Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm — Center on Budget and Policy Priorities

…recent articles regarding the fiscal situation of states and localities have lumped together their current fiscal problems, stemming largely from the recession, with longer-term issues relating to debt, pension obligations, and retiree health costs, to create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown.

• Municipal bond defaults have been extremely rare; the three rating agencies calculate the default rate at less than one-third of 1 percent .[1]  Between 1970 and 2009, only four defaults were from cities or counties.  Most defaults are on non-general obligation bonds to finance the construction of housing or hospitals and reflect problems with those individual projects; they provide no indication of the fiscal health of local governments.
• State and local shortfalls in funding pensions for future retirees have gradually emerged over the last decade principally because of the two most recent recessions, which reduced the value of assets in those funds and made it difficult for some jurisdictions to find sufficient revenues to make required deposits into the trust funds.  Before these two recessions, state and local pensions were, in the aggregate, funded at 100 percent of future liabilities.   
• A debate has begun over what assumptions public pension plans should use for the “discount rate,” which is the interest rate used to translate future benefit obligations into today’s dollars. The discount rate assumption affects the stated future liabilities and may affect the required annual contributions.  The oft-cited $3 trillion estimate of unfunded liabilities calculates liabilities using what is known as the “riskless rate,” because the pension obligations themselves are guaranteed and virtually riskless to the recipients.  In contrast, standard analyses based on accepted state and local accounting rules, which calculate liabilities using the historical return on plans’ assets, put the unfunded liability at about a quarter of that amount, a more manageable (although still troubling) $700 billion


Projected Operating Deficits

• State revenues are 12 percent below pre-recession levels, and localities also are experiencing diminished revenues.  There simply are few good choices for meeting state and local balanced-budget requirements during an economic downturn this long and this deep.
• Some pictures of the longer term realities of government finance.

And what about Illinois: 

Illinois is an extreme example of the implications of failure to fix these types of problems.  It has a flat, low-rate income tax that does not adequately capture income growth, and income tax revenues thus routinely lag behind economic growth.  The state relies heavily on a state and local sales tax that is almost exclusively applied to goods and excludes almost all services.  It is among the states that exempt from state income tax the largest share of income received by elderly individuals, regardless of their income levels.  Illinois also does a relatively poor job of scrutinizing its spending through the tax code.  Its budget considers only the single upcoming fiscal year, and policymakers often have taken budget actions without full consideration of the longer-term implications.

Because Illinois is chronically short of the revenues it needs to cover its expenses, it has engaged in a number of poor fiscal practices over the years.  It has postponed payments to vendors, failed to make adequate pension contributions or borrowed money to make the contributions, securitized or sold assets, and taken other dubious actions.  As a result, it has had a particularly difficult time coping with revenue declines during this recession, with a fiscal year 2012 deficit projected to equal half of its general fund budget, and has developed an large overhang of longer-term debt and unfunded liabilities. 

But it is important to remember that the root cause of Illinois’ problem is a revenue system in urgent need of modernization, one that cannot support the level of expenditures that the state has chosen.  Proposals have repeatedly been made over the last 25 years to remedy many of these problems, but political gridlock has prevented solutions to Illinois’ well-known budget problems from being enacted.  In January 2011 Illinois temporarily increased its personal and corporate income tax rates to close a portion of its budget gap.  But it still plans to borrow to cover its pension contributions and has not addressed the fundamental problems in its revenue system that are the principal cause of its large structural deficit.       

Most states are not in as dire shape as Illinois.

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