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Commentary By Steven Malanga

America's States Of (Fiscal) Siege

Economics, Economics Tax & Budget, Tax & Budget

U.S. states and cities should be awash in good budget news. But due to slow economic growth, pension underfunding and health care costs, they're struggling.

America's states and municipalities should be awash in good budget news. Unemployment remains below 5%, inflation is tame, and the stock market rose more than 20% in 2017 — the ninth year of a bull market. Yet many local governments faced intense struggles last year to balance their books.

Localities have confronted unrelenting fiscal pressure since 2008, a result of the  weakest recovery since World War II of tax revenues combined with ever-escalating costs. Many states and localities have had to rewrite budget books in ways that leave taxpayers paying more — and receiving less.

"U.S. states have entered a new era characterized by chronic budget stress," the financial analyst Gabriel Petek, a managing director in the U.S. Public Finance group at S&P Global Ratings, wrote last April.

President Trump has promised $1 trillion in infrastructure spending that could provide some help to localities, but what governments across the country really need is a return to economic growth rates of 3% or higher.

Tax reform passed in December looks like it will help but states and cities will also need to become more efficient and innovative in delivering basic services, or else face a future of tax hikes and service cuts to keep up with their mounting bills.

Local governments got a sense that something might be different starting in 2009, when state tax revenues, hammered by the steep recession, collapsed by nearly 9% — only the second time in the postwar era that state revenues had declined from one year to the next.

Then revenues slumped again in 2010, by 4% this time, leaving governments tens of billions of dollars short of where they'd been just two years earlier.

Regaining Lost Ground

It took states until 2016 to regain everything that they had lost in the recession, on an inflation-adjusted basis. They needed only slightly more than half that time to rebound after the recessions of the early 1990s and 2001–02.

Meanwhile, according to a recent National League of Cities survey, America's major cities still haven't seen revenues return to pre-recessionary levels. The pressure on cities and states has been so great that in 2016, eight years into the recovery, ratings agencies downgraded the credit of 489 state and local governments.

Some of the weakness in tax receipts results from structural demographic and economic changes, including the aging of the population and a decline in work participation rates that local officials knew were coming but have done little to prepare for.

States should have spent cautiously but piled on new obligations that they likely would have had trouble financing even in a stronger recovery.

Medicaid has been the biggest driver. Last year, states spent $211 billion on Medicaid, out of $1.29 trillion in total expenditures. That sum represents a nearly 70% rise in spending on the program in ten years and a 220% increase over 20 years. Including federal dollars that flow to states, Medicaid now eats up more than a quarter of state budgets.

And more is coming. Thirty-two states expanded Medicaid under the Affordable Care Act to previously ineligible households. Though the federal government initially picked up most of the Obamacare costs, states must gradually start paying a share.

A 2016 Boston Globe story reflects typical exasperation over the state's seemingly perpetual Medicaid-related fiscal crisis. "Why does Massachusetts, which has been in an economic recovery for seven years, constantly careen from one state budget gap to another?" the paper asked.

Health Care's Cost Pinch

Blame in large part runaway health-care spending, which, the Globe notes, is "generally outpacing inflation, personal income, and tax revenue growth" — and thus "constraining the cash available for everything else, from education to support for cities and towns."

Medicaid accounts for one-third of the state budget, up from one-quarter in 2000. Originally designed as an insurance program for the poor, Medicaid now covers one-quarter of all Massachusetts residents — though the state's poverty rate is 12%.

Exploding Medicaid costs are being felt in many other states. In its early days in the mid-1970s, Nevada's Medicaid program covered about 23,000 poor residents.

Today, 638,000 Nevadans get insurance through the program; officials had underestimated by more than 130,000 the number of residents who would apply for the subsidy once the state expanded it under the Affordable Care Act. Medicaid costs twice as much in Nevada as it did ten years ago, and the state's contribution of tax dollars has swollen by more than two-thirds over that time period.

An immense pension crisis also looms over local governments. States and municipalities have amassed at least $1.5 trillion in this debt — equal to what states collect in taxes in one year—though some estimates put the real cost at three times that much.

Most states and localities struggle to put enough money aside yearly to stop the debt from climbing, much less reduce it.

A recent Bloomberg study found that, from 2014 through 2016, only six states managed to reduce pension debt, despite the national economic expansion. On average, state pension systems were less than 72% funded at the close of 2016. Although that number has risen with the market in the last 15 months,  funding is still not near levels before the market crash of 2008.

Threat Of Underfunded Pensions Looms

Nearly two dozen states have less than 70% of the money they need to fulfill their obligations, and a dozen are less than 60% funded, including Massachusetts, Colorado, Maryland, Minnesota, South Carolina, New Hampshire, and Louisiana. The Financial Accounting Standards Board, which sets policy for private-sector pensions, defines the status of a system less than 80% funded as "critical."

Governments are struggling to make the necessary payments. In a September meeting with CalPERS, the giant California public pension fund, representatives from a dozen California localities complained that dramatically rising pension costs — projected to triple for some cities and school districts — will lead to a "gradual strangulation" of public services.

"We have been saying the bankruptcy word, which is not very popular,"   the finance director of Oroville testified.

The added burden couldn't come at a worse time for cities, with states pushing their own financial woes down to their municipalities in the form of significantly curtailed local aid. State aid to counties, cities, towns, and school districts averaged an annual growth rate of just 1.1% from 2009 to 2015 — a major comedown from the 4.1% average growth rate that had previously prevailed.

Local governments have also cut investments in the once-basic category of infrastructure. Adjusted for inflation, construction spending on infrastructure is down by $47 billion, or 18%, since 2009.

How can states and localities escape chronic budget stress? Seizing control of Medicaid spending is perhaps the No. 1 task. Though efforts to repeal or modify the Affordable Care Act have thus far failed because some congressional Republicans worry about the impact on state budgets, the numbers are inexorable: allowing Medicaid spending to keep escalating at its current rate will utterly drain state and federal budgets.

A far better alternative is to pare Medicaid back to its origins as a program for the poor, and let each state experiment with private insurance innovations to cover many of those recently put on Medicaid who aren't destitute.

Serious Health Care Reform Needed

The solution would also entail ending Obamacare-mandated high-cost, low-deductible insurance plans, which force insurers to pay for many services at prices that discourage people from purchasing private insurance.

Instead, the federal government should allow states to experiment with low-cost, high-deductible plans that protect patients from catastrophic costs — the kinds of plans that many states were exploring before Obamacare eradicated them.

Grappling with pension debt is also essential. Since 2009, virtually every state has claimed to make some kind of reform to its pension system, but the basic math of most defined-benefit retirement systems still doesn't work.

As most pension systems keep accumulating debt, states must stop the bleeding by switching to some form of defined-contribution or hybrid pensions, which reduce costs and don't expose taxpayers to unlimited long-term debts. Rhode Island, which created just such a system, has shown the way.

Local governments also need to do more than rely on debt and higher taxes to boost their infrastructure efforts. In a more technologically sophisticated environment, local governments should focus on a private-enterprise model for financing transportation through user fees, which ultimately direct responsibility for paying for new projects — whether toll roads, airports, or bridges — to those who will use the facilities, rather than forcing everyone to pay through general taxes.

"One of the few great inescapable facts in the field of economics is the reality of the business cycle," Moody's recently observed. "No matter how high-flying an economy might appear, another recession is coming sooner or later."

The only way to prepare is to face up to the fact that public-sector budget math has changed—and that governments have to change with it.

This piece originally appeared at Investor's Business Daily


Steven Malanga is the George M. Yeager Fellow at the Manhattan Institute and a senior editor at City Journal. This piece was adapted from the Winter 2018 Issue of City Journal.

This piece originally appeared in Investor's Business Daily