For the Balkinization symposium on David Schleicher, In a Bad State: Responding to State and Local Budget Crises (Oxford University Press, 2023).
Amy Monahan
State and local finance has an enormous impact on the lives
of nearly all Americans, yet is too often ignored in favor of splashier or more
digestible areas of public life. I was therefore delighted to see David
Schleicher’s new book, In a Bad State: Responding to State and Local Budget
Crises, take a sustained look at both the complex world of state and local
finance, and how federal actors might think through whether and how to respond
to state and local fiscal crises.
I will begin with a few disclaimers. First, there were so many interesting issues raised by this book that I had a difficult time limiting myself to a length appropriate for this online symposium. I have therefore chosen to highlight just one of many potential discussion points, which I hope will be of broad interest to readers. Second (and maybe in contradiction to my first disclaimer regarding broad interest), I am going to focus my comments on In a Bad State’s treatment of distressed state and local employee pension plans (referred to as “public pensions” for the sake of simplicity).
For the uninitiated, most state and local employees receive
retirement benefits in the form of a traditional pension plan that pays a
participant a specified benefit amount every month beginning at retirement and
continuing for the rest of the participant’s life (or surviving spouse’s life).
These plans play a significant role in retirement security for state and local
workers, particularly for the quarter of state and local employees who do not
participate in federal social security. Ideally, public pension plans are
funded in advance as benefits are accrued, with contributions set aside in a
trust that can be used to pay out benefits once a participant retires. According
to the Boston College Center for Retirement Research, such plans were on average only 76% funded
in 2021. But this average figure obscures significant differences at the
individual plan level. Some plans are fully funded, while others have a funded
ratio of only 20%. In dollars, the total amount of unfunded pension liability
at the state and local level was estimated to be $1.45 trillion in 2022.
While the existence of significant unfunded pension
liabilities at the state and local level is by now widely known within policy
circles, In a Bad State powerfully explains why such underfunding is so
common and why it is a particularly problematic type of debt.
As Schleicher explains, there are both structural and
political explanations for widespread pension underfunding. Shortchanging
public pensions has been a convenient method for states and cities to avoid
balanced budget requirements because, nonsensically, such shortfalls do not
count as debt for purposes of either balanced budget requirements or state
constitutional debt limits. This sets up an enormous incentive for politicians
who are facing budgetary pressure to avoid tradeoffs by simply putting a little
(or a lot) less than is due into the pension trust year after year. After all,
the effect of that underfunding in most cases won’t be felt for decades.
The end result is policymakers in many jurisdictions succumb
to a rather irresistible temptation to systematically underfund these plans.
And while such underfunding is clearly a form of debt, Schleicher points out
that it is fundamentally different from most other municipal debt. Generally,
states and cities borrow money for infrastructure investments. This makes
sense. If you are going to build a bridge, several generations will benefit
from the investment and should therefore share in its costs. Pension debt,
however, violates these norms of intergenerational fairness, by requiring
future generations to pay for yesterday’s services. As Schleicher explains, “[h]eavily
underfunded pensions mean today’s taxpayers are paying for two school systems –
today’s and yesterday’s,” which then crowds out other governmental services.
Where a public pension plan has been underfunded for years
or decades, the annual contributions that are required grow larger and larger,
eventually exerting real pressure on state and local budgets. And while
politicians could simply ignore these increased funding needs, underfunding
typically gets to a point where it becomes politically salient, and public
employees begin to exert significant pressure to ensure plans can continue to
pay benefits for the foreseeable future. The result is that this pension debt
that was allowed to accrue year after year often leads to public employees,
bondholders, and taxpayers fighting over limited resources.
While the book is focused on offering a framework for
federal policymakers to analyze the tradeoffs involved in federal assistance to
states and municipalities in crisis, it does devote chapters to how such crises
might be prevented in the first place – including some proposals related to
pension underfunding. Of the solutions offered, I think the most powerful is
the proposal to reform state constitutional debt limitations to include pension
underfunding within the definition of debt. I am intrigued by this idea because
it both addresses the political and structural incentives to underfund pensions
and because it results in paying compensation expenses when they are accrued
rather than allowing them to be shifted to future taxpayers. Imagine how
quickly pension funding behavior would change if politicians had to receive
voter approval to make less than the required annual pension contribution.
To make this theoretically sound idea a reality, however,
would require addressing many fine details. The state would need to specify in
detail how pension debt is to be calculated for state constitutional purposes.
As states like to do with any number of budgetary matters, it would be easy to
use gimmicks to claim that there was not pension debt even when a plan was
significantly underfunded, for example, by using outrageous investment return
or actuarial assumptions, or flawed funding methods. And the level of detail
necessary to prevent such gimmicks would be highly unusual to commit to a state
constitution. Such details are more naturally found in statute, creating the
possibility that future legislatures may simply change those rules when faced
with difficult fiscal choices.
In addition, there would need to be a plan for existing
unfunded pension liabilities. Perhaps existing pension liabilities could be
grandfathered and not considered debt for constitutional purposes. But this
solution fails to address a significant source of potential state and local
distress. Maybe a grace period could be specified that allows a state to pay
down legacy pension debt over a specified number of years, with any amounts
that are not repaid treated as unconstitutional debt.
And last but not least, there are the mechanics of
implementing the jurisprudential change even if we could agree on the details.
Presumably an amendment to the state constitution would be required, or a refinement
of existing precedent, neither of which are easy lifts.
Another potential avenue to achieve a similar result, which
is not discussed in In a Bad State, is using federal tax law to impose
external discipline on state and local pension funding. While In a Bad State
discusses the role of federal tax policy in municipal bond markets, in my
view it misses an opportunity to discuss how federal tax policy might also be
used to address the proclivity of state policymakers to underfund public
pensions. In the 1970s, in response to highly publicized private employer
pension defaults, Congress imposed funding standards and a federal insurance
program for defined benefit pension plans through the federal tax code and the
Employee Retirement Income Security Act (ERISA), but chose to exempt state and
local plans from such requirements. The exemption was justified in part on the
premise that public plans were not at risk for default because states held the
power to tax and therefore could not run out of money to pay benefits. But this
position was somewhat controversial, and as a compromise Congress included in ERISA
a requirement to study the issue of state and local plans. In the fifty years
since, nothing has changed. The federal government provides a tax exemption to
public pension plans but does not require those plans to satisfy any funding
requirements or standards. Now that we have a better idea of the funding
challenges faced by state and local plans, perhaps the best federal
intervention would be to revisit the funding exemption for public plans.
As with the proposed state constitutional change, many
details would need to be addressed in crafting federal legislation. But one
advantage of this approach is that the federal government has already done a
lot of the heavy lifting in developing funding standards for private employer
plans. There are of course still difficult choices that would need to be made –
such as the desirability of including public plans in the federal pension
insurance program – but many technical details are already well known by the
stakeholders involved. While still not easy, the federal path to controlling
state and local pension debt may be a more realistic and more efficient option
than state-level constitutional reforms. And In a Bad State makes clear
why the federal government has a particular interest in avoiding the fiscal
distress that can result from systemic underfunding of state and local pension
plans.
In focusing on its treatment of public pensions, I haven’t
been able to highlight the many other contributions of In a Bad State,
which is a great read for anyone interested in state and local finance. While
it bills itself as a framework for analyzing federal intervention, it provides
a wonderful history of state and local fiscal crises and a clear-eyed look at
the challenges and tradeoffs. In a Bad State concludes with what is in
my view the very crux of the matter. One of the primary reasons fiscal crises
are allowed to develop is that “most voters know little and care less about
state politics.” We would all be better off if someone could devise a solution
to that fundamental problem.
Amy Monahan is Distinguished McKnight University
Professor and Melvin C. Steen Professor of Law at the University of Minnesota
Law School. Her email is monahan@umn.edu.