Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

While the Goldman Sachs testimony yesterday made all the political headlines yesterday, there was a second event occurring simultaneously that is much more important for our long-term economic security.  You see, despite all the rhetoric about financial regulatory reform, the Goldman Sachs hearings are really all about the past. 

The bigger story is about our future.  President Obama formally kicked-off of the “National Commission on Fiscal Responsibility.”

This Commission has the most difficult and important jobs in Washington – to figure out how to restore U.S. fiscal policy to something akin to a sustainable course.  It won’t be easy.  After 50+ years of total government spending comprising about 1/5 of the U.S. economy, the three entitlement programs - Medicare, Medicaid and Social Security - are projected – all by themselves – to exceed this share of the economy in the lifetime our today’s schoolchildren.  Throw in continued expenditures on all other functions of government – national defense, homeland security, environmental protection, education, the court system, and more – government spending is projected to consume an ever larger share of our economy.  This, in turn, has the potential to raise interest rates, crowd-out private investment, and thus reduce our rate of economic growth.

The President was careful not to take anything off the table yesterday.  That is important because this is not going to be an easy problem to solve.  At the end of the day, there are only two solutions to our fiscal problem. 

Solution 1: Raise more revenue.  In political terms, this means raising taxes.  I doubt that the Republican members of the Commission will be fond of this.

Solution 2: Cut spending.  In political terms, this means reducing the growth rate and/or level of benefits from “sacred cow” programs with vocal constituencies – such as seniors.  Democrats proved in 2005 that they are unwilling to cut benefits.  And many Republican members of the House sought to “solve” the problem through free lunch gimmickry, arguing that personal accounts (which I support, albeit for different reasons) would generate high enough returns that no benefit cuts would be needed. 

Where does that leave the Commission?  I see it most likely pursuing one of three possible outcomes.

Outcome 1:  The D’s and R’s on the Commission are unable to find enough common ground, and thus the Commission issues a final report that offers a series of options, each with proponents and dissenters.  In other words, partisanship.

Outcome 2: The Commission agrees they need to have at least some options that most members agree to.  And, caving to political pressure, they throw intellectual honesty out the window, and use a combination of both time-tested and brand new gimmicks to make it seem like the problem can be fixed without serious revenue increases or spending cuts.

Outcome 3:  The Commission takes a brave political stand by pointing out the extraordinarily difficult fiscal challenges ahead of us, proposes politically earth-shattering reforms, and then disbands and watches its proposals wither and die in the backrooms of Congressional committees.

Given the composition of the committee (see list here), I am optimistic that option 2 will be discarded.  But I think 1 and 3 are equally likely.

If there is hope for real reform coming out of this Commission, it will be because the Commission actually includes many sitting members of Congress who control the key committees.  In this important sense, this Commission has more in common with the 1983 Greenspan Commission, which led to politically difficult Social Security reforms being passed by Congress, than with the 2001 President’s Commission to Strengthen Social Security, which had no members of Congress and which saw its recommendations soundly ignored.

I hope my skepticism is mis-placed.  I sincerely hope this Commission comes up with good options, and that those in power listen.  If this happens, the long-term implications for “good” are far greater than 99% of all other economic news …

April 15 - tax filing day.  Undoubtedly, the newspapers will be full of the usual debate about whether the rich pay too much or too little in taxes. 

A Washington Post article (reprinted here) written by my fellow economists Rosanne Altshuler and Roberton Williams last week has received a fair amount of press coverage by pointing out that “about 45 percent of households will owe no federal income tax in 2010.”  This has led to the usual debates about whether this is “fair” or not.  But “fairness” is not a particularly well-defined notion, and your view of it probably depends a lot on whether you are one of those paying taxes, or one of those not. 

Rather than get into a debate about fairness, I want to make a point about economic efficiency, and a point about the interaction of politics and economic policy.  

The economic efficiency point is straight out of introductory public finance.  Most taxes have two impacts.  First, they redistribute resources in some way.  Second, they usually change relative prices and therefore distort economic decision-making.  These distortions in economic decision-making lead to real economic costs.  There are many names for it – the deadweight loss of taxation, including the excess burden of taxation, the efficiency cost of taxation, even the Harberger Triangle (named after the eminent economist who rigorously made this point). 

Whatever name you use, the point is simple: when you tax an activity, you not only raise revenue, but you also destroy some economic value along the way.  In other words, to raise a dollar of revenue, you may destroy another 25 or 30 cents of activity in the process of raising the dollar.  These excess burdens are not always easy to see with the naked eye because often it is in the form of something that did not happen – a transaction that never occurs, an hour of labor withheld from the market, an investment not made, and so forth.  Think of the “dog that did not bark in the night.”       

What is particularly important about this is that the size of this excess burden grows with the square of the tax rate.  That means, essentially, that if you double the tax rate, you significantly more than double the excess burden.  In short, each dollar of revenue gets a more expensive to collect.

As a result of this, most economists agree that the most efficient way to raise a given amount of revenue is to have a smaller tax rate applied to a larger tax base.  The Tax Reform Act of 1986 was a particularly good example of tax policy designed to do exactly that – including more sources of income in the tax base, removing special exclusions and exemptions, and then lowering the marginal tax rate.    

The fact that 45% of households face no income tax is one of many indications that we may have too narrow of a tax base, and therefore too high of a tax rate.  (There are many other examples, most of which are even more quantitatively important, including things like the exemption of home mortgage interest or health care insurance premia). When we leave one person untaxed, the tax burden on the remaining individuals must be higher.  And, importantly, the deadweight loss is higher. 

The second point I would make is that when nearly half of the population pays no income tax, what incentive does that half have to control government spending?  As we have learned over and over again in numerous contexts (including 3^rd party insurance payments), people are a lot more likely to spend money when the money they are spending is somebody else’s.  After all, who wouldn’t like more public spending if somebody else is going to foot the bill?  

So whatever your views about the “fairness” of who pays taxes, let’s be clear that it has real economic and political consequences.  

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.