Nothing is Wrong with a “Do-Nothing” Congress!

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Nov 18, 2011

The Budget Control Act of 2011 established a joint congressional committee (the “Super Committee”) and charged it with the responsibility of reducing the deficit by $1.2 trillion over 10 years.  If the Super Committee fails to reach an agreement, automatic cuts of $1.2 trillion over 10 years are triggered, starting in January 2013.  These are said to be “across the board”, but they are not.   They would apply $600 billion to Defense, and $600 to other spending.  Entitlements are exempt, including the Supplemental Nutrition Assistance Program (SNAP, formerly food stamps) and refundable tax credits such as the Earned Income Tax Credit and child tax credit.  These entitlements are exempt from the cuts because anyone who qualifies can participate (that spending is determined by participation, not by Congress).

In addition, the Bush-era tax cuts are set to expire at the end of 2012, so doing nothing means that tax rates would jump back to pre-2001 levels.  That combination might be the best thing yet for our huge budget deficit.

The Federal government’s annual deficit has been more than $1 trillion since 2009.  Continuation of that excess spending might create a debt crisis similar than the one now in Europe.

The Center on Budget and Policy Priorities estimates that the trigger would cut $54.7 billion annually in both defense and non-defense spending from 2013 through 2021.  Meanwhile, U.S. defense spending is around $700 billion per year, with cuts of about $35 billion per year already enacted, so the automatic trigger would reduce defense spending from about $665 billion to about $610 billion.  Some may view that 10% cut as draconian, but the simple fact is that the U.S. needs to wind down its spending on two wars.  Congress and voters are fooling themselves if they think the U.S. can continue to spend the same level on defense, not raise taxes, and make any major dent in the huge annual deficit.

The same point can be made for automatic cuts in Social Security, which in its current form is unsustainable.  Since it was enacted in 1935, life expectancy has increased dramatically, which means more payouts than anticipated.  Birth rates have declined, which means fewer workers and less payroll tax than anticipated.  The system will run out of money in 2037.  Congress either needs to raise taxes or cut spending.  But they won’t do either!  The only solution might be the automatic course, without action by Congress!

For further reading, see “Why doing nothing yields $7.1 trillion in deficit cuts”.

A Look at Herman Cain’s 999 Tax Plan

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Oct 21, 2011

The point of this blog is to inject some substance into discussion of Presidential candidates. To see the problem, consider what I wrote on my facebook page: “In an airport for an hour yesterday, we could not avoid hearing CNN talk about the upcoming presidential debate. For the entire hour, we heard only comments like: Perry needs to come out swinging; or, ‘Is Cain a viable candidate?’; or, Bachmann has really fallen in the polls; or, ‘This now boils down to a two-man race’, followed immediately by the wisdom that ‘Yes, but we don’t know yet who the two men are.’  What inanity! It is JUST a horse race! Not a single comment during the entire hour had anything whatever to do with any substantial issue of policy. Is this all we get?”

There must be more to consider, in this important decision.  So, I started by looking at Herman Cain’s 999 tax reform plan.  See more at his website, with the key bullets in the insert below. 

Bear in mind that I’m a former Deputy Assistant Secretary of the U.S. Treasury (1985-87), so I worked hard on President Reagan’s successful “Tax Reform Act of 1986” to lower the rates and broaden the base.  Since 1986, however, Congress has managed to reintroduce plenty of new deductions and tax breaks, while raising the rate.  Maybe it’s time to do something again!

Cain’s proposal has a lot of similarities to the 1986 reform, if perhaps more extreme.  It is meant to be revenue neutral, raising the same total tax.  It would eliminate virtually ALL deductions, like mortgage interest paid, and it would cut rates drastically.  It would eliminate the income tax as we know it, and introduce a national sales tax (or value added tax).   What about the accuracy of Cain’s claims below?  By reducing rates drastically, this proposal probably WOULD reduce the distorting effects of taxation by reducing the interference of taxes in the productive activities of workers and business – what economists call “deadweight loss”.  For similar reasons, it probably would provide greater incentive for work and investment, and therefore probably provide some stimulus to growth.  That’s all for the good.

However, ANY tax reform plan of ANY politician EVER, no matter what motivation, will always have two effects to watch out for.  First, any tax reform will always raise taxes on some taxpayers and reduce taxes for others.  It will have distributional effects worth analyzing.  Second, it will therefore create disruptions and reallocations.  Activities to pay additional tax may shrink – laying off workers who may remain unemployed for some time until they can re-train and find work in other activities that now face lower tax rates and hope to expand.  That is, for only one example, the Cain plan might hurt homeowners and homeownership by eliminating the mortgage interest deduction.  With such pervasive changes, however, the disruptions will be widespread and costly in themselves.

Finally, for now, note the point about distributional effects.  Nothing in any of Cain’s bullets says anything whatever about distributional effects.   I’m afraid this point is the Achilles heel of Cain’s 999 plan.  According to the non-partisan Tax Policy Center, Cain’s plan will greatly reduce taxes of those with the highest incomes and raise total taxes on those with low incomes.  It is ‘regressive’.  And you don’t even need to read the TPC analysis to know this is true.  Cain’s plan cuts the top personal rate from 35% to 9%.  There is no amount of tax-base broadening for those high income taxpayers that can get back the same tax revenue from them.  And currently those with the least income pay no Federal tax at all.   Under Cain’s plan, everybody will pay the 9% sales tax, on everything they buy.  Moreover, if those low-income individuals are working, they will probably bear some additional burden of the 9% business tax that applies to all profits AND wages paid: it applies to all sales revenue minus purchases and capital investment, not subtracting wages paid to workers.

I’d personally favor another revenue-neutral reform like the TRA of 1986, one that lowers the rates and broadens the base.  Such a reform would undoubtedly cause some disruptions and adjustments costs.  And it would help some while hurting others.  But perhaps it could be designed in a way that also tries to be distributionally neutral, not adding tax burdens on those least fortunate while cutting taxes on those already doing well.

Here we go again, …

Filed Under (Environmental Policy, Health Care, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Feb 25, 2011

Yes, I’ve written about the budget before, and perhaps I’m getting repetitive.  But it’s important, and surprising, so I’ll give it another go.  But nevermind President Obama’s recent release of a proposed budget for next year.  That document is already irrelevant!  Let’s start with the current budget. 

Current federal spending now is over  $3 trillion per year.  The deficit is $1.6 trillion.  The U.S. House of Representatives approved a plan to cut spending by $60 billion.  The Republicans chose not to change spending on defense and homeland security, nor entitlement programs like Social Security, Medicare, and Medicaid.  The problem is that then other discretionary spending must be cut for some government agencies by as much as 40%.  And yet that total $60 billion cut is only a drop in the bucket.  It cuts the annual deficit only from $1.6 trillion to 1.54 trillion!

My point is that you can’t get there from here.  First of all, it’s not wise to cast such a wide net, without thinking, making cuts of 40% or more to discretionary programs simply because they are called discretionary.  It means cuts to national parks, environmental programs, and federal employees who provide many public services people want.

Second, who says we need to leave defense and entitlements untouched?   Within just a few years, Medicaid will cost about $300 billion per year, Medicare will cost $500 billion, and Social Security will cost $800 billion, and defense $800 billion.  ALL of domestic discretionary spending will be only $400 billion.  By those round numbers, $60 billion from that last category is a 15% cut.   The same $60 billion cut proportionally from all of those categories would be only a 2% cut.  That’s what I mean by a drop in the bucket.

Anyway, that plan would still cut the deficit only from $1.6 trillion to $1.54 trillion.  The ONLY way to make any sizeable dent in the huge $1.6 trillion deficit is to look at all the current spending, not just at $400 billion of domestic discretionary spending, but at the $800 billion of defense spending, $800 billion of social  security, $500 billion of Medicare, and/or $300 billion of Medicaid.

And who says taxes are sacrosanct?  A $1.6 trillion deficit means we are spending more than our income, so one just MIGHT think that problem can be approached from both ends.

Happy 75th Birthday Social Security. But What Now?

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 9, 2010

This coming Saturday, August 14, marks the 75th birthday of the U.S. Social Security system. Specifically, it marks the date that President Roosevelt signed the Act into law, famously stating:

“We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family …”

The original Act specified that benefits were to be paid only to primary workers when they retired at age 65.  The Act established that benefits would be based on payroll tax contributions made during the working years.  Of course, the program has been modified many times over the years (e.g., allowing benefits to be taken at 62, expanding coverage to spouses, disabled workers, and others, dramatic increases in tax rates, changes in benefits, etc). 

Initially, benefits were paid as a lump-sum.  While Ida May Fuller is best known as the first recipient of Social Security benefits, SSA’s historian indicates that the first benefits were paid as a lump-sum, and that:

“The earliest reported applicant for a lump-sum benefit was a retired Cleveland motorman named Ernest Ackerman, who retired one day after the Social Security program began. During his one day of participation in the program, a nickel was withheld from Mr. Ackerman’s pay for Social Security, and, upon retiring, he received a lump-sum payment of 17 cents.”

It was not uncommon for early recipients to receive much more than they put in.  Indeed, it has been estimated that the net transfers to early generations of recipients is well in excess of $10 trillion.  In other words, for most of the last 75 years, the majority of Social Security recipients received far more in payments than they paid into the system (and, yes, this is true even if one accounts for inflation and implied interest on those contributions.)

How is this possible?  Actually, it is quite simple.  Social Security is not a funded pension system.  It is a “pay-as-you-go” transfer system in which the funds paid out to current beneficiaries are provided by current taxpayers.  Such a system can work quite well so long as we have wage growth and so long as the ratio of workers-to-retirees is stable or growing. 

But therein lies the crux of Social Security’s financing problems.  Unlike what many citizens believe, the true problem facing Social Security has very little to do with Congress’ penchant for “spending the Social Security surpluses” of the past 25 years.  It has far more to do with the basic financing structure of the program.

In the 1950s, there were 16 workers paying taxes to support each Social Security beneficiary.  By the time JFK was elected President, it was about 5 workers per beneficiary.  Today we have a bit more than 3 workers for each beneficiary.  In my lifetime, that will fall to 2 workers per beneficiary.

So do the math.  If you want to replace 40% of the average workers income upon retirement, and you have 16 workers supporting each retiree, you only need to collect taxes from each worker equal to 2.5% of their income (2.5 x 16 = 40).  With only 5 workers per retiree, you need to tax them at a rate of 8%.  When there are only 3.3 workers (today’s ratio), you need a tax rate of 12.1%.  (Today’s combined tax rate is about 12.4%).  As the ratio falls to 2-to-1, tax rates need to climb to 20% to keep the system in balance.

(I am simplifying a bit here, but it is remarkable how closely this very simple calculation mirrors the Social Security Trustees’ long-term financial outlook!)

So, as we celebrate the birthday of the Social Security system, we have to ask ourselves some difficult questions.  Can we afford the system we have?  If not, whose benefits do we cut? High income retirees ?  Low income retirees?  Today’s retirees?  Today’s workers?  Alternatively, whose taxes do we raise?  Everyone?  Only high income households?

Just as most members of the human race who are fortunate enough to live to age 75 begin to notice varying degrees of health declines due to aging, so too must we deal with the unhealthy economic consequences of an aging Social Security system. 

We Need a New Retirement System

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 20, 2009

The past year has not been good for 401(k)s and other retirement plans.  Among many implications of the financial crisis and deep recession, we have seen the dramatic, correlated losses across nearly every major asset class underscore the fragility of a 401(k) system that is focused predominantly on wealth accumulation rather than secure retirement income.  In essence, the 401(k) system was exposed for what it truly is – a promising supplemental savings plan, but an inadequate vehicle for ensuring a secure retirement.  

 

I’m not alone in this view.  I spend much of my time interacting with people who specialize in thinking about retirement income security – academic researchers, policymakers on both sides of the political aisle, insurance companies, financial advisors, consultants and consumers.  Over the past 12 months I have noticed a striking degree of commonality in their thinking around the fact that we need a better retirement system in the U.S.  This is not to say there are not still important areas of disagreement – for example, I find proposals to increase Social Security benefits, to return to a defined benefit system, and/or to have the government guarantee retirement income to be a combination of naive, reckless and fiscally irresponsible.  But when it comes to the future of private sector retirement plans, I believe there are a number of common themes emerging that make very good sense.

 

Yesterday, I had the opportunity to speak at the annual conference of the American Council of Life Insurers (www.acli.com) about my proposal for encouraging plan sponsors to use guaranteed lifetime income products as the default distribution option.  Before my session, I had the privilege of hearing Dr. Roger Ferguson, President and CEO of TIAA-CREF – one of the largest providers of retirement income in the world – speak on this issue.  (In the interest of full disclosure, I should note that I am a trustee of TIAA). 

 

Dr. Ferguson outlined 5 areas that need improvement in our system.  (I should note that I am paraphrasing here and including some of my own thoughts – so please do not interpret this as an exact representation of his remarks!)

 

  1. We need to return to a focus on providing guaranteed income.  During the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) pension plans like the 401(k) and 403(b), we somehow lost sight of the fact that the point of saving for retirement is to provide income security.  We need to get the focus back on annuitized, lifetime income.  This does not mean a return to the old style DB systems.  It does mean looking for innovative ways to convert 401(k) and 403(b) wealth into income before, during, and after retirement.
  2. We need to broaden coverage.  Millions of households do not have access to any employer sponsored retirement plan.  Somehow, someway, we need to fix this.  While it is true that individuals can save on their own, the evidence is overwhelming that “employers matter” in promoting saving.  Social Security alone is sufficient to replace adequate income for only a minority of households.  Indeed, given the poor fiscal trajectory of the program, the rising normal retirement age that will reduce benefits for those who claim at earlier ages, and rising Medicare premiums, its adequacy will only diminish further.    
  3. We need to ensure that individuals are broadly diversified.  I, personally, would love to see us put together individualized retirement plans that include a life cycle portfolio trajectory that gradually converts into annuitized income the closer one gets to retirement.  The investment options need to include not just stocks and bonds, but also real estate and other asset classes.  
  4. We need to ensure that individuals have access to good information and advice.  Our current regulatory structure – designed to protect consumers from tainted advice by those who might have a conflict of interest – has had the unfortunate effect of making plan sponsors go through a torturous and administratively complex route to provide good advice to participants.  We need to find sensible ways to streamline this process. 
  5. We need to provide vehicles for individuals to be able to save for retiree health care expenses.  Health Savings Accounts and other similar tools have a useful role to play here.

 

To get there from here, we do need some regulatory and policy changes.  I suspect that we may see this discussion rise closer to the top of the agenda after health care reform is behind us …

Why Human Services’ time never seems to arrive

Filed Under (Health Care) by Elizabeth Powers on Oct 16, 2009

 I just returned from a meeting of human service agency heads, foundation officers, nonprofit leaders, and an academic (me) convened to talk about reforming the state’s contracting practices. Just to be clear about it up front – ‘human services’ is a lot more than welfare. Think afterschool programs, child care, mental health and substance abuse services, lifetime support services for the developmentally disabled, and services for the aged and disabled. One thing that everyone in the room agreed on was that human service reform has been hamstrung for many years by the generally woeful underfunding of this sector in the state of Illinois.

If we could figure out the cause of this chronic condition, maybe we could find a cure.  From the discussion, I could parse out a few theories about why Human Services’ time never seems to arrive..

People are complacent by nature. Politicians and voters are people. Ergo, a prerequisite for reform of any sector is an enormous political-fiscal crisis (a.k.a. the ‘big crisis’) that would awaken us all to the necessity of reform. The ‘big crisis’ model is widely believed. In fact, I have heard the “big crisis” idea espoused by legislators at ‘on the record’ events; “don’t worry, the GA will act once there is a big crisis. Until then you can’t expect …[your issue here]… to get off the back burner.” In fact, Governor Quinn trusted the “big crisis” model when he proposed the doomsday budget this summer that would have radically slashed human services funding. His “big crisis” premise was that voters would not tolerate a budget balanced by draconian cuts falling on the most vulnerable. Further, the ‘big crisis’ thinking went, legislators would tremble at the thought of blessing such a situation because of the retribution that angry voters would surely visit upon them at the polls. HA! The Governor’s ultimately well-meaning but dangerous bluff was called. I didn’t notice much spontaneous expression of surprised outrage on the part of the electorate the day this happened, did you?

Once the budget is fixed, human services funding will rebound. This is an appealing notion until you consider that human service funding in key areas has been in actual decline for decades. Clearly, with the enormous structural deficit the state faces, a tax increase is going to be essential. Unfortunately for this theory, though, human services were also underfunded in good (or at least better) times. If the past is any guide, human services will continue to stand at  the back of the funding priorities line, as usual.

Political leaders and voters are ignorant of the essential services provided by government and would act to make changes if better informed. I must admit, as an academic I’m partial to the notion that facts and logic can persuade key actors to care about issues and change political priorities. The current health care reform debate provides strong evidence that many people, including policymakers, so-called policy experts, journalists and pundits, do not know what services the government provides, what various programs do and whom they reach (Medicaid v. Medicare, anyone?). Many also appear quite sure that no friends or relatives of theirs have ever benefited from government services (Medicare and Medicaid, anyone?). While there is considerable evidence that the first part of the hypothesis is true (people are ignorant), assuming that they would act differently if better informed is another matter entirely.

This brings me to the final hypothesis:

Political leaders and voters lack an emotional connection to the issues. One of the problems of being human is that we are bound up in our ohsolimited web of personal experience. Unfortunately, this seems to apply equally to those individuals who have hone to great effort of attaining public office in order to help make wise decisions for all of us (Daniel Patrick Moynihan may have been the exception that proves the rule).  In his address to Congress, President Obama argued that Ted Kennedy’s concern with health care reform stemmed from his “experience of having two children stricken with cancer.”  I can’t count how many times I’ve heard a policymaker trot a personal anecdote about a relative in order to to his or her colleagues why a certain service is actually really, really important.  Apparently, Mr. Spock, this is how humans relate to each other.  It is fascinating but sad fact that most people aren’t very imaginative.

I’m reluctantly partial to the view that if key leaders had direct experience with mental health, substance abuse, developmental disabilities, and poverty issues, real change in the human service area would emerge.  One of the major examples of this is the impact of the Kennedy family had on awareness of developmental disabilities and in shaping public programs for the developmentally disabled.  Very recently, Sarah Palin vowed to become a champion of the developmentally disabled in her prospective role as Vice President (her son has a developmental disability).  Taking this notion seriously implies that advocacy groups should strive to identify politicians and gifted potential candidates with direct experience of their issues if they want real change.

 

The Real Risk to Illinois Public Pension Participants: Retiree Health Care

Filed Under (Health Care, U.S. Fiscal Policy) by Jeffrey Brown on Oct 6, 2009

I’ve noted in prior postings that public pensioners in Illinois have very little to worry about with regard to their pension benefits.  But now the bad news – they do have reason to be concerned about retiree health insurance.

 

As I stated in a previous post, Article XIII, Section 5 of the Illinois state constitution protects pension benefits.  Specifically, it states:

 

“Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

That is about as strong of a guarantee as anyone could hope for in this day and age.  Indeed, Social Security offers no such guarantees.  The Supreme Court of the United States has previously (in 1960) ruled that individuals have no inherent “right” to their Social Security benefits (see Fleming v. Nestor).  Congress can alter them at anytime. 

 

But, the above guarantee is limited to the benefits from the retirement system, such as the Statue Universities Retirement System (SURS) or the Teachers’ Retirement System (TRS).  As much as participants might hope that retiree health insurance is a benefit of the retirement system, I (and, more importantly, most of the lawyers to whom I have posed this question) don’t think this argument would stand much of a chance in the courts. 

 

Of course, even in states that do not have explicit constitutional guarantees, retirement benefits are often protected by a contract clause.  And, yes, Illinois has one of those too.  Specifically, the Illinois constitution states:

 

“No ex post facto law, or law impairing the obligation of contracts or making an irrevocable grant of special privileges or immunities, shall be passed.”

 

I have asked a few knowledgeable legal experts about whether this would apply in the case of retiree health care.  The responses are typically consistent – that while contract impairment provisions are sometimes successful with regard to the terms of a retirement system contract, nobody could point to a case where this provision was successfully applied to benefits under an employment contract because employment contracts, by their nature, are temporary.  If you doubt this, just consider the fact that the University of Illinois changed our contracts for the current year to allow the University to require involuntary, unpaid furloughs!

 

Of course, I am an economist, not a lawyer – and I am certainly no judge.  So this is not to say that retired Illinois public servants don’t have a case worthy of court if the state were to eliminate or substantially reduce their retiree health care benefits.  As has been pointed out to me by others, such a case is certainly likely to be given “an attentive listen” by the courts.  But whether that translates into any actual protection of benefits is anybody’s guess.  If I were a betting man (I’m not), then I would best against it.

 

So should retirees panic?  Of course not.  We should never forget that we live in a democracy, and most politicians know that the surest way to lose the next election is to do something that makes a large voting bloc – especially seniors – angry, motivated and mobilized.  Politically, I doubt the state will do anything so drastic as to eliminate retiree health benefits for existing retirees or those close to retirement.  But even if drastic changes are out, the reality of the dire long-run budget picture in Illinois would seem to dictate that retiree health care will be an area that legislators look to for future savings. 

 

So, I would much rather that retired public servants enjoy their retirement worry-free.  But for those who want something to worry about, then retiree health benefits are worth a lot more worry than pension benefits.

Do Illinois Pensioners and Taxpayers Know the True Value of Public Pensions?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 28, 2009

Last week I wrote about the (often misguided) debate over the generosity of public pensions in the state of Illinois.  I ended by noting that it was important to further examine how my previous analysis would change once we account for two under-appreciated facts about the Illinois pension system.    

 

The first under-appreciated fact is that Illinois is one of a small number of states that provides an explicit constitutional guarantee against the impairment of pension benefits.  Specifically, Article XIII section 5 of the Illinois State constitution states that: “Membership in any pension or retirement system of the State … shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

While Illinois is not alone in providing this guarantee – similar language is included in the constitutions of Alaska, Arizona, Hawaii, Louisiana, Michigan and New York – it should be noted that not all states provide such a guarantee.  In Indiana, for example, the Indiana Court of Appeals (in Haverstock v. State Public Employees Retirement Fund” stated that “pensions are mere gratuities springing from the appreciation and graciousness of the state.”

 

In a paper that I wrote with David Wilcox in the May 2009 American Economic Review, we discuss just how powerful these guarantees have proven to be over the years.  On the basis of that analysis, I am highly confident that Illinois pensioners will receive their benefits.  Unfortunately, with Illinois having one of the worst records of effective governance in the U.S., most other pensioners and participants are not quite so confident.  One way or another, most of them think, the politicians in this state will find some way to renege (at least partially) on these benefits.  (As an aside, what public servants really have reason to be afraid of is that retiree health benefits will disappear – those are not covered by the impairment clause.) 

 

The second underappreciated fact is that the public defined benefit pension plans in Illinois are far too complex for the average (or even the highly sophisticated) participant, taxpayer or legislator to properly value.  There are many reasons for this, but mainly it boils down to the fact that the ultimate benefit depends on a lot of variables that will only be known with certainty many years in the future, such as one’s final average salary.  If that were not complex enough, the legislature has made it even more complicated by having multiple benefit formulas in place.  For example, in the “Traditional” defined benefit plan under the State Universities Retirement System (SURS), participants who joined the system prior to July 2005 received a benefit that was the higher of two approaches.  The first was the standard formula (2.2% times years of service times final average compensation).  The second was a “money purchase” option that essentially kept track of the individual’s contributions, matched them with a state match (at least on paper – we already know the state did not really provide the money), and then credited them with an “Effective Rate of Interest,” or ERI.  Then, at retirement, the “balance” in this largely fictitious account was converted to an annuity using an annuity table that used a rate quite close to the ERI.  If the resulting number was higher than the standard formula, the annuitant gets this higher amount instead. 

 

Confused yet?  If you answered “yes,” don’t feel bad.  Most participants don’t understand all these details.  It is complex stuff that requires a high degree of financial sophistication to truly follow.  If you answer “no,” then let me ask a few extra credit questions.  First, do you know what mean, standard deviation and range the ERI has been in for the last 25 years?  And do you know how the annuity conversion factor compares to market rates?

 

By this point, I suspect very few people know the answer.  Again, don’t feel bad.  I study pensions for a living, and it took me a lot of time and research to find these answers (and, alas, it was too late – by the time I understood all the details, I had already made a sub-optimal pension choice – and it was unfortunately a lifetime irrevocable one!) 

 

Without boring you with details, let me give you a flavor of what I have since learned.  The way the SURS board has historically set the ERI, participants in the DB plan were getting an enormously high return (roughly 8-9%) relative to the risk (as measured by the standard deviation in the ERI, which was tiny over the past 25 years), and this high return was being implicitly guaranteed by the taxpayer.  And the annuity rate?  It is substantially more favorable than even the most attractive private market annuity prices – I’m talking in the range of 50% or more benefits per dollar in the “account,” and in some cases, far more.  These two factors explain why most people retiring from SURS in recent years actually received a higher benefit from the money purchase calculation than the basic formula.

 

What do these two points – the constitutional guarantee and the complexity of the benefit formula – have to do with each other?  Put simply, they have conspired to put an enormous pension funding burden on taxpayers without providing commensurate perceived value to state workers!

 

Let me explain.  As a result of a complex benefit formula that hides the true value of the pensions – combined with the fact that most participants view the DB pension promises as being at some risk of not being honored – means that most public pension participants do not value the pensions at their full economic value.  This fact partially mitigates the point I made last time because this means the “compensating wage differential” will not be dollar-for-dollar. 

 

However, the fact that participants discount their benefits in this way does NOT mean that the state is not actually incurring the full economic costs.  Indeed, the constitutional guarantee means that the states’ taxpayers ARE on the hook for the full economic cost of these benefits.

 

In essence, we have the worst of both worlds.  Public employees are earning a valuable benefit, but because our legislators have (i) created a needlessly complex system, (ii) created a complete lack of confidence in the security of these promises, and (iii) have provided us with a constitutional guarantee that the benefits will be paid, the participants don’t fully value the benefits even though the state bears the full costs.

 

If any private company did this – providing a costly benefit that was valued by employees at less than the true cost to the employer – that company would soon be bankrupt.  But this is Illinois state government.  So, instead, we continue to build up enormous funding liabilities that will simply be passed on to the next generation of Illinois taxpayers.  It may be “business as usual” in Illinois.  But it’s also a real shame.

 

Public servants and taxpayers of Illinois deserve better.

 

The True Size of Government

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Sep 25, 2009

In 2008, the federal government’s receipts were 17% of GNP, and its expenditures including transfer payments were 21.4% of GNP (implying the budget deficit was 4.4% of GNP).  If State and Local taxes and expenditures are added to those numbers, they become 30.5% and 35.2% of GNP, respectively.  For many reasons, however, government’s reach is wider than reflected in those numbers.  Government does not just spend its own tax revenue; it spends other people’s money as well.

For just one example, consider environmental regulations.  I have not seen a recent estimate of the total costs of environmental protection, so I will rely on some older numbers.  Note, however, than none of this discussion is meant to imply that the environment should not be protected!   Maybe protections should be more limited, or expanded.  The point is just that measured dollar expenditure by government does not accurately reflect its true size.

In “The Cost of Clean”, the U.S. EPA in 1990 estimated that the total private cost of required environmental protection was approximately $115 billion (in 1990 dollars) or 2.1% of GNP.  By the year 2000, they said the value could approach 2.8% of GNP.  If I assume the same rate of growth through 2008, then these private costs of environmental protection could be as high as 3.5% of GNP by 2008, a figure that would be $514.0 billion, or 21.6% of non-defense federal expenditures.

This cost of environmental protection comes mainly in the form of mandates imposed on firms.  Examples of mandates include the forced adoption of best practices pollution abatement technology or binding emission rates (e.g. limits on pollution per unit of output).  However, these mandates are just like taxes in two respects.  First, the government imposes these costs on private firms.  Second, the mandates provide “public goods” like clean air and water that we all can enjoy.

In other words, if these costs to private firms were converted into an equivalent tax program with direct government expenditures, then U.S. discretionary spending would appear to be 21.6% higher.  These expenditures do not appear explicitly in the federal budget, so they merit further study.  How do we divide our limited resources between private or public consumption, versus private or public investment?  How much of that environmental spending is in each category?  What are we getting for these outlays?  How can we measure the value of the improved environment?  Do these expenditures provide environmental benefits now, or are they investment in the future?

In order address these questions, a full “environmental budget” would need to show each cost, including the cost of complexity created by mandates.  In addition, some environmental protection programs are required by state and local governments (just like taxes).  Each of the programs has implicit transfers from one state to another, and from one income group to another (just like taxes).  Why are these programs not evaluated just like taxes?

Who Bears the Burden of Energy Policy?

Filed Under (Environmental Policy) by Don Fullerton on Sep 4, 2009

Economists have tools to analyze the distributional effects of income taxes, payroll taxes, property taxes, and corporate income taxes.  Some existing research even looks at distributional effects of environmental or energy taxes used to help control pollution or energy consumption.  Yet most pollution policy does not involve taxation at all!  Instead, we use permits or command and control regulations such as technology standards, quotas, and quantity constraints.  Existing studies of energy policy are mostly about effects on economic efficiency, addressing questions such as: how to measure the costs of reducing pollution or energy use, how to measure benefits of that pollution abatement, what is the optimal amount of protection, and what is the most cost-effective way to achieve it.

Yet environmental mandates do impose costs, and an important question is who bears those costs.  Moreover, those restrictions provide benefits of environmental protection, so who gets those benefits?  Full analysis of environmental policy could address all the same questions as in tax analysis.  Perhaps it could use the same tools to address distributional effects – not of taxes, but of these other policies that are used to protect the environment.

Thinking about the distributional effects of environmental policy is interesting and difficult.  For example, a standard tax analysis would point out some complex implications of an excise tax: not only does it affect the relative price of the taxed commodity, and thus consumers according to how they use income, but it also impacts factors intensively used in the production of that commodity, and thus individuals according to the sources of their income.  Yet an environmental mandate can have those effects and more!  Consider a simple requirement that electric generating companies cut a particular pollutant to less than some maximum quota.  This type of mandate is a common policy choice, and it has at least the following six distributional effects.

First, it raises the cost of production like a tax, so it may raise the equilibrium price of output and affect consumers according to spending on electricity.

Second, it may reduce production like a tax, reduce returns in that industry, and place burdens on workers or investors.

Third, a quota is likely to generate scarcity rents.  For simplicity, suppose pollution has a fixed relation to output, so the only “abatement technology” is to reduce output.  Then a restriction on the quantity of pollution is essentially a restriction on output.  Normally firms want to restrict output but are thwarted by antitrust policy.  Yet in this case, environmental policy requires firms to restrict output.  It allows firms to raise price, and so they make profits, or rents, from the artificial scarcity of production.  Just as tradable permit systems hand out valuable permits, the non-tradable quota also provides scarcity rents – to those given the restricted “rights” to pollute.

Fourth, if it cleans up the air, this policy provides benefits that may accrue to some individuals more than others.  The “incidence” of these costs and benefits usually refers to their distribution across groups ranked from rich to poor, but analysts and policy-makers may also be interested in the distribution of costs or benefits across groups defined by age, ethnicity, region, or between urban, rural, and suburban households.

Fifth, regardless of a neighborhood’s air quality improvement, many individuals could be greatly affected through capitalization effects, especially through land and house prices.  Suppose this pollution restriction improves air quality everywhere, but in some locations more than others.  If the policy is permanent, then anybody who owns land in the most-improved locations experience capital gains that could equal the present value of all future willingness to pay for cleaner air in that neighborhood. Similar capitalization effects provide windfall gains and losses to those who own corporate stock: capital losses on stockholdings in the company that must pay more for environmental technology, and capital gains on stockholdings in companies that sell a substitute product.

Capitalization effects are pernicious.  A large capital gain may be experienced by absentee landlords, because they can charge higher rents in future years.  Certain renters with cleaner air might be worse off, if their rent increases by more than their willingness to pay for that improvement.  Moreover, the gains may not even accrue to those who breathe the cleaner air!  If households move into the cleaner area after the policy change, then they must pay more for the privilege.  The entire capital gain goes to those who happen to own property at the time of the change, even if they sell it at the higher price and move out before the air improves.  Similarly, new stockholders in the burdened company may be “paying” for abatement technology in name only, with the entire present value of the burden felt by those who did own the stock at the time of enactment, even if they sell that stock before the policy is implemented.

Sixth, strong distributional effects are felt during the transition.  If workers are laid off by the impacted firm, their burden is not just the lower wage they might have to accept at another firm.  It includes the very sharp pain of disruption, retraining, and months or years of unemployment between jobs.  These effects are analogous to capitalization effects, if the worker has large investment in particular skills – human capital that is specific to this industry.  If the industry shrinks, those workers suffer a significant loss in the value of that human capital.  They must also move their families, acquire new training, and start back at the bottom of the firm hierarchy, with significant psychological costs.

The challenge here is that many of these effects of environmental policy are likely to be regressive.  Consider the six categories just listed.  First, it likely raises the price of products that intensively use fossil fuels, such as electricity and transportation.  Expenditures on these products make up a high fraction of low income budgets.  Second, if abatement technologies are capital-intensive, then any mandate to abate pollution likely induces firms to use new capital as a substitute for polluting inputs.  If so, then capital is in more demand relative to labor, depressing the relative wage (which may also impact low-income households).  Third, pollution permits handed out to firms bestow scarcity rents on well-off individuals who own those firms.  Fourth, low-income individuals may place more value on food and shelter than on incremental improvements in environmental quality.  If high-income individuals get the most benefit of pollution abatement, then this effect is regressive as well.  Fifth, low-income renters miss out on house price capitalization of air quality benefits.  Well-off landlords may reap those gains.  Sixth, transition effects are hard to analyze, but could well impact the economy in ways that hurt the unemployed, those already at some disadvantage relative to the rest of us.

That is a potentially incredible list of effects that might all hurt the poor more than the rich.  The challenge for those of us who want to claim to do policy-relevant research, then, is to determine whether these fears are valid, and whether anything can be done about them – other than to forego environmental improvements!