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The Economics of State and Local Government Finance

Public Affairs Forum

October 26, 2011

Ed English, moderator: Today we're talking with Joshua Rauh, associate professor of finance at the Kellogg School of Management at Northwestern University.

According to your research, you say state governments have placed their aggregate unfunded liability for pensions at $1.3 trillion. But you say the actual unfunded liability is much greater than that. Why the difference?

Dr. Joshua Rauh: Great question. State and local governments use accounting methods to calculate the value of their liabilities that would generally not be accepted by economists or by practitioners in the private sector. In particular, they assume certain expected returns on their assets and use those expected returns in calculating their debts and in stating their debts to the public. It would be as though you walked into a bank and wanted to take out a loan, and the bank asked you to declare your assets and your liabilities and you asked if it was OK to ignore your debts because, in fact, the assets that you had set aside were invested in the stock market, which had performed very well historically and would be likely to be able to pay off your debts. That's not the kind of accounting that works in the private sector and it shouldn't work in the public sector, either. So when we correct for that and when we use market-based calculations, market-based interest rates, to measure what state and local governments owe net of what they have set aside, we find there is an unfunded liability of around $4 trillion that will have to be paid for one way or another.

English: What are the risks of underfunding these pensions, both for taxpayers and for state employees?

Rauh: Well, it goes back to this measurement problem. The major problem is that when we make these promises to public sector workers, we're not properly calculating the value of the new promises that we're making and so, therefore, we're not setting aside enough to date. What that means is that future taxpayers—taxpayers in 10 or 20 years—are going to have to pay a lot more. A lot of them aren't really aware of this. Some of them are young and can't even express their opinions about this matter. Essentially, what we're doing is we're making future generations of taxpayers write insurance for us, and if the stock market doesn't perform exceptionally—well, then our kids will be asked to pay more for these benefits for the legacy of what we didn't set aside in the past.

English: Can you speak to how states might address these unfunded liabilities and what the effect might be on the macroeconomy?

Rauh: Well, states are really in a bind because the Government Accounting Standards Board, which sets generally accepted accounting practice for state and local governments, is setting that practice in a way that just flies in the face of all economic logic. And states, if they really want to address this problem, have to individually say that this accounting standard is wrong, and they have to use actual accounting that reflects the economic reality of the promises. That's asking a lot of them, so what I think needs to happen first is there needs to be fundamental reform of the Government Accounting Standards Board procedures for measuring pension liabilities. Pension liabilities need to be measured in a way that is consistent with financial logic and private sector practice. And then the magnitude of the problem will be revealed, the true magnitude of the problem will be apparent to everyone, and we can get on with the business of trying to make some reforms.

Unfortunately, when you wake up and realize that there is $4 trillion of, basically, credit card debt you didn't realize was there before, it's not a happy situation and the kinds of solutions that state and local governments have access to are ones that are politically not very appealing. They include increasing taxes to pay for the benefits, cutting spending to pay for the benefits, raising contributions for public sector employees into these pension benefits—although the magnitude of that can only go so far—and also trying to restructure the way that the benefits are offered. So it's a menu of politically very difficult choices, and it's driven by the fact that the national standards for the state and local pension accounting are so problematic.

English: Can you compare the reforms that might be undertaken in state pensions for workers that are near retirement versus, say, younger state workers?

Rauh: Well, those two groups of workers have interests that are rather at odds with each other. Workers who are closer to retirement would probably like the systems to run as they are, keep the status quo for a little bit longer. Workers who are far away from retirement, if they see the economics of the situation, will realize that the assets are just not going to be there to pay the pensions that they are receiving. From a political standpoint, it seems likely that changes that grandfather in individuals who are closer to retirement, at the expense of those who are further away, are likely to happen.

English: How do pension programs in the Southeast compare with those in other parts of the country?

Rauh: Well, in Georgia and Florida, they are somewhat better off than in many other parts of the country. Part of this is because Georgia has actually wrestled with these issues, has taken on reforms both for the state workers and the local workers. Florida has been a state that has generally funded what the actuaries say they are supposed to fund. I'm a big critic of the actuarial standards, but certainly it's better to have followed those standards than to not have followed any standards at all. States like Illinois and New Jersey have simply not followed the actuarial recommendations for contributions. So the combinations of reforms that have been undertaken and also the adherence to at least the minimal actuarially required contribution standards have put some of the states in the Southeast in a bit better shape than states are in other places.

English: What about local municipalities? What kind of shape are they in?

Rauh: Well, some of the local municipalities are in even worse shape than the states. A lot of them haven't actually followed the actuarially recommended contribution standards and they also face a problem in that many municipal workers are not in the federal Social Security system. This means that they're depending on the local governments for their benefits for their entire retirement, and that really ties the hands of the governments in terms of what kinds of reforms can be made. Another issue that is very specific to local governments is the idea of flight from the cities—that people might simply leave and go to the suburbs rather than pay the higher taxes that taxpayers are going to be asked to pay in order to pay for these pensions. What cities are looking at [are] higher taxes and lower spending. That's not something that citizens like. They might just decide to leave to go to other areas, and that's going to make the problem even harder to address.

English: Thank you, Dr. Rauh. We've been speaking with Joshua Rauh. For more information, see our website at frbatlanta.org.