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Podcast: Misunderstandings About State Debt and Pensions Create Unnecessary Alarm

In this podcast, we will discuss misconceptions concerning bond debt, pensions and other challenges facing states. I’m Shannon Spillane and I’m joined by Senior Advisor Iris Lav.

1. Iris, in a new paper you note that recent media coverage of the fiscal situation of states and localities has been confusing a number of issues and producing unnecessary alarm among policy makers and the public at large. What is the main misconception?

The main problem is that the media and others have lumped together states current fiscal problems, which stem largely from the recession, with longer-term issues relating to debt, pension obligations, and retiree health costs. This has created the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown.

States and localities do face difficult choices. And they are using the tools they have — largely budget cuts and tax increases — to deal with their short-term, recession-induced challenges. This has very little to do with the longer-term issues, which states have several decades to address.

2. You mentioned one long-term issue is bond indebtedness. Can you tell us about that?

Sure. Recent claims that states and localities have run up massive bond indebtedness, and that a number of localities may default on their bonds, are greatly exaggerated. First, states and localities have issued bonds almost exclusively to fund infrastructure projects, not finance operating costs, as some have claimed. Second, the amount of outstanding debt has increased slightly over the last decade but remains within historical parameters. Third, municipal bond defaults have been extremely rare. And finally, there is no bubble in the municipal bond market, and no grounds for comparing it to the mortgage market before the bubble burst.

3. What about claims that states and localities have $3 trillion in unfunded pension liabilities that may drive them into bankruptcy?

These claims are exaggerated. The size of the unfunded liability is closer to $700 billion – which still sounds like a big number but is actually much more manageable. In most states, a modest increase in funding and/or changes to pension eligibility and benefits should be sufficient to remedy underfunding. A few states that have skipped contributions or increased benefits without increasing funding likely will have to make larger changes. But states and localities have the next 30 years in which to remedy any pension shortfalls; and in general, they actually should avoid increasing pension contributions as long as the economy remains weak and they are struggling to provide basic services.

4. In your report you mention that exaggeration about these issues draws attention away from the need to modernize state and local budget systems. Can you explain?

Sure, Shannon. States suffer from “structural deficits.” That means that revenues don’t grow at the same pace as the cost of services, even during healthy economic times. Structural deficits stem in large part from out-of-date tax systems, which in many cases have remained largely unchanged for decades. For example, few states tax the sales of services on the same basis that they tax the sale of tangible goods. So while a person pays tax when they buy a lawn mower, they don’t pay tax when they hire a landscaper to come mow their lawn. State tax systems also haven’t adapted to the fact that purchases are increasingly taking place over the internet.

All of these are serious challenges that states must begin to address as the economy recovers.

5. Iris, what’s the bottom line?

Overheated claims about state and local budget problems not only are inaccurate, but also could lead policymakers to take unwise steps such as allowing states to declare bankruptcy or forcing them to change the way they report their pension liabilities as a condition for issuing tax exempt bonds. That would be a huge mistake.

Thanks for joining me, Iris.