The disturbingly large present and prospective fiscal deficits of the federal government receive much attention, and deservedly so. Yet the financial situations of many state and local government finances are also in bad shape, and in many respects they are far more difficult to solve than are the federal fiscal problems.
California provides a dramatic example. It has a current annual budget deficit of over $20 billion, which amounts to about 20% of its annual spending. My home state of Illinois is not far behind, with a fiscal deficit also of about 20% of total spending. States like Nevada even have much bigger deficits. Many cities, like Chicago and New York, also face dismal fiscal futures. Some states, like Texas, have much better fiscal health, either because they have had greater fiscal discipline, or because the Great Recession has a smaller impact on their tax revenues.
Tax revenues will recover as the American economy recovers, and that will help reduce state and local fiscal deficits. For many states, however, such as California and Illinois, the increased tax revenues from an economic recovery are unlikely to eliminate their deficits because they have a structural gap between spending and revenues. They cannot easily cut spending because a sizable fraction of their spending goes to education, welfare, health, roads, and criminal justice. All these activities have strong political support.
Nor is it easy for states and cities to greatly raise taxes. Taxpayer groups are generally well organized politically to lobby against their own taxes being raised. In addition, competition among states and localities for companies and residents, and competition from untaxed online sales, puts a ceiling on how much taxes can be increased without badly hurting a state or local economy. Perhaps states that have relatively low income taxes-Illinois has a flat tax of 3%- can raise them a little, but states that have high income taxes- the maximum rate in California already reaches almost 10% at moderate income levels- would find it difficult to raise income taxes by much without encouraging substantial out-migration of small businesses and richer individuals.
As bad as their present fiscal situation is, the long-term picture for state and local government finance is even more dismal. The vast looming problem is the huge level of unfunded liabilities for pensions and health care to retired government employees. Recent estimates place the present, or discounted, value of state and local government unfunded liabilities at over $3 trillion. This amounts to about 22% of American GDP, and it is more than 150% of annual state and local government spending. Unfunded liabilities are so large because of several factors.
Most state and local government employees can retire when they are still young- often after 20-25 years of government employment. To make matters worse, these governments continue to use defined benefit systems, where the amounts paid to retired workers are only very loosely based on a worker's contributions to the pension system. Often, retirement incomes depend mainly on earnings during the last few years of government employment prior to retirement. Earnings tend to be much higher at older than at younger ages, and workers sometimes make the relevant earnings even higher by taking overtime pay shortly before retirement, and by other means.
Medical benefits to retired state and local government workers are another important determinant of unfunded liabilities. These benefits are usually quite generous, with low deductibles and co-payments, and low premiums. Of the $3 trillion in unfunded liabilities, about 20% are liabilities from expected medical care, and the large remainder is from pensions. Since medical spending has been rising rapidly over time, the share of state and local liabilities due to medical spending is likely also to be rising over time.
Fiscal adjustment by states and cities is further complicated by the heavy unionization of their employees. Whereas unionization in the private sector declined drastically during the past several decades to only about 7% of the private labor force, unionized state and local government employees grew dramatically to about 40% of all these employees. Government unions, like the teachers unions, are powerful and entrenched, and would battle fiercely against efforts to greatly reduce any part of their total compensation.
The federal government also has immense unfunded medical and social security liabilities for retired workers. But unlike state and local governments, the federal government can in a pinch help finance these liabilities by effectively printing money through bonds that are directly or indirectly purchased by the Federal Reserve. The federal government can also raise taxes without worrying about the competition among states for businesses or richer individuals, although federal income and other taxes have sizable effects on incentives as well.
Nevertheless, despite the obstacles, state and local governments do have several options that could help get their unfunded liabilities under better control. They could delay retirement ages of most new state and local employees, and even of many present employees, until they reach their sixties (employees doing strenuous physical work could retire earlier). That would simply be requiring their employees to retire at about the same ages as do most non-governmental workers. In addition, they can begin to convert, as have many private employers, from defined benefit retirement systems to defined contribution systems. In the latter system, retirement benefits depend on the present value of pension taxes paid by each worker, accounting also for changes in returns on assets. Finally, states and local governments could force present and future retirees to pay for a larger fraction of the medical care that they receive.
Of course, the teachers union and other powerful state and local government unions will strongly resist efforts to substantially cut their generous retirement benefits. Governments can, however, fight back if they have strong support from the taxpayers who will be burdened with financing these unfunded obligations. If the governments were losing these political battles, cities but not states, as Posner indicates, could even threaten the “nuclear” option of declaring bankruptcy in the expectation that bankruptcy courts will reduce the size of their unfunded retirement obligations.
One way or another, cities and all states with the most serious unfunded liability problems would eventually be forced to either lower their spending or raise their taxes. Either way that would reduce their competitiveness against other states. It is hard to come away with much optimism for the economic futures of the states and cities with the greatest fiscal problems.