U.S. States Are Going Bust & Why You Should Care

1. U.S. States Are Going Bust & Why You Should Care Andrew P. Morriss H. Ross & Helen Workman Professor of Law & Business University of Illinois, Urbana-Champaign

2. Not the usual rogues’ gallery

3. Not just rogues

4. If US states were countries

5. 3 reasons to worry • Structural deficits are large. • The state/local pension crisis is worsening. • Financial chicanery & the bag of tricks is almost empty.

6. 3 reasons to care • State officials’ impact on federal initiatives in financial regulation. • State and local pension funds are major institutional investors. • State financial meltdowns will drag down the U.S. economy.

7. Structural Deficits • “States have structural deficits largely because they have failed to modernize their revenue systems to reflect far-reaching changes in the economy. Several states have changed their revenue systems little since the 1930s or 1940s; others have revenue systems that are twenty or thirty years out of date.” • Lav, McNichol, & Zahradnik, Faulty Foundations: State Structural Budget Problems and How to Fix Them (Center on Budget & Policy Priorities, 2005)

8. Immediate impacts • “Our rating reflects the magnitude and persistent nature of the state’s fiscal problems and the likelihood that the budget to be enacted for next year, fiscal year 2011, will not address annual operating deficits or accumulated liabilities.” • Fitch Analyst Karen Krop, March 31, 2010 as Fitch downgraded Illinois bonds to ‘A’

9. Major state revenue trends • Post-1992 TABORs. • 1990s one time revenue boosts (tobacco money). • Large rainy day fund balances in 1990s. • Expanding legislated tax exemptions (no services). • Cross-border shopping (Amazon). • Changing purchasing patterns.

10. TABOR/TEL impacts • “TELs … may have created an important and not easily reversible divide in the American federal system: between the states that have strong TELs and those that do not, a divide that may eventually produce large differences in spending and revenue priorities across the states.” • Subo Bae and Thomas Gais, The Effects of State-Level Tax and Expenditure Limitations on Revenues and Expenditures 7 (Rockefeller Institute, May 21, 2007) available at http://www.rockinst.org/WorkArea/showcontent.aspx?id=11804

11. State tax trends • State sales tax base changes, 1990-2003 • Median -8%. • 8 states declined more than 15%. • Corporate income taxes • Share of state tax revenue fell from 10.2% in 1979 to 6.3% in 2000. • Effective rate down 1/3 from 1980s. • Post-2001 recession & revenue drought • Attributed to over-reliance on income taxes.

12. Relative state burdens ~30% difference top to bottom

13. Do you pay your fair share of income taxes? AP Survey, April 2010

14. Tax sources Federal State

15. Ease of tax burden shifting Federal State

16. State spending • "If you don't tie our hands, we'll keep stealing.“ Rep. Tom Perriello (D. Va.)

17. State spending: Compensation 2001-2007

18. 35 of 51 jurisdictions state employees’ compensation grew faster than private sector employees 2001-2007 • California – 8% • Hawaii – 17% • Michigan – 10%

19. No federal rescues • “On average, Democratic [congressional] districts received 1.53 times the amount of awards that Republicans were granted. … Democratic districts also received 2.65 times the amount of stimulus dollars that Republican districts received ($122 billion vs. $46 billion). … In total, Democratic districts received 73 percent of the total stimulus funds awarded and Republican districts received 27 percent of the total amount awarded.” • Veronique de Rugy, Stimulus Facts, Period 2 (Mercatus Working Paper April 7, 2010).

20. Pensions • “To a significant degree, the $1 trillion gap reflects states’ own policy choices and lack of discipline: failing to make annual payments for pension systems at the levels recommended by their own actuaries; expanding benefits and offering cost-of-living increases without fully considering their long-term price tag or determining how to pay for them; and providing retiree health care without adequately funding it.” • Pew Center on the States

21. $1 trillion gap • Pew Center calculation is conservative: • based on 6/30/08 numbers • smoothed results = 4 more years of losses • FY 2008: $108 billion actuarial vs. $72 billion actual • Contributing < amount necessary to average 90% of actuarially required contributions (2003-2008) = 21 states • Assumed investment returns too high (8%)

22. Pension examples • 1998: 106% funded • 2000-2006 state never exceeded 30% of actuarially required level • 2008: <73% funded • 2009 contributions • Required - $2.3bn • Actual - $105m • In 1990s, PERS funded with 12.5% employer contribution rate. • Legislature cut to10% through FY 2005 to fund public employee wage increases. • In FY2004-05, covered < 60% of required contributions. New Jersey Oklahoma

23. Colorado • Combined state and local pension funding • 2000 - 105% • 2008 - < 70% • Only reflects 25% of 2008 losses • Causes • Automatic COLAs • Reduced retirement age from 55 to 50 (30 yrs. service) • Missed contributions: post 2002, only 50-70% of contributions (missed $2.4 billion) • Investment losses • 8.5% = return assumed • -26% = actual 2008 return

24. Assumed performance • 231 state and local funds: 8% • Top 100 private pension funds: 6.36%

25. Pension fund outlooks • Losses will continue to mount due to smoothing. • Underfunding will continue due to state fiscal crises. • Pension claims will increase due to retirement incentive programs. • Pressure on state budgets will worsen.

26. Financial chicanery • "It's a question of whether the creditors that we owe money to can actually stay in business or whether they'll collapse.“ • IL budget director David Vaught • “Government and jurisdictions are held to very different accounting standards - or lamentably are held to different accounting standards from private companies. So this goes on all the time.” • Dean Philip Romero, College of Business & Economics, California State University, Los Angeles

27. State officials operate “by overestimating revenues, underestimating costs or a combination of both. The cash basis method used to calculate budget allows these accounting shenanigans. For example, it permits borrowed money to be included as inflows (revenues). It also allows proceeds from onetime sales of state assets to be used to pay current expenditures. … Legislatures avoid an immediate effect on the current state budget by promising retirement benefits rather than increase state employees’ currently payable salaries.” • Institute for Truth in Accounting, The Truth About Balanced Budgets (2009)

28. Arizona’s state capital sale • “Daily Show” correspondent Jason Jones:Okay, so you’ve got 735 million dollars for this year. What happens next year when you don’t have that and you’ve got to pay rent. • AZ State Sen. Linda Lopez:See, that’s always the problem, but, y’know.... • Jones:That’s a big problem. • Lopez:We’ve got to get through this year. And ... there are already cuts in the budget. • Jones:Okay, but next year you’ve got to pay rent. • Lopez:Right. • Jones:Isn’t that adding to your deficit? • Lopez:Yes, but it will have helped us bridge the gap for this year. • Jones:Okay. I gotta say again. Next year, what are you gonna do? • Lopez:Oh my goodness. You’re killing me here. You’re absolutely killing me.

29. California’s budget tricks • Borrow from local government funds. • Increase payroll withholding. • Accelerate estimated tax payments. • Shift June 2010 payroll to July 2010 ($1.2 bn). • Basing budgetary calculus on “extremely dubious assumptions.” ($100 m in oil lease payments from Santa Barbara Channel).

30. Familiar concerns • “On the basis of the information so far available, I remain concerned that your budget forecasts are highly optimistic, on both the expenditure and revenue sides. Your budget plans leave little room for maneuver in the event of unforeseen contingencies, and your public finances may not be sustainable in the medium term.” • Letter from FCO Minister Chris Bryant to Hon. McKeeva Bush, October 8, 2009.

31. Why care about US politicians’ tricks? • States (and the federal government) have serious debt problems (pensions and more). • States have serious structural deficits. • States have almost run out of tricks. • One last trick: inflation.

32. Krugman’s lessons from Greece • “What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover.... America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off.” • Learning from Greece, NYT, April 8, 2010, http://www.nytimes.com/2010/04/09/opinion/09krugman.html?hp

33. Not just Krugman • “Everyone thinks the Fed's job is to fight inflation, but right now the Fed is actually doing everything it can to cause inflation. Why? It part to help the economy get cranking gain.  Inflation provides an incentive for people to spend cash rather than saving it, because if they save it, the cash will lose value rapidly. Inflation also helps solve another problem, though--our debt problem.  The more inflation we have, the less our dollars will be worth.  Because our debts are based on a specific number of dollars and not a specific value, the less our dollars are worth, the easier it will be for us to pay off our debts.” • Peter Gorenstein, Pray for Inflation – It’s Our Only Hope, Tech Ticker (April 9, 2010). • http://finance.yahoo.com/tech-ticker/pray-for-inflation----it%27s-our-only-hope-464142.html?tickers=^dji,^gspc,spy,dia,udn,tip&sec=topStories&pos=9&asset=&ccode=

34. Is California Greece? • Wolfgang Munchau, Greece will default, but not this year, FT (April 4, 2010) • 5 possible outcomes • A “significant fall” in the euro’s exchange rate + a strong recovery in the eurozone. • Access to EU/ IMF low interest rate loans. • Private sector debt restructuring. • Greece leaves the eurozone. • Default.

35. Miller Commission Report • “The Cayman Government is on a path that is no longer fiscally sustainable.” • “The Cayman Government has huge unfunded liabilities -- specifically its civil servants' defined-benefit retirement and healthcare plans.”

36. “The Illinois Spiral” • Employers tend to be harder-headed in deciding where to invest their money than our lawmakers are in spending other people's money. The employers see Illinois pols dithering through a crisis, inviting an even more bleak future with their refusal to reform government spending and reduce what it costs to have a payroll in Illinois: • • You haven't heard Illinois leaders confront a November warning from advisers to the legislature's economic think tank — the Commission on Government Forecasting and Accountability — that while half the states would recover from their job losses by mid-2013, "Illinois would not recover its peak employment level until 2014 or 2015." In the meantime, " … 10 states, including Illinois, are expected to suffer unemployment rates in excess of 9 percent. • Chicago Tribune editorial (April 11, 2010)

37. Conclusion • Don’t become California (or Arizona or Illinois…). • Do worry about the future value of government debt issued by US states. • Do worry about what role US state politicians will play in the future of financial regulation. • Do worry about the future of US state and local pension funds as investors. • Do worry about what the coming state meltdown will do to the US economy and its impact on Cayman.