Tag Archives: state governments

House Promises not to Bailout State Pension Funds

With the appropriately foreboding headline, “The corruption you see; the doomsday you don’t,” The Chicago Tribune reports:

Every indication suggests that, once again, [House Speaker] Madigan and [Senate President] Cullerton will be waving from the curb as this situation grows even more disastrous. We see no evidence that Madigan and Cullerton will use the legislative veto session that opens Tuesday to reduce future pension earnings, while protecting benefits already earned, for current employees.

Yesterday, the House took up a bill aimed at preventing union leaders from collecting pensions based on salaries that they earned working for a public sector union rather than the state. While the issue of pension fund abuse has provoked media outrage, this reform would do little to help the funds’ overall solvency.

Legislators remain reticent to enact major reforms, despite the growing pressure of insolvency that state and municipal funds are facing. Part of the reason that policymakers may not believe that they have to make the difficult decisions involved in reform may be that recent federal bailouts for Wall Street, Detroit, and state governments have led to moral hazard. Under a system where legislators do not believe that their taxpayers and recipients will bear the full cost of bringing the fund back to solvency, they are not concerned with making reforms, instead perhaps assuming that the federal government will step in to bail out the ailing fund.

However, the political climate has changed markedly since 2008 when the federal government looked at bailouts as stimulus. Last week, U.S. House Republicans issued a letter stating that Congress would not step in to help state pension funds remain solvent. The Chicago Sun Times reports:

The letter bearing signatures from U.S. Rep. Peter Roskam (R-Ill.) and other members of the Illinois GOP delegation along with the influential chairmen of eight House committees, including U.S. Rep. Paul Ryan (R-Wis.), urged Springfield to “seize the opportunity to appropriately reform the state’s public pension systems to address their massive unfunded liabilities – and to do so by your own means” during the veto session.

While state leaders say they expect no help from the federal government, they also don’t seem to be in a hurry to accept the difficult sacrifices that will have to be made now that Illinois’ pensions have the lowest funding ratio of all states. As Eileen Norcross and Ben VanMetre found in a recent working paper, Illinois’s budget woes have reached this precipice because the state’s budget rules allow for overspending and permit today’s policymakers to push bills on to tomorrow’s voters. Changing these institution won’t be easy, but this is where policymakers need to start if they want real reform for Illinois.

Balanced Budget Rules and Unintended Consequences

In my view this is one reason of many why a balanced budget amendment is not a workable path toward fiscal conservatism.

That is Tyler Cowen’s take on my paper with Noel Johnson and Steven Yamarik. I can certainly see why he might come to this conclusion.  We find that when Democratically-controlled states face a binding constraint on their ability to carry a deficit over from one year to the next, they may regulate more instead. A friend of mine calls this the “muffin-top” problem: belt-tightening can sometimes lead to unsightly bulging…elsewhere.  In spite of the muffin-top problem, I am actually still an advocate of a balanced budget amendment at the federal level.

Though I often marvel at the fiscal irresponsibility of state governments, I can’t help but feel that if the states and the federal government were in some sort of fiscal beauty contest, the states would easily come in 1st through 50th while the federal government would come in 51st.  Consider:

  • Collectively, state and local governments are in debt to the tune of about 2.6 trillion dollars, while the federal government has racked up nearly 4 times that amount.
  • The states have accumulated $9.9 trillion in unfunded obligations that will come due over the next several decades.  The Feds, meanwhile have accumulated 5 to 10 times this amount (depending on whether you agree with Medicare’s chief actuary that the current political path is highly unlikely).
  • Most states manage to balance their operating expenses (some gimmickry aside) on an annual or biannual basis. In contrast,
    for the last 80 years, the federal government’s norm has been to run an annual operating deficit (with deficits about 85 percent of the time).
  • When states do borrow, it is typically for long-term capital projects (again, some gimmickry aside).  So future generations are on the hook for bridges and buildings that they, too, will use. In contrast, the Feds don’t even pretend to borrow for future projects; much of what my daughter’s generation will pay for is my generation’s consumption.
  • When states encounter budgetary problems, they tend to deal with them by cutting spending rather than raising taxes.

All of this is somewhat surprising given the fact that, constitutionally, the states were given a blank check whereas the feds were not. As Madison put it in Federalist 45:

The powers delegated by the proposed Constitution to the federal government, are few and defined. Those which are to remain in the State governments are numerous and indefinite.

So why, given so much more (constitutional) power than the feds, do the states seem to manage their affairs more-responsibly? Tiebout competition and the lack of a central bank likely play a role. But I believe the fact that every state but Vermont has to balance its books each year must account for a large share of this relative fiscal probity.  As James Buchanan and Richard Wagner argued over 30 years ago, the ability to buy items for today’s generation while putting the tab on tomorrow’s generation creates a systematic bias in favor of irresponsible spending. In contrast, they argue:

The restoration of the balanced-budget rule will serve only to allow for a somewhat more conscious and careful weighting of benefits and costs. The rule will have the effect of bringing the real costs of public outlays to the awareness of decision makers; it will tend to dispel the illusory “something for nothing” aspects of fiscal choice.

I believe the evidence supports this claim.  David Primo (2003) and Mark Crain (2003) find that states with a strict balanced budget requirement tend to spend less than other states.  Shanna Rose (2006) finds that states with strict balanced budget requirements tend not to experience a political business cycle in which government spending rises just prior to an election and falls shortly thereafter. Bohn and Inman (1996) find that states with strict balanced budget requirements tend to have larger General Fund surpluses and larger rainy day funds.

In our paper we find that stricter balanced budget rules tend to constrain partisan fiscal outcomes.  The fact that they may lead to bulges in the regulatory state is, indeed, unfortunate.  But in my view, that suggests that we should also examine biases in the political economy of regulation and consider institutional reform to address those as well.  Perhaps there is need for a more-conscious weighing of the benefits and costs of regulation?  If belt-tightening leads to muffin-tops, maybe we need more than a balanced budget amendment?  Perhaps spanxs?

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.

Public Sector Inc.

The Manhattan Institute has a new website: Public Sector Inc. featuring the latest research, news, interviews, and articles on public sector unionism and in particular on the crisis in state and local pensions. Edited by Manhattan Institute fellow, Josh Barro, the site includes my article on the discount rate and how it has affected the management of pensions as well as a podcast with E.J. McMahon on the same topic.

Reform of public sector unionism is sure to be a major policy issue facing the states in the coming decade. Josh notes at PSI’s blog that Governor Tim Pawlenty in Minnesota has written in today’s Wall Street Journal about what states need to do to fix the fiscal disaster that public sector unionism has delivered to state governments – and that includes getting the accounting of public sector liabilities, right.

Should States Be Able to File for Bankruptcy?

At The Weekly Standard, University of Pennsylvania law professor, David Skeel asks if it’s time to consider allowing state governments a way to declare bankruptcy.Despite signs of skittishness in the municipal bond market and increasing budgetary pressures, states continue to avoid the kind of austerity measures that are going to be necessary to balance their books while meeting pension obligations.

Why cut spending or raise taxes when the bill can be shifted upward? The hard budget constraint necessary for market-preserving federalism has been already violated via bailouts (and one can argue, federal grants-in-aid). The bailout route also indirectly grants states an escape hatch from their political dilemma. The federal government can raise taxes, issue debt, or create money: the last refuge of a profligate government.

Would a state bankruptcy law be Constitutional? Does it constitute the federal government meddling in the state’s affairs? Skeel argues that no one is forcing a state to declare bankruptcy, but merely providing a legal avenue to do so. For an active debate on the idea check out the Volokh Conspiracy.

Assorted Links

Jeff Dircksen at the National Taxpayers Union writes about a new ranking of state governments:

There’s a new ranking that looks at how well states are run, or in some cases not so well run.  According to its web site, “24/7 Wall St. has completed one of the most comprehensive studies of state financial management ever performed by the mainstream media. It is based on evaluation principles used in the award-winning Best Run States In America ratings published by the Financial World Magazine during the 1990s. These studies were used by state governments to evaluate the efficiency of their own operations. The new 24/7 Wall St. study is meant to help businesses and individuals examine state operation with an unbiased eye.”

Take a look and see how your state does.  Spoiler alert:  Wyoming is the best and Kentucky is the worst.

On an unrelated note, Joe Henchman at the Tax Foundation cautions against the use of the Center on Budget and Policy Priorities’ state budget gap data (note: I used this data in my paper on budget gaps—in part because it was timely and because it is so commonly cited). Joe writes:

The number is probably accurate from their methodology, but is ultimately meaningless. Here’s why:

  • A state “budget deficit” is the revenue projected (usually by the Governor’s office) minus hoped-for spending according to some formula, in the initial budget plan. For instance, say a state raised and spent $10 billion this year, but wants to spend $20 billion next year, projecting $11 billion in revenues. Ultimately they settle on spending $11 billion. That state has “closed a $9 billion budget deficit” even though revenues and spending are up from the previous year.
  • The exact method of estimating next year’s spending varies by state, with some starting with last year’s budget while others throw in additional wish list programs. Adding up all the states’ numbers is adding apples and oranges.
  • States must balance their budgets so there really is no cumulative state budget deficit in the end, at least on paper.
  • It’s routine for states to want to spend more than they actually can, at least at first, and having a deficit in the initial plan happens even in flush times. Thus, CBPP’s numbers overestimate the scope of actual state budget deficits.
  • CBPP also presents the deficits as a percent of each state’s general fund. While the general fund is usually the largest and most important part of a state’s budget, in many states it can represent less than half of the total budget. This number thus exaggerates the seriousness of a budget deficit.
  • A budget deficit could exist because of overly ambitious spending plans that are whittled down to reality, overly optimistic revenue projections, fiscal irresponsibility, or structural imbalance. CBPP’s tale of the recession causing everything and federal aid being the only salvation doesn’t fit the facts. For instance, California’s deficit this year includes unpaid bills kicked over from last year, so it’s the same money being double-counted. This irresponsibility is glossed over in CBPP’s report.

Medicaid Costs: Take II

Last week, I posted about Medicaid costs and raised the question: if Medicaid spending has gone up (which it has), is it because prices have gone up or because governments are simply buying more. I presented a chart, adapted from one of my working papers, which attempted to disentangle the effect. I concluded that while medical care inflation is certainly a factor in the spending increase, it cannot account for all of it. A significant factor in increased Medicaid spending is the fact that governments are buying more medical care services (by, for example, expanding the eligibility requirements to enroll more people in the program).   

Astute Neighborhood Effects reader Ben, however, pointed out a flaw in my chart: If X is the product of Y and Z, and if Y and Z grow over time, then one cannot simply sum the growth rates of Y and Z and arrive at the growth rate of X. (This is the basic logic behind the product rule in calculus).

Ben was absolutely correct. And because of that, I have edited the working paper to include new charts that illustrate the same point. At the same time, I have added more detail to the discussion of the expansion in Medicaid spending.

Here is the old version of the paper and here is a new version.

Below is the first chart. It shows inflation-adjusted per capita spending growth in each of the major areas of state spending from 1987 through 2009. Note that even after adjusting for inflation and population growth, total per capita spending increased 64 percent over this period. Far and away, Medicaid spending growth is the main reason. When using the general price level to make the adjustment, inflation-adjusted per capita spending on Medicaid grew 240 percent from 1987 to 2009.

Many, however, have pointed out that health care prices have grown much faster than the general price level. For this reason, perhaps it is not fair to use the general price level to inflation-adjust Medicaid spending. In the chart below, I instead use medical care prices to adjust for inflation. I look at the growth in real, per capita Medicaid spending over two periods: 1987-2009 and 1987-2007. The 1987-2007 period allows us to see what was happening to Medicaid spending even before the recession.

The bottom line: even before the recession hit and even when controlling for the rapid growth in medical care inflation, state governments have markedly increased Medicaid expenditures. State per capita spending on the program grew 116 percent from 1987 to 2007. No other aspect of state spending grew anywhere near as fast.

As Holahan and Yemane have shown, enrollment growth explains most of the growth in Medicaid expenditures. While the U.S. population increases at a rate of less than 1 percent per year, they show that enrollment in Medicaid grew, on average, 4.2 percent per year. This is due, in part, to eligibility expansions.

Coughlin and Zuckerman found that since 2001, 24 states expanded eligibility. In some cases, the expansion was dramatic. For example, New York expanded its eligibility requirements so that the share of those eligible grew from 13 to 35 percent of the state’s population. Most of these expansions did not target those who are least-advantaged. According to Coughlin and Zuckerman:

[H]igher-income parents and childless adults have been the two major expansion groups.

If states hope to tackle their long-term budget problem, they will need to grapple with this fact.

Is a Municipal Debt Crisis Imminent?

Veronique de Rugy has a great post at NRO about the potential for a muni debt crisis in the near term. The basic problem: state and local governments are facing a new budgetary reality. Benefits to public employees and Medicaid obligations are growing, while revenues are only starting to show signs of recovery. Is there a tradeoff imminent for governments between paying bondholders, pensioners, or for current services?

Meredith Whitney joined Warren Buffett among those warning of widespread defaults in the $2.8 trillion muni debt market necessitating a federal bailout. However other experts disagree, arguing that taxpayers, municipal workers, and service beneficiaries will feel the coming cuts to local and state governments, thus cushioning debt holders.

Much also depends on the extent to which state and local governments have an accurate picture of their true financial condition. The past few years have revealed sometimes an extreme disconnect between fiscal reality and official accounting, something I would argue the stimulus helped to augment.

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.

Stimulating $19,000,000,000 in New State Taxes

Among the proposals the president is considering in his latest round of stimulus is an additional $50 billion in transportation spending. It is not clear, but near as I can tell from reading the reports, the money would be channeled through the states. Now, one might think that federal lump-sum grants to state governments would offset the states’ own expenditures, allowing them to cut their own taxes. In fact, according to new research, a $50 billion grant to state governments is likely to cause them to raise their own taxes by about $19 billion.

A well-documented phenomenon known as the “flypaper effect” has found that when the federal government makes grants to state governments, the latter do not decrease their own expenditures by anywhere close to the level of the grant. The idea is that the money sticks where it lands; hence the funny-sounding name. Now, new research by the University of West Virginia University’s Russell Sobel and George Crowley shows that it is even worse than previously thought. 

Prior studies had focused on state spending reactions in the year in which grants were made. But Sobel and Crowley’s research (based on data from 50 states over a 13 year period) finds that even after the federal money goes away, state and local governments tend to permanently increase their own spending and taxation in order to keep the newly-funded programs running. (If this argument sounds familiar, it is because Governor Sanford actually made it back when the last stimulus was passed).

What is the magnitude? For every $1.00 in federal grants that a state receives today, the state can be expected to increase its own future taxes by somewhere between $0.33 and $0.42 in the future. Let’s assume it is the average of this range and that future state taxes will rise by $0.38 for every $1.00 in federal aid. If this is the case, then an additional $50 billion in “aid” to the states will cause states to raise their own future taxes by about $19 billion.