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.

Financial Alchemy in Wisconsin

Filed Under (Finance, Retirement Policy) by Jeffrey Brown on Jan 27, 2010

Economists know there is No Free Lunch.  Nowhere is that more true than in financial markets.  Indeed, if I had to pick a single lesson in financial economics that is more important than any other, I would go with something along the lines of “if you are already holding an efficient portfolio, then you cannot generate higher expected returns without taking on more risk.”  

 

Yet, time and again, we see individuals and public policy makers act as if this were not the case.  This is especially true for managers of state pension funds.  The latest case – the State of Wisconsin Investment Board.  According to the Wall Street Journal, the Wisconsin public pension funds “are turning to one of the oldest investment strategies – using borrowed money to boost performance.”  In essence, they want to increase the leverage of their pension portfolio by borrowing money and investing it. 

 

You might be thinking “Leverage? Isn’t that what partly got us into the recent financial crisis?”  Yes, of course it is.  And that should definitely concern Wisconsin taxpayers. 

 

Let’s think about what SWIB officials are trying to do.  According to a story in Pensions and Investments on January 11, officials want to reach an investment portfolio that is 120% of plan assets by the year 2012. 

 

If you think about this for 2 seconds, you realize that this emperor has no clothes.  Consider a simplified example in which I have a $100 portfolio.  I invest $60 in stocks, and $40 in bonds.  Now, I borrow $20 by issuing a bond.  If I invest the $20 of bond proceeds in someone else’s bonds, then I now have $60 in stocks and $60 in bonds.  Therefore, it appears I have reduced my equity allocation from 60% to 50% of my portfolio, and that will reduce the standard deviation of my portfolio.

 

Of course, this only holds true if I ignore the $20 of debt.  If I account for it in my analysis, then my true portfolio allocation has not changed – I still have the same $60 equity allocation, and my NET bond portfolio is still $40 (I own $60 but owe $20).  If the risk / return characteristics of my own bond match those of the bonds that I purchase, I have done absolutely nothing to my portfolio! 

 

Of course, Wisconsin is unlikely to invest in identical bonds.  They might invest in bonds with different risk/return/maturity/liquidity characteristics, but if so, then all they are doing is trading off returns for some form of risk. What Wisconsin appears to want to do is simultaneously alter their overall investment allocation.  But the same basic lesson applies – they are simply trading off risk and return.  

 

To suggest that borrowing and investing creates value is inconsistent with both elementary and advanced financial market theory, principles and empirical evidence.  The best financial engineer in the world can not build a financial free lunch.  

 

So to Wisconsin taxpayers, I say “beware.”  You can dress up misleading financial alchemy as a sophisticated investment strategy, but dressing up a pig does not change the fact that it is still a pig.   

The worst of it?  Steven Foresti, managing director of Wilshire Associates, is quoted in the P&I piece that “we think this is the direction institutions will go.”  Personally, I hope that Wisconsin sticks with exporting cheese, rather than bad investment policies.