Why it is Unlikely that the Federal Government Will Bailout State Pensions

Filed Under (U.S. Fiscal Policy) by Jeffrey Brown on May 30, 2011

Earlier this year, I received a call from some not-to-be-named Congressional committee staffers who wanted to get my perspective on the economic and financial impact of having the federal government bailout state public pensions.  Readers of my blog will probably not be surprised that I was not exactly enamored of the idea, for a variety of reasons.

Several weeks ago, my friend Doug Elliott of the Brookings Institution put out a policy white paper taking at look at some of the pros and cons of various approaches to federal intervention. I think you would find his discussion interesting, and I recommend the paper to you.

Rather than reproduce his economic arguments here, I wanted to focus on a simpler, political point.  Doug points out that it is very unlikely that federal money will flow to the states.  As he stated in an email to me, “one way of gauging the politics is to note that the best-funded 20 states, roughly enough to sustain a filibuster against aid, are only 12% underfunded on average, compared to the remaining states, which are 33% underfunded on average.”  In other words, the more fiscally responsible states (i.e., those that would be footing the bill to bail out fiscally irresponsible states like Illinois) have enough votes in the Senate to block explicit aid.

Even though I live in a state where a federal bailout would, selfishly, be a good thing, I hope Doug is right that it is unlikely.  On principle, I can’t stomach the idea of bailing out fiscally irresponsible states for two main reasons.  First, the federal government faces its own fiscal nightmare, and taking steps to bail out the states is akin to robbing Peter to pay Paul.  Further, the moral hazard that such a policy creates for the future would set the stage for even worse behavior going forward.  And, trust me, the state of Illinois does not need any more incentives to behave irresponsibly.

Why Taxpayers, and Not Just Public Workers, Likely Contribute to Public Worker Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Mar 15, 2011

David Cay Johnston of Tax.com wrote a piece that appears to have gone viral on Facebook.  In it, he makes a well-reasoned case that public workers in Wisconsin have paid for their own benefits by accepting lower wages.

The key to his argument is this statement:

“The fact is that all of the money going into these plans belongs to the workers because it is part of the compensation of the state workers. The fact is that the state workers negotiate their total compensation, which they then divvy up between cash wages, paid vacations, health insurance and, yes, pensions. Since the Wisconsin government workers collectively bargained for their compensation, all of the compensation they have bargained for is part of their pay and thus only the workers contribute to the pension plan. This is an indisputable fact.”

This argument is one that economists clearly understand.  In fact, I agree that this view is the right starting point for analysis.  But that does not mean it is the right ending point.  In this case, I think Mr. Johnston has over-played his hand.  Indeed, there are compelling reasons to think that taxpayers do pay for part of these pensions – although not for the naïve reasons that Mr. Johnston blasts the press and politicians for touting.

As background, let me explain how economists like me tend to think about these things by starting with the case of a simple per-unit tax on a good.  One of the first lessons of public finance is that it generally does not matter whether this tax is levied on the buyers of the good or the sellers.  Why?  Because in a competitive market, prices will adjust so that the net-of-tax prices paid by the buyer and received by the seller are the same under either scenario.  We refer to this as the “economic incidence” of the tax (i.e., who really pays the tax in the sense of bearing the economic burden of the tax).  This is separate from the “statutory incidence” of the tax (i.e., who is responsible for writing the check to pay the tax authorities).  This is a key lesson from the economics of taxation and it has broad implications.

An example of this is the Social Security payroll tax.  Up to a cap, individuals pay a 6.2% tax to support Social Security, and their employer pays another 6.2%.  But most economists who have studied the issue believe that, given the characteristics of the labor market in the U.S., it is likely the workers who bear most of (perhaps the entire) 12.4% payroll tax burden.

An example helps.  Suppose you earn $100,000 and you and your employer each pay $6,200 to the government.  If the entire 12.4% tax was shifted onto the worker, and the employer did not have to pay any at all, the idea is that in a competitive market, your salary would rise so that your after-tax income would be unchanged.

In a similar vein, Mr. Johnston is making the observation that public employees negotiate over pension benefits as part of an overall compensation package, and that, therefore, every dollar (in present value) of future pension benefits requires that an individual worker give up a dollar of salary today.

As I noted above, this is the natural starting place for any economist when thinking about labor markets.  Indeed, I have made similar points myself in this blog when discussing changes to the Illinois pension system.

Thus, if Mr. Johnston wrote this piece for my undergraduate economics class, he would receive an A.  However, if Mr. Johnston wrote this piece for an advanced course in economics, he would probably get a C for massively overstating his case and extrapolating beyond what evidence suggests.

My main concern is his claim that “only the workers contribute to the pension plan. This is an indisputable fact.”  Because despite everything I have said so far, this claim IS disputable.

How?

The theory above works well in a competitive labor market in which all of the actors are operating with perfect information.  It implicitly assumes that public workers value the pension benefit at its full cost, and that politicians and union leaders are negotiating a deal that approximates a market outcome.

There are many problems with this.

For starters, there IS evidence that workers tend to under-value future pension benefits (or at least discount future benefits at a rate far surpassing market rates, which has the same effect: see, for example, Warner and Pleeter 2001).  Indeed a recent study by Fitzpatrick (2011) using the DB plan of Illinois teachers provides evidence that teachers value future pension benefits (at least on the margin) at only about 18 cents on the dollar of present value!  How can this be?

For one thing, the federal tax preference for pensions relative to wages creates an incentive to provide compensation in the form of tax-preferred pension benefits even if they are valued less than dollar-for-dollar.  If someone is in, say, a 25% marginal tax bracket, they might prefer pensions over wages even if they value the pension at only 80 cents on the dollar.

But even this cannot explain the entire discrepancy.  More likely, we are observing the fact that union leaders and legislators are not operating in a perfectly competitive market environment.  This is not a case of employees negotiating with employers over a pool of profits, in which the employers are accountable to shareholders through the board.  This is a case in which unions help elect the officials with whom they are negotiating.  And they are not bargaining over profits, they are bargaining over tax revenue, which the government can require a third party – the taxpayer – to pay.  Now, of course, the non-public-employee taxpayers can theoretically hold the legislature accountable, but this is easy to circumvent by a) pushing the real cost of the increased pensions onto future taxpayers and b) hiding behind government accounting rules that disguise the true cost of providing the pensions.  So Mr. Johnston is holding the size of the overall compensation package fixed in his analysis – when in reality the size of the compensation package may be inflated by the bargaining process that is partially protected from market forces.

In sum, there are legitimate reasons to think that public employees may not have paid for their entire pension.  If so, then in Mr. Johnston’s own words, this could be considered a “serious crime” because it is “the gift of public funds rather than payment for services.”

Unfortunately, we really do not know the extent of this “crime” because we lack a careful empirical study of the Wisconsin situation.  But if I were a betting man, I think the odds are quite good that taxpayers have borne (or perhaps more accurately, future taxpayers will bear) at least a sizable part of the cost of public pensions.

Can States Use “Police Powers” to Cut Pensions?

Filed Under (Retirement Policy, Uncategorized) by Jeffrey Brown on Jun 9, 2010

Mark Guarino of the Christian Science Monitor published a piece yesterday (“States cap workers benefits to reduce shortfalls: Is your pension fund at risk?”) that discussed the status of state pension funds.  

Most of the article discusses points that I and others have made on this blog before, such as large size of the shortfall, the fact that it is politically difficult to fix, and the State of Illinois’ efforts to reduce costs by cutting pensions on future workers 

There was one thing in the article, however, that struck me as new and, quite frankly, frightening.  I am not sure if this is purely “academic” (and as an academic myself, I do not use the term disparagingly) or whether this is something that has any real practical potential.  But Amy Monahan of the University of Minnesota law school points out in the article that states have “police powers” which “given them fundamental rights to protect the welfare of their citizens in a crisis, which in this case would allow a legal ‘out’ in providing benefits.”  The use of this power to cut constitutionally protected benefits is an idea that has never been tested in the courts, but even so, there are two aspects of this possibility that are disheartening. 

The first is obvious – namely, that perhaps the constitutional guarantee of benefits may not be as strong as participants would like or expect.  Although, in reality, I think it is still clear that the constitutional provision is still the strongest guarantee that one can find anywhere – stronger than unfunded promises from Social Security, and stronger than underfunded promises from a private employer that are guaranteed by an underfunded PBGC.  So, as scary as it sounds, I am still not inclined to believe it more than an extremely remote possibility.

The second aspect is more subtle, but also more pernicious.  As I have written in earlier posts, in a competitive labor market, the perceived value of future pension benefits serve as a substitute for other forms of compensation.  Thus, the more employees have a perception that the Illinois public pension benefits are not secure, the less value employees will place on those benefits.  As a result, either taxpayers must pony up more cash to pay these employees in another form (e.g., higher wages), or many of them will take jobs elsewhere.  

The worst situation from a state’s fiscal perspective is one in which the benefits are actually inviolable, but that nobody believes this to be true.  In that situation, the states’ total compensation costs go up in the short-run – we have to pay employees more to make up for the perceived risky pension – but do not come back down in the long-run if the pensions actually end up being paid. 

Misguided Reform Rhetoric Around Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 31, 2010

Illinois pensions are in the news yet again.  Last month, the Pew Center on the States reported that Illinois was once again the poster child for everything wrong with the funding of state pensions, noting that we had the worst funding ratio of any state in the country.

 

Last week, Illinois House Speaker Michael Madigan decided – finally – to take some action.  He secured a House vote to change pension benefits for future Illinois state workers.  Specifically, this proposal would raise the full benefit age to 67, cap the maximum pension income at a bit over $100,000, limit cost-of-living increases, and so on.  In short, the package amounts to benefit reductions for not-yet-hired future state workers.  

 

Why this option?  To put it simply, there are only two options for fixing the funding problem. 

 

Option one is increase revenue to the system.  In other words, make additional contributions.  But this would require that Illinois lawmakers raise taxes or cut other state spending, neither of which is politically popular.  

 

Option two is to reduce the liabilities.  But as I have written before, the impairment clause in the state constitution prohibits benefit reductions to existing retirees and existing employees.  So the only way to reduce liabilities is to cut benefits for future workers – those that have not yet joined the system.  And that is precisely what Madigan pushed through the House.

 

[By the way, the only “option three” is to, in the words of Alan Greenspan when discussing Social Security, is to “repeal the laws of arithmetic.”  I am pretty sure that most state governments would choose this option if they could!]    

 

As a fiscal conservative, I have no real objection to the decision to reduce future liabilities in the way that the House has chosen to do.  But two issues that have come up in the debate that I think are worth a bit of analytical clarity.  

 

First, estimates of future savings are almost surely inflated.  There are two reasons for this.  One is that some of the estimates appear to have simply looked at undiscounted dollar flows, which implicitly assumes a dollar saved in 2050 is the same as a dollar saved in 2020.  This is obviously not the case, since a dollar saved earlier has a much higher present value.  A second reasons is that – as I have written before – pensions are part of the overall compensation package.  If we reduce future retirement benefits, our ability to attract top faculty members, for example, will be reduced unless we increase compensation in some other way.  None of the cost savings estimates account for this.    

 

Second, there is clear confusion about the source of the funding problem.  Much of the rhetoric around this legislation focused on the level of benefits.  The Champaign News-Gazette is a typical example, stating:

“A big part of Illinois’ horrendous budget problems can be traced to the high costs for the lavish pensions many public employees enjoy. They are far more generous than those available to workers in the private sector, and that’s a big reason why state public pensions are underfunded to the tune of an estimated $80 billion.”

This is wrong for several reasons.

First, the real source of the funding problem is not level of benefits.  It is the fact the Illinois legislature has consistently failed to make the annual contributions that are called for under standard funding formulas.  My colleague Fred Giertz has done some calculations suggesting that if the legislature had made its required contributions every year, the Illinois system would be slightly over-funded, not under-funded.  In short, don’t blame the pensioners for the lack of fiscal discipline on the part of our politicians.

Second, the comparison of public pensions to private pensions is misleading.  One reason is that the public pension replaces both Social Security and a private pension.  Social Security costs roughly 12% of payroll today.  Private employers who offer pensions typically contribute several percent more.  On that basis, Illinois public pensions are not “lavish.”  A second reason is that – yes, I am repeating myself – this is part of an overall compensation package.  So any comparison needs to account for the value of all salary and benefits, not just a single piece of it.