Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Hot off the Internet, the Supreme Court has upheld the “Obamacare” individual mandate, which requires most people to buy health insurance or else pay a tax.  The ruling isn’t available yet, but I have to say that I’m really, really impressed by this decision because it shows that the Supreme Court was able to look beyond the politics of the situation and the poor argument by the administration in defense of the bill, and rule according to the law.

The argument against the mandate was that it violated the Commerce Clause of the Constitution in that it regulated economic “inactivity” rather than activity.  That is, it forced people to participate in the individual insurance market even if they didn’t want to.  The administration flubbed its defense on this point by failing to show how health insurance markets are different than most other markets, giving the Supreme Court a limiting principle that would prohibit the ruling from establishing that Congress can regulate anything it wants.

It sounds like the Supreme Court did not buy the argument that the indivual mandate was justified under the Commerce Clause.  But, in some sense this is all a red herring.  The individual mandate is a tax, plain and simple.  People who do not buy health insurance must pay a fine to the IRS.  A fine paid to the IRS is a tax.  The Democrats and the administration tried to hide the fact that this was a tax while rallying support for the bill for obvious reasons.  Nobody wanted to be seen as raising taxes, and President Obama had promised during the campaign that he would not raise taxes for middle income Americans.  But, just because the Democrats wanted to pretend that this wasn’t a tax, that doesn’t make it true.  It’s a tax. And, Congress has the right to impose taxes.

Despite the fact that the administration did not emphasize the tax aspect of PPACA’s indivual mandate in either its presetation of the bill to the public or in its defense before the Supreme Court, the Court was able to step beyond the narrative that was being fed to them and identify the key legal principle involved.

Whether you support the bill or not, I think that in a post Bush v. Gore / Citizens United world, when people are wondering whether the Supreme Court really is an impartial arbiter of the law, you have to see this as a great moment for the Court.  Hooray for them.

More after I have a chance to look at the ruling.

Cigarettes are heavily regulated in America. Federal and state cigarette taxes account for 44% of the retail price of cigarettes (Tax Burden on Tobacco 2011). This percentage is even higher if one accounts for local taxes like New York City’s $1.50 per-pack tax. (A pack of cigarettes retails for $6.01 on average.) Many local and state governments have also banned smoking in bars, restaurants, and workplaces.

Some libertarians oppose these taxes and regulations. They argue that consumers should have the freedom to make their own choices without interference from the government. Many public health officials oppose this viewpoint in the case of cigarettes. They argue that many consumers do not properly account for the negative future consequences of their smoking behavior, which causes them to consume too many cigarettes. In addition, second-hand smoke is a negative externality that annoys and potentially harms others. Finally, cigarettes may raise the cost of government healthcare systems like Medicaid and Medicare. These are all important points, but today I will focus on the last one.

Calculating the costs that a smoker imposes on society is difficult because we do not know for certain what would have happened if she were not a smoker. For example, smokers who die from lung cancer impose large costs on Medicaid and Medicare. However, if those individuals had never begun smoking then they may still have imposed costs on government healthcare systems by contracting a different disease such as Alzheimer’s. The analysis becomes further complicated if we try to account for the fact that smokers die about seven years earlier than non-smokers and thus tend to collect fewer social security payments. This is a morbid observation but it must be accounted for in order to estimate properly the effect of smoking on government spending.

These issues are addressed in a recent report from the Congressional Budget Office (CBO) that analyzes the effect of a hypothetical cigarette tax increase on the federal budget. The main effect is a large increase in excise tax receipts: a total of $38 billion within the first ten years. Because an increase in the cigarette tax decreases the smoking rate, and thus increases the health of the population, the researchers at the CBO also account for the tax’s effects on Medicaid, Medicare, and Social Security spending. They estimate that total government spending would decrease in the short run, mostly due to Medicaid savings resulting from better health among pregnant women and young children.

In the long run, however, the report estimates that the increase in longevity due to less smoking will cause a nontrivial increase in annual government spending equal to 0.012 percent of GDP ($1.8 billion using 2012 GDP) by 2085. The CBO’s finding that a reduction in smoking would actually increase spending on Medicare and Social Security is consistent with economist Kip Viscusi’s finding that smoking does not have negative financial externalities. The annual excise tax receipts are estimated to equal 0.018 percent of GDP ($2.7 billion using 2012 GDP), however, so the proposed tax is beneficial overall for the government’s budget.

Although it does not appear that cigarette smoking creates negative financial externalities for the government, there may be other reasons (mentioned above) to tax and regulate smoking. Regardless, Americans have largely accepted cigarette taxes and smoking regulations and thus these are likely to remain in place.

The issue of whether and how to best regulate consumer health, however, will continue to resurface for other products. For example, Mayor Bloomberg’s recent proposal to ban sugary drinks in containers larger than 16 ounces is justified by many on the grounds that consumers lack self control when making dining decisions and that obesity imposes costs on the government. (Sound familiar?) Sugary drinks, of course, are not the same product as cigarettes. There is no such thing as “second-hand drink” and the health effects of drinking soda every day are not as well known as the effects of smoking every day; quantifying the effect of a sugary drink ban on the government budget is therefore difficult. I expect we will see more research (and more debate!) on this topic in the future.

Despite being in a Department of Finance, my own background and research is in economics and public policy (hence the “Center for Business and Public Policy” in our department).  I don’t claim expertise in finance, per se.   On the other hand, it seems that both sides of the JP Morgan debate are using discussion of the Volcker Rule and their other financial expertise to obscure the basic logic of government bank regulation.  It is a basic logic of incentives, which does not require expertise in finance!

JP Morgan wants to make money; we can hardly blame them for that.  In economics generally, we let companies try to make money, as they have the expertise in their own line of business to determine the risk-reward tradeoff.  If they lose money, then they lose money.  They might even be able to buy various kinds of insurance – that’s between the company and their insurer.  A person or company with insurance might have incentive to undertake riskier activities, since any gains are retained, while losses go to the insurer.  But the insurance company might enter the deal willingly, to charge premiums, especially if it can require the company or person to limit some of their riskier activities.  Your auto insurance has co-insurance and deductibles, to make you pay at least part of a loss and to restore some of your incentive for precaution.  

But when a bank becomes “too big to fail”, the U.S. government is thrown into the role of insurer, without being able to collect premiums, co-insurance, or deductibles.  It is not a “deal” between the bank and their insurer, because the government has no choice.  Because of financial contagion, a single major bank failure could bring down the whole system and cause horrific recession.

Given that the bank’s biggest losses must be covered by their insurer (the U.S. government), the bank has more incentive to undertake even riskier activities: they get any profits, and they don’t suffer the worst losses.   Any private insurer would require the bank to limit their riskiest activities, in order to be willing to sell that insurance.  But the government is the insurer by default, with no private “deal” allowing the government to require limits on the riskiest activities in order to be willing to offer that insurance.

To be sure, the bank still must be careful about some risks, as many different kinds of losses would reduce their profits without requiring government bailout.  The recent JP Morgan case did not create danger of bankruptcy or bailout, because their $2 billion loss on that one operation only offset part of their positive profits!  But any bank that is “too big to fail” has less incentive to avoid the really big losses that could cause bankruptcy, because that would require the government to bail them out.

The government could pass laws and regulations to limit the banks’ riskiest activities, and that is the purpose of the much discussed Volcker Rule.  I will leave the discussion of the details to the experts in finance.  For example, the Volcker Rule may or may not be the best way to regulate banks.  The effects depend a lot on the rule’s design, implementation, and enforcement!  Maybe some other rule or incentive-management would be better.  I will leave those details to the experts.  Instead, the point here is just the simple logic that the government is not a private insurer who would require limitations on risky activity to be willing to sell insurance.  The government must provide insurance, so they must have some kind of regulation to limit banks’ risky activities: higher capitalization requirement, Volcker rule, or other regulations.   

I did in fact talk to some of the finance department’s experts, like Jeff Brown and George Pennacchi.  George notes that “the incentive to take big risks declines as a bank finances itself with more shareholders’ equity (capital), and in JPMorgan’s defense they are one of the most highly capitalized banks, which helped them survive the crisis.”  He adds that “If banks carry government deposit insurance, whether explicit or implicit due to Too-Big-to-Fail, then the government should limit their activities to protect taxpayers from losses.”  Moreover, “it is noteworthy that, prior to the establishment of deposit insurance in 1933, banks had much greater capital (financing via shareholders’ equity) and made much less risky loans. … Indeed, there are several recent “narrow bank” proposals to greatly limit the activities of banks that issue insured deposits.”  He has a review of the topic on his website (forthcoming in the Annual Review of Financial Economics).

The bottom line is that in a private deal between a bank and its insurance company, the bank would have to agree to limit risky activity in exchange for being able to buy this insurance.  With government as insurer, they get the insurance regardless.  So just look at their incentives!  The banks have incentive to make money, and so they have incentive to take more risks since they can keep any profits and not cover the biggest losses.  AND they have incentive to lobby Congress to avoid government regulations.  We switch from a private market “deal” to the world of politics!  If they can get Congress to limit regulation of banks, they can make riskier investments, make more money, and not have to cover the biggest losses.

So just think about those incentives, next time you hear a bank executive use the jargon of financial expertise to make the case against “unfair interference by government regulators into the private market”.

After a week of legislative wrangling that had more twists and turns than Hawaii’s famous “Road to Hana,” the Illinois General Assembly failed to come to agreement last week on a pension reform package in time for yesterday’s May 31 deadline.  As a result, they will return to Springfield – possibly this week – for a special session facing an even larger hurdle for passing reform legislation: by Illinois law, bills passed after May 31 require a three-fifths vote rather than a simple majority.

Agreement fell apart over the issue of who should pay for the “normal cost” of future public pension accruals.  “Downstate” lawmakers objected to shifting all of the costs onto school districts, public universities and community colleges on the grounds that this would lead to higher property taxes to fund teacher pensions and do grave damage to the ability of our university system to compete for academic talent.  Once Democratic Governor Quinn agreed to pull this cost-shifting out of the bill, Democratic House Speaker Mike Madigan withdrew his support of the bill.

As I wrote this past Wednesday, one of the grave concerns I have about the leading proposals is that so many of our elected officials seem perfectly content to shift all of the costs onto universities and school districts while maintaining legislative control over the design of the benefits package.  This is a mistake on so many levels.  The separation of responsibility and control is a recipe for fiscal shenanigans.  It is also highly disrespectful of the employer-employee relationship that Bob Rich and I wrote about in our pension reform proposal earlier this year.  

Although I still like the plan that Bob Rich and I put out, it seems clear that the General Assembly has gone another route.  But given that they are stuck on the cost-shifting issue, I thought it might be useful to put forth a more radical proposal that would respect the constitutional constraints, appropriately align the incentives of all the affected parties, respect the employer/employee relationship, and still save the state billions.  Perhaps most importantly from a political perspective, it might overcome the cost-shifting stalemate, because it shifts the costs but offers something very valuable in return.  This proposal would apply to those institutions – such as school districts, universities and community colleges – that, while public, are not part of the state government apparatus itself.  

While “radical,” the idea is deceptively simple.  Here it is in 4 simple steps:

1.       The state agrees to pay 100% of all pension benefits that have been accrued by public sector retirees and current workers as of 7/1/2013.  Whether the state wishes to do this by paying down the amortized unfunded liability, or simply provide the cash as need to pay benefits, is immaterial, so long as they respect the constitutional guarantee and pay it.  Not only does this respect the constitution, but it would also be fair to the generations of workers and retirees who consistently paid their share to the pension fund while the politicians enjoyed their “pension funding holidays.”    

2.       The existing public pension plans – for example, TRS and SURS – are closed to all further accruals as of 7/1/2013.  No new benefits will be earned under any of the plans.

3.       Going forward, each state employer is given 100% autonomy – free from the shackles of state regulation and political interference – to construct a benefits package that is optimally designed for its own employees.  In order to comply with federal law that applies when a state like Illinois opts out of Social Security, each employer would be required to provide a retirement package that is at least as generous as Social Security.  Beyond that, it would be up to each employer to determine the optimal mix of wages, pensions, and other employee benefits that would be required to attract, retain, motivate, and manage the retirement of their workers.  If similar employers wished to joint together as a group (e.g., all community colleges) to provide a common pension plan, or if unions wanted to provide multi-employer pensions funded by a group of employers, they would be permitted to do this.  But if the University of Illinois decided that its needs differed sufficiently from other public universities, they would have the freedom to go their own way.  

4.       The state would agree to a pre-determined, annual “block grant” (basically, an extra appropriation) to each employer that would start out as an amount equal to the “normal cost” of providing pensions, and would gradually decline to zero over a 20-year period of time.  This would slowly shift the entire financial burden of providing pensions from the state to the employers themselves.  

In essence, this plan calls for 100% cost-shifting, but with two critical differences relative to the reform package being debated last week.  First, and most importantly, it accompanies the cost-shifting with a freedom from political interference.  Second, it spreads the cost-shifting out over a much longer period of time (twenty years instead of approximately eight or so) in order to ensure that employers can adapt.

If there is anything I have learned from observing our Illinois state government in action, it is that it cannot relied upon to design a sensible pension package that is fiscally sustainable, credible to employees, and meets the diverse needs of our public employers.  So if they are so eager to get out paying for pensions, let’s take this idea all the way – aside from atoning for their past sins by making good on constitutionally guaranteed promises that they have so far failed to fund – let’s have the state get out of the pension business altogether.  

Doing so would free employers and employees from being subject to the unpredictable whims of the states’ politicians.  And that freedom, it seems to me, is priceless. 

After last night’s somewhat surprising announcement that Speaker Madigan has agreed to the Governor’s request to remove from the pension reform legislation the provision that would have shifted normal costs onto school districts, universities and community colleges, it now appears that particular provision is dead.  Along with it, it appears that the ability of employers to replace the inadequate Tier II pension (for those hired after 1/1/11) wit a new cash balance plan is also dead.

The main provision of forcing a possibly unconstitutional choice between giving up one’s cost-of-living adjustments after retirement or giving up retiree health insurance, however, is still intact.  As is the provision that would freeze pensionable earnings for those that want to keep their current COLA.  And, rumor has it, the legislature is looking for other ways to save costs as well … so look for some additional benefit changes in the final package.

Also, people who don’t work with compound versus simple growth rates on a daily basis may not realize just how big the COLA changes are.  So here is a simple but useful example.  Suppose someone retires at age 60 and lives until age 85.  Under the current law, they receive 3% COLA each year compounded.  Under the proposed law, they get a 0% COLA for the first 5 years, followed by half of inflation or 3%, whichever is less.  If inflation runs at 3% per year, this is a 1.5% non-compounded (i.e., simple) interest.

This may not sound like much.  But don’t be misled — at age 85, this person’s pension would be 37% LOWER UNDER THE PROPOSED LEGISLATION.  If we compute a present value using a 4-6% nominal discount rate, it is a 20% reduction in lifetime pension payments.  This is why the proposal saves so much money.  It is also why it is pretty clearly an impairment or diminishment of benefits!

As I’ve said before, I’m not a lawyer.  But, since the Illinois House Democrats have decided to move into incentives, why not?  The details of the pension reform proposal that passed an Illinois House committee today are still vague, but here is a write up about it.

Simply put: the proposals currently under consideration in which members are offered a “choice” between options, as currently constructed, are not constitutional.  Here’s why.

The Illinois Constitution says that membership in a state pension program is a contractual relationship the benefits of which shall not be diminished or impaired.

Any contractual relationship has to have, well, a contract.  In this case, the terms of the contract are spelled out in the Illinois Pension Code.

The Illinois Pension Code specifies the way in which pension benefits will be calculated.  The details are slightly different for different pension funds, but I’ll talk about the part that pertains to Tier I participants in the State Universities Retirement System (SURS).  In particular, the amount of the retirement annuity is specified in Section 15-136 of the Pension Code.  Here it is:

Rule 1: The retirement annuity shall be … for persons who retire on or after January 1, 1998, 2.2% of the final rate of earnings for each year of service.

That seems pretty clear.  The “final rate of earnings” is defined in Section 15-112.  For a person who first becomes a participant before Jan. 1, 2011 (i.e., Tier I participants), the final rate of earnings is defined as:

For an employee who is paid on an hourly basis or who receives an annual salary in installments during 12 months of each academic year, the average annual earnings during the 48 consecutive calendar month period ending with the last day of final termination of employment or the 4 consecutive academic years of service in which the employee’s earnings were the highest, whichever is greater. For any other employee, the average annual earnings during the 4 consecutive academic years of service in which his or her earnings were the highest. For an employee with less than 48 months or 4 consecutive academic years of service, the average earnings during his or her entire period of service.

That also seems pretty clear.

One more excerpt from the Pension Code.  This one has to do with annual cost of living adjustments (COLAs).  From Section 15-136

The annuitant shall receive an increase in his or her monthly retirement annuity on each January 1 thereafter during the annuitant’s life of 3% of the monthly annuity provided under Rule 1, Rule 2, Rule 3, Rule 4, or Rule 5 contained in this Section. The change made under this subsection by P.A. 81-970 is effective January 1, 1980 and applies to each annuitant whose status as an employee terminates before or after that date.

Beginning January 1, 1990, all automatic annual increases payable under this Section shall be calculated as a percentage of the total annuity payable at the time of the increase, including all increases previously granted under this Article.

This part of the Pension Code also seems clear: COLAs are to “include all increases previously granted under this Article.”  In other words, COLAs compound rather than being based on the original amount of the annuity.  And, COLAs start the January after retirement.

So, let’s review.  The Illinois Constitution says that membership in a pension system is a contractual relationship. The terms of that contract are given by the Pension Code, and the Pension Code specifies the way in which final pension benefits should be computed.  In particular, it specifies that the final rate of earnings is average earnings over the final 4 years of service, or the 4 consecutive years in which earnings were the highest.  Thus, the Pension Code states that future pay raises will be included in future pension benefits.  The Pension Code also states that COLAs are to begin immediately after retirement and be computed on a compound basis.

So, let’s return to the “choice” that would be offered to members of the pension system under the proposal.  Details are sparse, but the basic choice to be offered to members will be:

(A)  Keep the current pension plan, but give up the state subsidy for retiree health benefits and having future raises be included in pension benefits, and

(B) Keep the state subsidy for retiree health benefits, but receive a less generous cost of living adjustment (COLA) where annual increases are based on the pension payment at the time of retirement rather than the most recent year’s pension.  That is, the COLA is not compounded over time.  Further, the COLA will not kick in until 5 years after retirement or age 67, whichever comes first.  There is also language in at least the governor’s proposal that will limit the COLA to a simple 3% or ½ the increase in the consumer price index, whichever is lower.

Now, supporters of this approach claim that is constitutional because it offers participants a choice.  This claim is invalid.  While a choice might be constitutional, in order for this to be the case, it must be that one of the options does not impair or diminish the benefits of the current pension system.  This is not true here.  Option (A) denies members their contractual right to have the final annual rate of earnings be based on their highest 4 years of earnings, which would include future raises.  Option (B) denies members their contractual right to have COLAs be 3% compounded each year.  Since both options impair and diminish the benefits of the pension, if members are forced to make a choice between A and B, their pension benefits will necessarily be reduced.

Constitutionally speaking, two wrongs don’t make a right.

Consequently, to me it seems clear that the proposals are not constitutional.  Given that so many of our legislators are backing these proposals, there must be an argument for why the proposal is constitutional.  I can’t see it, though.

ADDENDUM (5/30/12):  This isn’t a post about whether it is right or fair to reduce retiree health benefits (it isn’t), but rather whether it is constitutional (it probably is).  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  The state also does not contribute to Social Security, so state workers who retire are also not eligible for Social Security (unless it is by virtue of having worked for another employer).  Obviously, removing employer-sponsored health benefits and reducing the COLA is going to expose retirees to substantial new risks, and the proposal becomes much more complicated and controversial in this case.

Or, alternatively, “Why I Love Teaching”!  First, teaching lets me grandstand a bit, if that help students really think about the world around us.  Second, it lets me pretend to be an expert in fields other than economics, even fields such as philosophy (see below).  Third, trying to teach about a topic forces me to think hard about that topic myself!  A case in point is the standard lecture on “Justifications for Government Policy to Redistribute Income”, otherwise known as “Robin Hood”, otherwise known as government “theft” from the rich to give to the poor.   

One thing currently happening in the world around us is a heightened political debate about whether the top income tax rate is too low or too high.  See the diagram below.  So this “lecture topic” is not just textbook irrelevance.  It might even help YOU to think about what you read in the newspaper!  Then please decide for yourself.

I see four possible justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, however, then perhaps a different justification is more appealing. 

1.)    As described below, some in the field of “moral philosophy” have found ethical justifications for extra help to the poor.

2.)    Even if the poor are not deemed special in that way, and all individuals receive equal weight, it may still be that a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person (higher marginal utility).  If so, then equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor. 

3.)    If incomes are generally uncertain, so that any individual might do well in some years and not in other years, then government might actually make all of us happier by the provision of implicit “insurance” – taking premiums in good times in order to help any person who suffers bad times.

4.)    A reduction in income equality could be a “public good”, like the classic example of a lighthouse that benefits all ships whether they have helped to pay for it or not.  Everybody’s individual incentive is therefore not to pay (to “free ride”).  The private market never exists.  But government can raise welfare for all shippers by taxing all ships and using the funds to build and operate the lighthouse.  Similarly, if many people would LIKE to have more income equality in society, they could “free ride” on others who do give voluntarily to help the underprivileged. If so, then government could fix that market failure by taxing everybody and using the funds to improve income equality.

Having used up several paragraphs already, I will miss the chance to explain all four of these important points adequately in this one blog, and so I’ll save a few for the next blog.  Let’s just start with the first one.

In the field of moral philosophy, some libertarians such as Robert Nozick believe that theft itself is ethically wrong, that each person is morally entitled to the fruits of their own labor.  No person is allowed to steal from a rich neighbor, even to give to the poor, so why would government be allowed to do so?  If theft is morally wrong in itself, then government should not be redistributing from rich to poor, no matter how needy the poor nor how worthy the cause.  On the other hand, by the way, government steals from individuals through taxes in order to build highways and provide for national defense, and so one may wonder why theft is justified for some purposes and not others.  One way out of that problem is to decide that a tax for public purposes is not in fact “theft”.

In contrast, John Rawls argues that the moral choice is to help the poor.  Actually he has two important ideas.  One is that those who are already rich have no moral justification to argue for reducing taxes on the rich, just as those who are poor have no moral justification to argue for raising taxes on the rich.  Such positions are merely self-interested.  Therefore, a useful thought experiment is to put yourself in what Rawls calls the “Original Position”, at the beginning of the World, before places have been assigned in the wide distribution of incomes and well-being.  That is, suppose resources are limited, and that the world will inevitably have a distribution of different human abilities and disabilities.  You don’t yet know your IQ, or whether you will have any particular talents in music, sports, the arts, or management.  Our job in this “original position” is to write a constitution, a set of rules for government and human interaction.

The purpose of this thought experiment is to try to strip away self-interest and think about how rules “ought” to be designed.  And then, Rawls’ second idea is about what any of us would likely decide to do in such a position.  He argues that the only natural choice, indeed the only logical choice, is to be extremely risk averse.  We are not talking about twenty bucks you might lose at the Casino, where risk is fun.  Instead, we are talking about your entire life’s prospects, where risk is not fun.  It must be great to be Brad Pitt, but what if you end up with little talent or ability.  You could end up homeless, or worse.   Given that risk, he argues, one should design the rules such that society would take good care of those who are disadvantaged, unlucky, or disabled.  You might well be the person on the bottom of the totem pole.

His treatise, called “A Theory of Justice” is 600 pages, so I haven’t even read it all!  So I won’t try to explain all the reasoning, but the interesting point is the connection between risk aversion and redistribution.  Rawls himself is extremely risk averse, saying we ought to maximize the welfare of the poorest person with the minimum income – the “maximin” strategy.  That does not mean perfect equality, as he points out that the poorest person’s welfare might be improved by giving the most talented individuals plenty of incentive to work hard and invent new technology that generates plenty of profits, market success, and economic growth.  But cutting the tax rate on the rich is only justified for Rawls if that really does improve the welfare of the poorest.

Well, out of space for today, so I’ll save the other justifications for next time.  But in case you don’t like the justifications of Rawls, those other justifications (#2 through #4) are completely different!

in•cred•i•ble (adjective): too extraordinary and improbable to be believed.

I wrote last week about the Illinois public pension mess and how ceasing to offer fully-paid retiree health benefits might help to address the problem by causing workers to delay retirement.  The reason why such a convoluted route to reducing pension costs is needed is because of the non-impairment clause of the Illinois state constitution, which prevents the state from reducing benefits for current employees.  In short, the non-impairment clause says that membership in a state pension system is a contractual relationship between the worker and the state.  And since contracts cannot be unilaterally renegotiated by one of the parties, the state is in a situation where it would seem to have no way out of its obligation to pay promised benefits to its current and future retirees.

In his proposal to reform the state pension system, Governor Quinn has tried to avoid the non-impairment clause by offering workers a choice.

On the one hand, current workers can keep their current pension plan but lose the right to have future pay increases be included in their final pension benefits and lose the subsidy that the state currently pays for retiree health benefits.  (Now, the first part of this plan clearly violates the non-impairment clause because the formula used to compute final benefits is specified in the Illinois Pension Code and clearly includes future pay raises.  But, that’s not today’s topic.)

On the other hand, employees can accept a significantly less-generous pension plan but maintain the employer subsidy toward retiree health benefits.  (Now, the less-generous pension plan pushes full retirement to age 67, when employees would be eligible for Medicare anyway, so it is unclear how valuable this promise would be to retirees.  But, that’s not today’s topic either.  There is also the real question of whether this would be considered “coercion” by the state.  In the past the Supreme Court of the United States has ruled that an employee cannot be coerced into giving up his pension benefits.  But, that’s also not today’s topic.)

This would be the time to ask ourselves why the non-impairment clause was included in the Illinois Constitution in the first place.  An analysis by Eric Madiar, Chief Legal Counsel to Illinois Senate President John Cullerton, confirms what you might suspect.  Public workers in the state of Illinois were concerned about whether the state would pay the pension benefits that it had promised them.  State and local workers generally receive lower cash wages than their private-sector counterparts, but higher benefits, including more generous pensions.  Thus, when an employee accepts a job working for state or local government, promised future pension benefits play a major role in making that job attractive enough for them to accept.  In light of this it is not surprising that they would be concerned about whether the state could be trusted to pay those future benefits.  This led state and local workers to propose that pension benefits be guaranteed in the Illinois constitution, and this proposal ultimately became the non-impairment clause.

Economists think a lot about commitment.  That is, we wonder about things like how it is that an agent can commit to take an action in the future that is not it its own short-term interest.  Or, we wonder how it is that an agent can be given incentives to take actions today that do not benefit it until the distant future.  Both of these issues arise in the context of pension funding.  In order to induce an worker to take a government job that pays less today, that worker must believe that the state will actually fulfill its promise to pay higher pension benefits in the future.  Similarly, in order for current legislators to cut current spending and use the money to fund future pension payments, there must be consequences.  The non-impairment clause addresses both of these issues.  The highest law of the state guarantees that the state will make the future payments.  This guarantee is so strong that a state that fails to properly plan for these payments will face fiscal collapse – as we do now.  Even in the face of fiscal collapse, the non-impairment clause suggests that pension payments must take precedent over many other payments.  With these promises in place, workers should be confident that the state will fulfill its future obligations.  Ideally, knowing that failure to plan for the future will jeopardize the entire state, legislators will make appropriate funding decisions to avert disaster.

Consequently, the non-impairment clause plays a vital role in the state’s finances.  Over the years it has been used to induce workers to accept a lower wage today in exchange for the seemingly-credible promise to provide higher benefits in the future.  In other words, the non-impairment clause has allowed the state to push the cost of paying current workers onto future taxpayers.  Kicking the can down the road in this manner has been a major tool in the state’s fiscal toolbox.

Let’s think about the role of commitment in regards to Governor Quinn’s proposed choice.  The plan says that those who want to keep their current pension will lose retiree health benefits.  The governor can take away retiree health benefits because they are not guaranteed by the non-impairment clause.  An employee who accepts the governor’s proposal would get a less-generous plan but keep the state’s promise of retiree health benefits.

In order for an employee to voluntarily accept this plan (if they believe that current pensions cannot be impaired), it must be because the employee values retiree health benefits.  But, even an employee who values retiree health benefits would have to believe that, when they retire in the future, the state would actually provide the promised benefits, and would continue to do so even if times were tough.  In fact, when times are tough that’s when people need their pensions the most.  So workers might be particularly concerned about whether a state under fiscal pressure would continue to fulfill their promises.  Sound familiar?

This is where things become a bit tricky for the state.  Times are tough right now, and the state has responded by threatening to take away retiree health benefits.  This has occurred both in the governor’s proposal and in the state legislature, where pending legislation would eliminate the state’s subsidy for retiree health premiums, which amounts to about $7400 per retiree per year.  So, the state is, on the one hand threatening to take away retiree health benefits and on the other hand asking workers to believe that their promise that those who accept the governor’s proposal will continue to receive these benefits in the future.  And, all of this is taking place in a situation that was brought about by the state’s failure to adequately plan to meet its constitutional obligation to pay pension benefits.

This brings us to the big question: Why should workers expect the state to honor its commitment to provide a non-guaranteed benefit when it isn’t even honoring the benefits that it is constitutionally obligated to provide? While the governor’s plan should be commended for attempting to address the pension crisis through asking workers to voluntarily accept a change in benefits, in the end I would be surprised if workers are willing to give up their constitutionally guaranteed pension benefits for an incredible promise to provide health benefits.

Practically speaking, any proposal that asks for voluntary acceptance by workers is going to have to exchange currently promised benefits for some promise of future benefits, and any such promise of future benefits is going to face this same credibility problem.  The state, by finding a way around its constitutional promise of future benefits, may find that it loses the ability to induce people to work today for lower wages and promises of higher payments via pensions in the future.  If workers respond to this by insisting on higher wages today, the state may find itself facing a choice between higher wage costs or lower-quality workers.  Even if the state can find a way around the non-impairment clause, it will not be without its costs.

ADDENDUM (5/30/12):  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.

My own research area is environmental and natural resource economics, which others often call “sustainability”.  That’s actually embarrassing, because I don’t know what it means.  For a renewable resource like timber, it seems pretty easy:  you just plant trees, let them grow, cut them down, and then plant trees again.  For a nonrenewable resource like oil, it’s impossible: once a barrel of oil is consumed, it’s gone forever.  The only way to make oil “sustainable” is not to use it, which does not make any sense, because oil has no value at all if it can’t be used.

So, sustainability is either obvious or impossible.  The concept seems to be of no use whatever.  So I turn to people smarter than me, to get some answers.  By “smarter than me”, in this case, I mean (1.) Nobel-Prize winning economist Robert Solow, and (2.) whoever writes for Wikipedia.

Way back in 1991, Robert Solow wrote “Sustainability: An Economist’s Perspective”, in which he says:  “It is very hard to be against sustainability. In fact, the less you know about it, the better it sounds.”   He says he has seen various definitions, but they all turn out to be vague.  So his essay is an attempt to make it more precise.  “Pretty clearly the notion of sustainability is about … a moral obligation that we are supposed to have for future generations.”   But you can’t be morally obligated to do something that is not feasible!  He notes UNESCO’s definition:  “… every generation should leave water, air, and soil resources as pure and unpolluted as when it came on earth.”   But taken literally, that injunction “would mean to make no use of mineral resources; it would mean to do no permanent construction, … build no roads, build no dams, build no piers.”  That is neither feasible nor desirable!

Instead, he suggests that sustainability might be both feasible and desirable if it is defined as “an obligation to conduct ourselves so that we leave to the future the option or the capacity to be as well off as we are.”   In the final analysis, what that means is that we don’t necessarily have to leave all the oil in the ground, if we leave something else of equal or greater value, some other investment that can be used by future generations to produce and consume as we do, and which they can leave to other generations after them.  It is a holistic concept, both simple and operational.  We only need to add the value of all assets, subtract all liabilities, and make sure that the net wealth we bequeath is not less than we inherited. 

We can use oil, but we should not simultaneously be running huge government budget deficits that reduce the net wealth left to our children and their children.  The measure of “net wealth” should include the value of ecosystems, fresh water supplies, biodiversity, and oil, as well as productive farmland, infrastructure, machinery, and other productive assets.   All those values are extremely difficult to measure, but at least the concept is clear.

Has that message been adopted since 1991?  It certainly does not seem to be part of the thinking of the U.S. Congress and the rest of our political system.   What are they using for guidance?

Wikipedia says  “Sustainability is the capacity to endure. For humans, sustainability is the long-term maintenance of responsibility, which has environmental, economic, and social dimensions, and encompasses the concept of stewardship, the responsible management of resource use.”  Okay, well, that’s still pretty vague, by Solow’s standards.  Let’s see if they make it more specific: “In ecology, sustainability describes how biological systems remain diverse and productive over time, a necessary precondition for the well-being of humans and other organisms. Long-lived and healthy wetlands and forests are examples of sustainable biological systems.”

I’m sorry, that kind of specificity does not make it more operational.   They haven’t read Solow.  In fact, the whole entry seems to read like it is intended to maximize the number of times it can link to other Wikipedia entries!

“Moving towards sustainability is also a social challenge that entails, among other factors, international and national law, urban planning and transport, local and individual lifestyles and ethical consumerism. Ways of living more sustainably can take many forms from controlling living conditions (e.g., ecovillages, eco-municipalities and sustainable cities), to reappraising work practices (e.g., using permaculture, green building, sustainable agriculture), or developing new technologies that reduce the consumption of resources.”

Actually, the only phrase in the whole entry that really struck me was “more sustainably.”  Now, I REALLY do not know that THAT means.  Our current trajectory is either sustainable, or it’s not!  If future generations can live forever, how can they live longer than that?  And if not, well, …

Ever since Governor Quinn proposed his plan to reform government employee pensions in Illinois, I’ve been thinking about how to blog about it.  The problem is, my primary opinion is a legal one – that the proposal clearly violates the non-impairment clause of the Illinois state constitution because it threatens current employees with excluding future pay raises from pensionable earnings in contradiction of the “contractual relationship” laid out in the Illinois Pension Code – and I’m not a lawyer.  Better to stick with what I am supposed to know.

So, let’s turn to economics.  While the non-impairment clause prevents the state from reducing pensions, it does not affect other benefits.  In particular, the state would seem free to reduce or remove subsidies for retirement health benefits without running afoul of the non-impairment clause.  New research from by Steven Nyce, Sylvester Schieber, John B. Shoven, Sita Slavov, and David A. Wise suggests that doing so might be a way to lower pension costs.  In short, they show that removing the employer subsidy for health benefits for early retirees would cause people to work longer.  And, when people work longer they contribute more toward the pension fund and draw pensions for less time, improving the overall finances of the pension system.

In the new article, entitled “Does Retiree Health Insurance Encourage Early Retirement,” the authors investigate the relationship between employer subsidies for health insurance to retirees.  The paper begins by noting that many Americans delay retirement until they reach age 65 because employment gives them access to health insurance at far better prices than they could receive in the private market (if such insurance is even available).  When an employer offers subsidized health insurance to those who retire before age 65, it makes it possible for people to retire earlier than they otherwise would.  Using newly-available data, the paper finds that retiree health coverage significantly increases retirements among people in their early 60s.  In fact, when employers subsidize 50 percent or more of the cost of retiree health insurance (as the state of Illinois does), retirements increase by “1-3 percentage points at ages 56-61, by 5.9 percentage points (33.7 percent) at age 62, and by 6.9 percentage points (43.7 percent) at age 63. Overall, an employer contribution of 50 percent or more reduces the total number of person-years worked between ages 56 and 64 by 9.6 percent relative to no coverage.”

What does this mean for the state of Illinois?  Take, for example, SURS, the State Universities Retirement System.  In this system, a worker’s total retirement benefit is limited to 80% of final salary.  This means that, after about 36 years of working for the state, the worker’s pension no longer increases with additional years of service.  Further, state law provides that the state will pay 5% of retiree health premiums for each year of service.  (Importantly, the applicable law is not the Pension Code!)  So, a person who started working for the state at age 25 would, by age 62, be eligible for the maximum pension and free health benefits.

Given this deal, it is no wonder that people choose to retire before age 65.  This costs the pension system, since early retirees do not contribute and they draw their pension for longer.  Removing retiree health benefits would have a significant financial impact on early retirees.  Back in 2006, the most recent data I could find in a quick search, the average health insurance premium for an adult age 60 – 64 on the non-group health insurance market was around $360/month.   A family policy would cost about twice that.  Such policies are usually less generous than employer-provided insurance and feature higher deductibles and coinsurance rates.  So, a near-elderly state employee contemplating retirement might face expected monthly costs of $500 – $700 or more if they had to pick up their own health insurance, and even more if they had a dependent spouse or children.

So, suppose the state were to eliminate retiree health benefits.  Faced with such costs, many people would choose to work until age 65 (or at least until age 63.5 when the COBRA law would allow them to continue to purchase health insurance under the state plan until they become eligible for Medicare at age 65).  And, when people retire later, they draw pensions for less time.

Now, I am not necessarily advocating this, and certainly not across the board.  There are strong arguments why for some government employees – in particular police and firefighters –the physical demands of the job make early retirement reasonable.  For other government employees, such as professors, there is no strong reason why the state should be subsidizing early retirement through providing free health benefits after I stop working.

My broader point is that whatever the state does, and it must do something, it must be done in a way that does not violate the constitution.  While the state cannot touch pension benefits, it is free to reduce health insurance.  And, since retiree health insurance makes retirement more attractive, reducing or removing retiree health benefits would seem to be a constitutional and, based on recent research, effective way to delay retirement, which would improve the ailing pension systems’ finances.

ADDENDUM (5/30/12):  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.