March 3, 2008
The fiscal state of the states (and municipalities): Not so good
By Rick Mattoon
Plenty of evidence is emerging that state and local governments are headed into a major fiscal pinch. Tax revenues are decreasing across the board, as everything from corporate profits to employment declines. The big question is how well are the states positioned to weather this storm? Is there anything different in the nature of this economic slowdown that will make circumstances more difficult?
Based on some preliminary evidence, the future looks challenging. The Center on Budget and Policy Priorities released a survey of state budget conditions on February 25, 2008. The survey reported 25 states having budget deficits for fiscal year 2009. Specific estimates of the magnitude of the deficits were available for 21 states. These particular states report an aggregate gap of between $36 billion and $38 billion, representing roughly 8% to 9% of total general fund spending. Of the states in the Seventh Federal Reserve District reporting a gap, Illinois has a $1.8 billion deficit (6.6% of general fund); Iowa, $350 million (6%); and Wisconsin, $652 million (4.8%).
The center’s report notes that one of the more vexing fiscal problems is the current instability of property tax revenues related to the housing downturn and mortgage foreclosures. In the 2001 recession, states were able to push expenditures on to local governments because property tax revenues were relatively stable. In the current housing crisis, it is more likely that local governments will be asking state governments for help.
The report also finds that states are rapidly drawing down rainy day funds. These fund levels peaked at 11.5% of annual state spending in fiscal year 2006 and are estimated to decline to 6.7% of state spending by the end of this fiscal year. It is unlikely that this is sufficient to see the states through even a shallow recession.
A final national development is that at the February meeting of the National Governors Association, the governors requested that the federal government offer a fiscal stimulus package for the states aimed at financing infrastructure investments. It is unlikely that this will go anywhere. In the 2001 recession, the federal government offered a $20 billion aid package to the states. Half of the $20 billion was earmarked for a temporary increase in the share of federal support for Medicaid programs, with the remaining half set aside for general grants based on population.
A closer look at the impact of the housing downturn on state and local revenues
The fallout from the subprime loans and foreclosures has had a negative effect on state and local revenues. The United States Conference of Mayors (and the Council for the New American City) hired the consulting firm Global Insight to estimate the implications of the mortgage crisis. The firm estimates that U.S. gross domestic product (GDP) will be $166 billion lower than otherwise because of the crisis and that 524,000 fewer jobs will be created. The firm further estimates a $1.2 trillion decline in property values in 2008.
The report provides estimates of metropolitan growth rates and changes in tax revenues for selected metros and states. For example, the estimated real gross metropolitan product (GMP) growth rate for metro Chicago in 2008 will be 2.23%. This represents a 0.56% reduction, or $3.9 billion decrease, attributable to the mortgage crisis. Metro Detroit’s real GMP growth rate is estimated at 1.3%. A reduction of 0.97% is attributable to the housing slowdown representing a $3.2 billion decline in GMP.
As for changes in tax revenues, the following table provides the fiscal impact estimates for ten states.
Click to enlarge.
As the table illustrates the fallout goes beyond just property tax revenues. Sales taxes decline because of the reduction in big-ticket items, such as appliances and furniture, that occur during a housing slump. Transfer taxes—the taxes on the passing of a title to property from one person (or entity) to another—fall in response to the lower volume of transactions; in recent years, transfer taxes had become increasingly important to municipalities. All in all, such trends suggest significant challenges.
What is the fiscal state of the states? Not very good. And it appears that the housing slowdown will make conditions more challenging than was found during the 2000-01 downturn.
Posted by Testa at 2:09 PM | Comments (1)
January 25, 2008
OPEB … Oh No!
By Rick Mattoon
Beginning in the 2008 fiscal year, state and local governments with over $100 million in revenues will begin to report the accrued liability they face for funding non-pension post-employment benefits. In government parlance this is referred to as OPEB—other post-employment benefits—with the largest expense being comprised of retiree healthcare. Given that state and local governments have long provided healthcare benefits to both working and retired employees, why is the identification of this burden on the government’s books creating such consternation?
The answer to this question can be divided into three parts—government worker demographics, the size of the obligation and how government has traditionally paid for retiree healthcare, and the difficulty of restructuring employee benefits once granted.
• Government worker demographics. Following the national trend of an aging population, a large share of the workforce of many state and local governments is approaching retirement eligibility. For example, the Illinois Comptroller reports that in FY2006, 65% of public employees in the state were either in their 40s or 50s, up from 41% in 1986. As these workers retire, the pressure on healthcare expenditures is skyrocketing. A report by the Pew Center on the States reports that in California, retiree health costs will rise from $4 billion in 2006 to $10 billion in 2012 and $27 billion in 2019.
• The size of the OPEB liability and traditional method by which government has paid for OPEB costs. Prior to GASB 45, which requires governments to record their OPEB liabilities, most states simply met their retiree benefit costs on a pay as you go basis, where costs are paid out of current revenues. As such, few states actually put aside money to fund OPEB costs. While governments have saved to meet pension obligations, the Pew Center report estimates that 97% of the OPEB liability is currently unfunded. Estimates of the outstanding OPEB liability range from $370 billion (for a subset of governments that have reported their liability) to $1.5 trillion for the entire sector. The size of the unfunded balance differs considerably from state to state (see figure below).
Click to enlarge.
• Difficulty in restructuring retiree healthcare. In the private sector, a clear strategy for limiting a firm’s exposure to retiree healthcare costs has been to either eliminate or restructure healthcare benefits. A survey by the Kaiser Family Foundation reports that only one-third of large companies still offer retiree health insurance and that these companies have often reduced their premium contribution, leaving the retiree to shoulder a larger share of the tab. The state and local governments that have been the most active in addressing OPEB costs have taken on changes to health benefits, but this has led to several difficult bargaining sessions with public employee unions and frequent legal challenges.
Are there strategies for meeting OPEB obligations?
On March 12, the Chicago Fed and the Civic Federation will host a half-day conference on what governments are doing to meet their OPEB obligations.
Presentations will include officials from the Ohio Public Employees Retirement System (OPERS) and Oakland County, Michigan. Both of these governments have been seen as innovative leaders in identifying and developing a strategy to fund OPEB expenses. Ohio had accumulated over $11 billion in assets by FY2006 to meet OPEB obligations and has moved to restructure benefits as well by placing a cap on lifetime benefits and increasing co-payments and deductibles. While the state has an unfunded liability of $6.5 billion, it has shown fiscal discipline in consistently reducing its outstanding liability.
Oakland County has used a series of fiscal tools over the last 20 years to meet its OPEB liability. These have included:
--in 1985, creating a tiered vesting schedule for retirement;
--beginning in 1987, adopting a policy to fund the full actuarially required contribution (ARC) for retiree healthcare liabilities;
--in 1988, creating a self-insurance pool for active and retired employees;
--in 2000, creating a VEBA trust which allowed the County to create a tax-exempt investment plan; and
--closing the retiree health care plan and creating a defined contribution plan in 2006.
The March 12 Chicago Fed/Civic Federation program will also bring in a number of Illinois governments to discuss their evolving strategies for meeting OPEB costs. This will include representatives from the city of Aurora, the Metropolitan Water Reclamation District, and the Chicago Public Schools. Illinois governments face a particularly acute problem. The Civic Committee of the Chicago Commercial Club has estimated that the state’s unfunded OPEB liability is $48 billion. Given that the state also faces an unfunded pension liability of $40 billion, developing a strategy to meet this challenge will be exceedingly important. Discussions in Illinois have already examined such strategies as issuing OPEB bonds, creating irrevocable trust funds and selling assets to allow for one-shot infusions of capital to help meet OPEB obligations.
For many states, meeting the twin responsibilities of pension and OPEB funding will be dominant public finance issues for some time to come. Given the increasing pressures of funding elementary and secondary education, Medicaid, and deferred infrastructure costs, creating a strategy for managing labor related benefits costs will be critical to the health of the state and local sector.
Posted by Testa at 10:54 AM | Comments (0)
June 25, 2007
State-local Business Taxation
To most people, the subject of tax structure is a sleepy one. An important exception is when looming changes to the tax structure raise the prospects for who will pay for public services (and how much they will pay). In characterizing this debate, Senator Russell B. Long of Louisiana once said, “Don’t tax me, don’t tax thee, tax that fellow behind the tree!”
Public discussion also becomes animated when considering whether state and local tax structures (or changes to them) will hinder economic growth and development. That is to say, will tax hikes on business drive away jobs and income?
A recent symposium held at our Bank gathered experts together to consider emerging trends in business taxation. In recent years, there have been significant changes to business taxation in Midwest states, such as Ohio and Michigan. Ohio enacted a modest tax on business gross receipts in 2005, replacing a local tax on capital machinery and equipment. Michigan has phased out its largest business tax and is now considering how to replace the revenues that it formerly generated with its Single Business Tax.
The State of Illinois was considering a large “business” tax on business gross receipts to fund education and a subsidized health care initiative. To pay for it, Governor Rod Blagojevich advocated a large business tax on gross receipts because it would be paid by those who could afford it. Interestingly, the Lieutenant Governor Pat Quinn disagreed on the very same grounds.
Who was correct? As with many such matters, there is no certainty. But at the business taxation conference, I stated that I did not favor the Illinois gross receipts tax, at least on equity grounds. I argued that our most common principle of equity in taxation is a poor guidepost by which to design a state’s business tax structure. By equity, most people mean “ability to pay” such that taxation should progressively burden high-income households relative to low-income ones. The trouble with this approach is that businesses are not households. Businesses are organized groups of people ranging from line workers to mid-managers to active owner-entrepreneurs to silent capital-owning partners.
So who are we really taxing? We are not really sure. In particular, the taxation of business activity often results in changes to product prices that burden consumers rather than wealthy individuals. In the same vein, business taxation can sometimes result in lower wage offers to a firm’s workers. The ultimate result of such “tax shifting” may mean that a tax intended to “soak the rich” may have the opposite result. For example, it is easy to see (and universally accepted) that unduly high taxes on companies that sell gasoline in a state or city are largely shifted forward to consumers of gasoline in that state or city. Why would the companies pay inordinate taxes on the gasoline they sell in Chicago, for example? The answer is that they would not and they do not. This is in part because gasoline (energy) companies sell their products and services into many markets worldwide. Accordingly, when taxes on gasoline are pushed too high in any one locale, the price of gasoline rises until it becomes profitable for companies to sell it there. And since gasoline is presently a necessity for nearly everyone in the industrialized world, low-income households end up paying taxes on it that are a larger share of their household income as compared with the share of high-income households. The intent to achieve equity, in this instance, is foiled.
More generally, analysts have only a fuzzy and foggy notion across the breadth of business taxes as to which ones (and how much of them) are actually shifted to workers and to consumers. And so, to achieve equity, tools such as direct income redistribution or manipulation of the individual income tax are more reliable for this purpose. For this reason, I argue that it is preferable to design state and local business taxes around our notions of efficiency rather than on equity.
In looking at the efficiency of taxing businesses, it is important to recognize that business organizations do use costly government services, including police, fire protection, roadways, and legal protections. Having businesses pay for such services, then, is not only fair, it is efficient in several respects.
In paying state and local governments for their public services, businesses will be motivated to articulate their service needs to these governments, just as customers do with service providers in market situations. In turn, this will promote growth and development in states and localities. The resulting negotiation and conversation between governments and businesses will help identify those essential roads, bridges, and property protections that make businesses more productive. So too the process of haggling over the price and cost of government services to businesses will tend to keep governments cost efficient.
This give and take between business and government will only take place if a state's business taxes are structured as a user charge and not set unduly high in an effort to redistribute income.
The purposeful conversation on business taxes and business service levels will also spill over in positive ways to government service provision to households. In recognizing that “business” taxes are not really subsidizing household services, such as education and health care, households and their representatives will more carefully evaluate the costs and benefits of government services.
The structure of taxes can be a sleepy one. However, those who doze off during the debate may very well find themselves stuck with the tab.
Posted by Testa at 8:01 AM | Comments (0)
February 26, 2007
Medicaid: In need of reform in Midwest states?
By Guest Blogger Rick Mattoon
A Forum on Medicaid and State Budgets
The U.S. Medicaid program provides healthcare coverage and long-term assistance to over 41 million low-income families and 14 million elderly people and persons with disabilities, according to the Kaiser Foundation. Given the high and rising costs of medical care, it is not surprising that the Medicaid program typically represents the largest single budget item (roughly 20%) for most state governments, having surpassed K-12 education. As such, the rising expenditures of state Medicaid programs are often the biggest culprit in the imbalance in state budgets from year to year. The question is, given current trends, can states afford Medicaid in the future without structural changes in either the program or in funding?
Medicaid is now funded as a partnership between the federal government and the states. The federal government provides matching funds (FMAP) as determined by a formula with the matching rate varying from 50% to 77% on the dollar. Given this matching feature, states have long been motivated to take advantage of the federal match by expanding their programs. In response, the federal government has tightened up eligible services, leaving many states with sole funding responsibility for certain current program services. In turn, many states have enacted cost containment strategies.
These developments have slowed the growth of Medicaid expenditures of late, holding it to 2.8% in FY2006 from an annual average of roughly 7.7% from 1997 to 2005. States have also enjoyed some respite from Medicaid budgetary pressures with the shifting of many prescription drug expenses to the federal government under the new Medicare Part D program covering prescription drugs. Budgetary pressures also have been eased from the revenue side as widespread economic recovery in the U.S. has often yielded better than expected state revenue growth. However, the respite may prove to be short-lived; states are budgeting for Medicaid growth of 6% in FY2007. Unfavorable trends will continue to put pressure on Medicaid spending including a growing elderly population, rising general health costs and an increasing number of uninsured in the general population.
In addition to addressing funding pressures to sustain existing programs, many analysts believe that Medicaid programs should be refashioned. Recent studies to this effect have been issued by the Medicaid Commission’s report to the Secretary of Health and Human Services and a report from the Deloitte Center for Health Solutions. For example, the Medicaid Commission recommended changes in five critical policy areas. These are:
• Long-term care—including providing incentives for individuals to plan for their own long-term care needs and shifting long-term care toward at-home rather than institutional care.
• Benefit design—providing states with greater flexibility to custom design Medicaid coverage to meet the needs of their covered population. In addition, an incentive system should be considered to reward Medicaid recipients who make prudent purchasing, resource-utilization and life-style health related decisions.
• Eligibility—permitting states to consolidate eligibility categories and increasing federal support for new options for the uninsured to obtain private insurance rather than falling into the Medicaid program. So too, the federal matching program should be scaled to provide a larger match for adding low-income recipients (the intended population for Medicaid) and a smaller match for adding higher income populations.
• Health information technology—including broad support for expanding the use of information technology including having all Medicaid beneficiaries having an electronic record by 2012.
• Quality and care coordination—further expansion of coordinated care programs as well as measuring the effectiveness of treatment by providers.
The Deloitte study suggests that fundamental reform is needed, particularly in the area of actively managing Medicaid programs. The study suggests that policymakers should be guided by six key choices in reforming their Medicaid programs.
• Choice 1. What should be the core function of the state’s Medicaid program?
• Choice 2. Should the program services be directly managed by the state or should it be contracted out?
• Choice 3. Where should the state be on the continuum between “traditional” Medicaid benefits and coverage and free health care for all low-income residents?
• Choice 4. Will the state go beyond simple program administration and use the Medicaid program to actively control the costs and quality of healthcare throughout the state?
• Choice 5. Which cost savings and policy levers will the state use to reduce, or at a minimum contain, the costs of the state’s program?
• Choice 6. To what extent will Medicaid recipients share in the state’s burden of cost reduction?
Clearly when it comes to Medicaid, there is no shortage of potential reforms.
To help investigate these issues, on March 15, the Federal Reserve Bank of Chicago and the Civic Federation are cosponsoring a program to look at the current status and features of Medicaid and how states are dealing with this sizable program responsibility. The conference attendees will hear from Medicaid policy researchers including representatives from the Kaiser Foundation and the University of Illinois, as well as the directors of the Medicaid programs in Illinois, Iowa, and Indiana. A keynote address will be delivered by former Wisconsin Governor and U.S. Health and Human Services Secretary Tommy Thompson. To register for this program please go to http://www.civicfed.org/events/070315_RegistrationForm.pdf.
Posted by Testa at 9:03 AM | Comments (0)
July 19, 2006
Honda and tax incentives
Honda recently decided on a site in Indiana for its new North American auto assembly plant over sites in Ohio and Illinois. Indiana offered Honda generous incentives of EDGE tax credits, training assistance, and real and personal property tax abatements totaling up to $41.5 million. In addition, the state will provide infrastructure support for water, wastewater, and road improvements of approximately $44 million. This offer was generous relative to packages that have been offered lately by northern states to woo automotive plants. Did the incentives swing the deal for Indiana? And how can states hope to recoup these upfront costs and revenue losses? More importantly, is society well served by such raw-knuckled competition among states for production facilities? The answers are not definitive, but, though often condemned, the use of fiscal incentives may not be such a bad thing.
Large offers of this nature have become commonplace. Speaking at the Chicago Fed’s recent symposium on the automotive parts industry, Sean McAlinden of the Center for Automotive Research reported that the state of Georgia offered Korean carmaker KIA a package estimated to be worth $409 million. This was noticeably larger than the recent average offers of $57 million in tax incentives for automotive assembly plants for northern states and $44.2 million (plus free or subsidized infrastructure and job training) for southern states.
On completion of such deals, company representatives often proclaim that the incentives did not determine the choice of location, but were rather a sweetener or a comforting pledge of good faith. Professional site selection analysts tend to echo these sentiments. Taking such statements at face value, why do states offer such high stakes packages?
No doubt, there are benefits at the ballot box to those elected officials who can brag about bringing jobs and income to the state. It has been argued that these benefits, especially for investment projects that loom large in the media, result in overly generous offers and poor decision-making by state officials. This is one reason that some states enact legal requirements making the terms of such deals easily available to public scrutiny.
But how can states afford to make such offers? One reason is that the public service costs of hosting businesses are usually lower than the taxes paid by them; that is, there is typically a fiscal surplus inherent in state business tax systems that allows state officials to discount the public tax and service bills on new investment. When I examined the likely costs of public services provided to businesses in a 1996 study, I found that, across all U.S. regions, direct business taxes tended to exceed the value of direct service benefits provided to business by a ratio ranging from 1.5:1 to 2:1. This excess may allow room for governments to lower business tax bills through selective incentives.
Click to enlarge image.
Even so, opponents of the use of selective tax abatements may argue that incentives were unnecessary and that businesses have an information advantage in bargaining with states for incentives even when they will end up choosing the same location in any event. Certainly, the proclamations of businesses that afterwards contend that incentives were not a primary consideration in their location decision bear this out. If so, states are arguably better off refraining from incentives and instead spending the business tax bounty on public services or returning personal taxes to state residents.
In the case of auto plants, it is interesting to note that even if individual states “give away the store” in luring a particular auto assembly facility, the end result may ultimately benefit the state’s economy. The reason is that the assembly plants typically attract auto parts suppliers to the area. As Chicago Fed economist Thomas Klier has shown (below), a typical assembly plant can draw a significant nearby supplier base. For recently opened assembly plants in North America, an average of 19 to 20 direct suppliers have typically opened up within 60 miles of the plant. More generally, assembly plants tend to pull in many more supplier plants within several hundred miles, and supplier plant employment generally exceeds assembly plant employment by around 3.5:1.
It is true that in the case of the Honda assembly plant in Greensburg, IN, many of the supplier plants will be outside Indiana’s border and tax reach. However, if all or many adjacent states are successful in attracting assembly plants, the spillover benefits of taxation and income will accrue in roughly equal measure to the states. A so-called cluster of automotive production capability may be achieved for the multi-state region.
Source: Thomas Klier and James Rubenstein.
Click to enlarge image.
But are the incentives necessary to achieve or preserve the region’s cluster of automotive plants? At least for highly capital-intensive industrial activities such as manufacturing, the so-called business climate of the state is paramount. Placement of an expensive investment by a company in a state must be based on a strong conviction that future government leaders will not expropriate the facility’s value through regulation, over-taxation, or non-cooperation in future land use and public infrastructure needs. The situation is not unlike making investments in a foreign country. When the capital investment is fixed and not easily moved, confidence in local government is a key factor in assessing investment risk.
In this regard, Honda’s decision to locate in Indiana rather than Ohio is understandable. While proximity to its large suppliers in Ohio and vicinity was a compelling reason for considering Indiana, the desirability of diversification among government entities may have also been a factor. As for the incentive package, there is surely more to a favorable state business climate than a flashy offer of tax incentives. But at the same time, the offer of a fiscal incentive package may be a strong signal to the business that its presence will be valued. In addition, a sizable and highly visible tax incentive package may represent an implicit acknowledgment by the state that the investment is wanted, making it more difficult for future political leaders to renege on the state’s cooperative relationship with the company.
Of course, implicit tax incentive contracts of this sort work both ways. Companies that receive generous tax incentive packages, but later do not deliver on promised jobs and investments, are easy targets for retribution by state officials. In many instances today, “clawback” provisions are included upfront that eliminate favorable tax treatment if companies do not deliver.
Even so, the “gold standard” by which public policies must be judged is whether the state could possibly do better. Opponents of tax incentives for business argue that, because of such tax breaks, critical public services such as education remain underfunded. In particular, public education suffers, contributing to sub-par income growth and exacerbating social problems such as crime, poor electoral participation, and poor public health. If we accept this view, the economic returns to the practice of competitive business tax incentives are not optimal; the economic returns from any short-term job and income gains to the local economy are less than the foregone returns that greater education spending would bring locally and nationally.
In rebuttal, one might argue that business taxes are not the only possible source of revenue for highly valued public services such as education. An ideal of government is one in which citizens understand both the value of public services provided and the real costs of these benefits and, subsequently, make their choices known at the ballot box.
With the tendency among governments to over-tax business activity, the electorate may believe that they are getting a free ride for public services—that they are not in fact paying for these services. But they are usually mistaken. People and households end up (indirectly) paying for public services in any event. After all, business taxes are ultimately reflected in higher product prices paid by state residents or in lower wages and salaries paid to employees.
So why do many voters and even some policy analysts advocate the taxation of business activity to finance public services that primarily benefit households? Some argue that Americans like their taxes hidden and furthermore that this is a reasonable way for governments to finance high-payoff public services. But this approach has risks. If taxes and prices for public services are hidden, can the citizenry really make sensible decisions about what levels, types, and extent of services government should provide? What do you think?
Posted by Testa at 10:47 AM | Comments (0)