State and Local Governments Facing $2 Trillion Fiscal Timebomb?

 
 
October 12, 2006

Economists Chris Edwards and Jagadeesh Gokhale have a provocative op-ed in this morning's Wall Street Journal that paints a gloomy picture for the future of state and local government finance. Looming pension obligations and underfunded retiree health costs add up to what they call a "$2 trillion fiscal time bomb." From the piece:

State and local governments are amassing huge obligations in the form of unfunded retirement benefits for their workers. Aside from underfunded pension plans, governments have also run up large obligations from their retiree health plans...

The prospect of funding $2 trillion of obligations with higher taxes is frightening, especially when you consider that state politicians would be imposing them on the same income base as federal politicians trying to finance massive shortfalls in Social Security and Medicare. Hopefully, most state policy makers appreciate that hiking taxes in today's highly competitive global economy is a losing proposition.

The only good options are to cut benefits and move state and local retirement plans to a pre-funded basis with personal savings plans. Two states, Alaska and Michigan, have moved to savings-based (defined-contribution) pension plans for their new employees. Alaska has also implemented a health-care plan for new state employees, which includes high-deductible insurance and a Health Savings Account. Expect to see more states following Alaska's lead.

State and local governments also need to cut retirement benefits, which were greatly expanded during the 1990s boom. From a fairness perspective, cutting benefits especially of younger workers is reasonable given the generosity of state and local plans. Federal data shows that state and local governments spend an average of $3.91 per hour worked on employee health benefits, compared to $1.72 in the private sector.

Underfunded -- or more accurately, over-promised -- retirement plans for state and local workers have created a $2 trillion fiscal hole. Every year that policy makers put off the tough decisions, the hole gets bigger. Hopefully, the new GASB rules will prompt them to enact the reforms needed to avert job-destroying tax increases on the next generation. (Full piece here.)

As Boston University economist Laurence Kotlikoff pointed out in our recent podcast, state and local governments aren't the only ones facing stark trade offs between looming spending obligations and tax burdens in coming decades. Check out the transcript for some of Prof. Kotlikoff's ideas for reform at the federal level.

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