The other “fiscal cliff”
While everyone is focused on Washington, D.C., there is another “fiscal cliff” that is rarely discussed — the massive unfunded liabilities of state and local governments. In Puerto Rico, the worst-case of these situations was highlighted in the New York Times this week. But the story is much bigger.
Muniland is the nation’s largest employer, with 19 million workers, or 15 percent of national employment. But the tax revenues that fuel the sector have yet to recover to their pre-crisis highs of 2008. According to a new report from The States Project, a joint venture of Harvard University’s Institute of Politics, the University of Pennsylvania’s Fels Institute of Government, and the American Education Foundation (page 9):
[T]he recovery in state revenues has been slower than in previous recessions. Revenues from income tax, corporate tax and sales tax are still lower in FY 2012 by 11 percent, 18 percent, and 4 percent, respectively than in FY 2008.
The report explains that there are structural as well as economic reasons for this (Page 10):
The sales tax base — the value of all taxed goods and services — declined from just over half of personal income in 1970 to one-third of personal income today. This is not only because Americans are spending less on consumables in recent years, but also because consumers are shifting towards more lightly taxed items and services. In addition, the states have had difficulty collecting tax on Internet purchases.
After the financial crisis of 2008, the federal government provided a fiscal cushion for states with the American Recovery and Reinvestment Act (ARRA), but that is now gone (page 12):
Unfortunately for states, federal stimulus funds largely ended in 2012, before state tax revenue had recovered. As a result, forty-two states faced budget deficits in FY 2012 and thirty-one states have projected (and in most cases now have closed) budget gaps totaling $55 billion for FY 2013.
States have attempted to balance their budgets in a variety of ways — by reducing spending, cutting government workers, raising debt to cover budget shortfalls, pushing off certain expenditures into future years, and sometimes by manipulating accounting procedures. Very few states, however, have sought to increase revenues through increasing taxes.
But as Tom Kozlik, a municipal credit analyst at Janney Montgomery, said in note on Tuesday:
One time fixes, short term budget solutions, and expectations to “grow-out” of deficits are misguided approaches.
The most significant of the structural problems that face state and local governments are the exploding costs of Medicaid. These costs have pushed aside other spending priorities:
And here is the backstory (page 11):
In FY 2012, states were forced to dramatically increase Medicaid spending by an average of 28.7 percent, largely to replace temporary federal stimulus funds that expired in June 2011. According to the Congressional Budget Office, total Medicaid costs are estimated to more than double by FY 2022, with the implementation of the new national health care law, the Affordable Care Act, driving costs.
A few other big structural liabilities that are crushing state and local governments are pension and retiree health liabilities and public debt loads. There are numerous estimates about the precise dollar burdens that states face. I think the States Report’s estimates (above) are high, but there is nevertheless a problem with these unrecognized promises that were made to public workers and bondholders. Recent changes in accounting rules will require that government entities more prominently display these future expenses, and this is likely to constrain current spending. This will exert more pressure on state and local government budgets.
The last and most immediate challenge to state and local governments is the more familiar “fiscal cliff” – the one happening in Washington, D.C. State and local governments currently receive over $612 billion of grants every year from the federal government. In this period of fiscal reform, it’s likely that some of this spending will be reduced. There is a frugal spending period ahead for muniland.
Every state and local government will have to develop its own solution. Muniland is the front line of public works, and given economic constraints, it will have to retreat a few paces.