On November 12 State Budget Solutions issued new research showing the level at which state public pension plans are underfunded, and it’s not good news. In 2013 state pension plans were underfunded by a staggering $4.1 trillion. In 2014 that number has risen to $4.7 trillion. Even though the economy has been improving and there is more talk about state budget surpluses than deficits, states are not addressing this major budgetary issue.
Most state and local governments provide some form of retirement income for their employees. Often, governments provide defined benefit plans, in which employees are guaranteed a specific pension payment upon retirement. Defined benefit plans are financed through dedicated trust funds, which are bankrolled to cover future pension liabilities. Payments into those trust funds come from employers (the state or local government) and employees, and the monies in the funds are invested.
The level of underfunding in state and local government pensions is significant. But in addition to pension benefits, many state and local governments provide healthcare benefits to retired state and local government workers, as well as life insurance and other smaller benefits. Often, these programs receive little funding because they are funded on a pay-as-you-go basis.
It’s time for states to begin planning for the future. This isn’t a can that can be kicked down the road. Given perpetually tight budgets, the potential for a decrease in federal funding (even for programs that are not directly related to state pensions or healthcare), the existing underfunded programs, and the fact that most states must balance their budget each year (and must stop shifting funds to achieve a balanced budget), states do not have the luxury of putting off planning for the future. They must plan for more than one year at a time, and they must start now.
States have a variety of reforms that could be used to improve the situation. Pension rules could be strengthened to reduce the potential for abuse, and benefits could be scaled back. But ultimately, contributions to pension funds, by state governments and employees alike, will need to be increased.
But increased contributions by state governments will require an increase in revenue or a decrease in spending elsewhere. Some reports have suggested that states’ inability to meet their funding requirements is tied to erosion of the state tax base. Yet rather than addressing the problem of a narrowing tax base, some states have compensated by increasing tax rates.
States should, if embarking on fundamental tax reform, seek to reverse the trend of continually narrowing the tax base and raising rates. Broadening the tax base and lowering tax rates is nearly always a better choice. Also, states should question their reliance on the corporate income tax (if they impose one). For state tax purposes, the corporate income tax is too cyclical to be a stable form of revenue. Because most states are required to balance their budgets, they should rely more heavily on stable streams of revenue.
States should constantly assess their budgetary outputs, including amounts that are put toward entitlement programs. Underfunding in state and local government pensions and healthcare plans can be addressed by either decreasing the plans’ liabilities or increasing the assets in the plans’ trust funds. If states are unable to increase the amount of assets in the plans, the value of the benefits will have to be decreased. State tax reform won’t solve the problem of overspending.
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