. Over the years, federal grants to state governments have steadily grown. Now, there are over 1,120 federal programs that are designed to aid the states. Today, federal funding now pays for nearly 1/3rd of all state spending.

What I find particularly alarming, however, is the recent growth in ad hoc state aid programs that are designed to offset short-term fiscal crunches. To me, these look an awful lot like bailouts. Consider the $135 billion in state aid in the stimulus which included:

  • A state fiscal stabilization fund designed to shore up deficits
  • A temporary increase in the federal Medicaid matching formula (FMAP)
  • Grants for various local projects from teachers to firefighters to police
  • The aforementioned interest-free loans for unemployment insurance
  • And much more

On top of that, the President successfully lobbied for an extension of the “temporary” FMAP increase and an extension of the federal-state unemployment insurance program (he was less-successful in last summer’s attempt to wrangle another $50 billion in state and local aid).

If somehow they could see this, I suspect that the senators and representatives who stopped a state bailout over 170 years ago might wonder if their “no bailout” stance really still stands.

Why the Federal Government Shouldn’t Use the States to Implement Fiscal Stimulus

[C]hannelling the stimulus package through state governments exposed it to agency costs, free-riding problem, and political expediency. As a result, the stimulus has failed to meet its objectives at the state level. The lesson is that fiscal stimulus should be conducted centrally.

That’s Robert Inman, writing over at Vox. He summarizes forthcoming research with Philadelphia Fed economist Gerald Carlino (I don’t believe the draft is on line yet). They find:

[A]n income multiplier for federal transfers to states of only 40 cents for each dollar of federal aid even after 20 quarters.

He also sums up his solo paper on states in fiscal distress:

ARRA’s assistance was largely distributed as a per capita transfer. Projected fiscal deficits did lead to more assistance, but ARRA covered at most $0.25 of each dollar of projected state budgetary shortfalls. The other important determinant of ARRA funding was whether the state’s Senators had membership on an important congressional committee making fiscal policy. Controlling for state population, deficits, and committee membership, the state’s rate of unemployment at the time of passage had no statistically significant impact on the level of assistance.

These results largely corroborate Veronique deRugy’s work.