The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.

Abstract

The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.

VII. Fiscal Challenges Facing the U.S. State and Local Governments1

With balanced budget rules, the deficits of U.S. state and local governments (SLGs) have remained low in the aftermath of the Great Recession, but the resulting fiscal contraction has partially offset the positive effects of federal stimulus. While tax receipts are now recovering, SLGs will need to continue their fiscal adjustment due to the expiration of federal emergency aid. The main medium-term challenges include unfunded pension and other retirement benefits, and rising health care costs.

A07ufig01

Comparison of State and Local & Federal Government Finances (2010)

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A007

Sources: Bureau of Economic Analysis; Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States; Collins and Rettenmaier (2010); and Fund staff calculations.Notes: Deficit out turns are reported here on the NIPA basis, with financial liabilities reported on the Federal Reserve’s Flow of Funds basis. The chart does not include federal unfunded liabilities for Social Security, Medicare, and other programs.

1. SLGs have so far managed to cope with the fallout from the Great Recession, but at a considerable social cost. The recession hit tax collections very hard given the significant exposure to very weak housing and labor markets and consumer spending. Aggressive spending cuts, some revenue measures, and reserve drawdown have kept the operating budgets roughly balanced as required by law, with a significant federal emergency aid smoothing adjustment to lower revenues. However, the involuntary fiscal consolidation at the state and local level has imparted considerable social costs, with cuts in education, health, transport, and welfare systems, which together account for the majority of SLG outlays. The state and local governments account for almost 20 percent of GDP in terms of total expenditures (on a GFSM-2001 basis), about 12 percent of aggregate purchases (on the national accounts basis) and 15 percent of total civilian employment.

A07ufig02

CDS Spreads and Market Volatility

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A007

Sources: Markit and Haver Analytics.

2. Although the tax receipts are now recovering, state and local governments will need to continue fiscal adjustment, while addressing unfunded long-term commitments. Emergency federal aid will be phased out soon, and the renewed declines in house prices pose risks especially to local governments. Rainy-day funds which have been depleted in almost half of the states will need to be replenished to rebuild room for maneuver. The state and local governments will also need to continue addressing their unfunded entitlements, especially pensions, which remain the long-term risk for a number of states due to strong legal protections of the already-accrued pension benefits. The SLGs will also face structural spending pressures from health care, both through higher Medicaid outlays and health benefits for government retirees.

3. Following a spell of risk aversion in the state and local government bond markets late last year, the situation has calmed down significantly. Lower bond supply following the expiration of the Build-America-Bond program, improved tax collections, and adjustment measures adopted by the lowest-rated states (California, Illinois) helped improve the market sentiment. More generally, defaults are unlikely at the state level given low debt, balanced budget rules, and statutory protections for investors. The last state default occurred during the Great Depression in 1933. Defaults at the local level have remained rare, mostly associated with mismanagement or high-risk projects by quasi-government institutions.

A07ufig03

State & Local Government Receipts and Expenditures

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A007

Source: Bureau of Economic Analysis and Fund staff calculations.

A. Fiscal Adjustment in the Aftermath of Great Recession

4. The balanced budget rules impose fiscal discipline but lead to pro-cyclical policies. By statute, almost all state governments (except Vermont) are obliged to maintain balanced operating budgets. During the Great Recession, the available rainy-day reserves proved insufficient and the SLGs were forced to sharply cut back their spending, with the SLG gross debt remaining low around 20 percent of GDP. The involuntary fiscal consolidation has had modest macroeconomic—but more significant social—side effects.

A07ufig04

Contributions to Changes in Nonfarm Payroll Employment

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A007

Source: Bureau of Labor Statistics; Haver Analytics; and Fund staff calculations.Note: Temporary Census employment is not seasonally adjusted.
  • Spending cuts have affected all expenditures, including primary and secondary education, health, transport, and welfare systems. Demand for social services such as Medicaid (health insurance for the poor) has increased, further exacerbating budgetary pressures. Since fall 2008, the SLGs have eliminated over 500,000 jobs, with more aggressive layoffs prevented by furloughs. The cumulative reduction in state operating spending during FY2008-10 was about ½ pct of GDP with only a partial recovery during FY2011, according to the NASBO (National Association of State Budget Officers) data.

  • Impetus for revenue measures has been more limited. Together with greater compliance efforts, the states raised about ¼ pct of GDP in new revenue over the last two years with a significant proportion coming from just a handful of states including California, according to NASBO. Many states have aimed for “low-hanging fruits” such as higher fees, excises on alcohol, tobacco, and gambling, and temporary revenue measures. Notably, Illinois raised its personal income taxes in early 2011.

  • The federal government has helped to ease the SLG fiscal stress considerably. Emergency transfers for Medicaid and education spending amounted to ¼ pct of GDP in FY2009 and ½ pct of GDP in FY2010, covering over one-third of the total state shortfalls in those two years.2 According to a CBPP (Center on Budget and Policy Priorities) report, the non-Medicaid portion of federal funds directly supported roughly 300,000 SLG jobs last year.

  • The states have also tapped their rainy day reserves, while opting for other temporary measures. Excluding the oil-rich states of Alaska and Texas, the cash balances have dropped by ¼ pct of GDP to roughly 0.1 pct of GDP at present. The states with remaining reserves are not willing to tap these resources in light of the uncertain outlook and concerns about a rating downgrade. Meanwhile, the SLGs continued to underfund pension funds, increasing further their long-term contingent liabilities (see Section B).

5. Despite the recovering economy, the SLG budgets will remain under pressure for some time given the phase-out of federal aid.

  • Tax collections have started to recover, but will remain below the pre-crisis trend. Consumer deleveraging is expected to keep sales taxes structurally weak, while the sluggish labor market will mute PIT collections. In some cases, property taxes have not fully caught up to the decline in house prices (the tax base is usually calculated as the 3-year moving average of house values), while a number of states have caps on property tax rates. Many state legislatures resist further revenue measures.

  • Meanwhile, the federal aid will drop off at the end of FY2011. The administration has provided over ¼ pct of GDP of emergency aid in FY2011, but the aid is coming to an end. Federal fiscal consolidation could lead to future cuts in other federal transfers. At the local level, there is a risk of domino effect from fiscal consolidation at both federal and state levels, as the local governments receive more than 1/3 of revenue from transfers.

  • All told, the ex ante funding gaps of the state governments will remain sizeable during FY2012, bringing the prospect of additional spending cuts—an unwelcome drag on the ongoing recovery. On the national account basis, the staff estimates that the SLG consumption and investment will subtract around 0.1–0.2 pct from GDP growth during 2011. The SLG layoffs are currently proceeding at the annual rate of about 300,000 workers, with some analysts expecting a temporary acceleration of job cuts given the expiring federal aid.

B. Medium-Term Challenges

6. The longer-term challenges include unfunded pension liabilities and other retirement benefits, and rising health care costs. The unfunded pension liabilities are the main medium-term policy issue facing the SLGs given legal impediments to their resolution and concentration of the problem among certain states. Almost 90 percent of the full time SLG employees have a defined-benefit pension plan—in contrast with about ¼ of workers in the private sector.

  • The contingent pension liabilities amounted to around $660 bn in FY2009 according to the Pew Center estimates. With assets estimated at $2.3 trillion, the state pension plans were on average 78 percent funded in FY2009, with the preliminary FY2010 data pointing to another slight decline in the funding ratio. While lower asset values after the Great Recession have clearly hit the pension fund finances, underpayments to the system prior to the crisis were prevalent, with roughly ½ of the states paying less than the actuarially-sound contributions during the previous cyclical expansion (2003–06).

  • The actual unfunded liabilities could be even higher according to some analysts, with alternative estimates in the wide range of up to $3 trillion. The differences in estimates are often attributable to alternative assumptions about future returns, discount rate, and longevity. A recent study by Collins and Rettenmaier (2010) reports the SLG unfunded pension liabilities at $1.5 trillion using the Social Security Trustees parameters, while the Pew Center reports the underfunding at $1.8 trillion using parameters typical for corporate pensions.

  • The degree of underfunding varies greatly among the states and localities (Figure 13 in the Staff Report). On the positive side, the New York state has a 101 percent funding ratio, but Illinois, West Virginia, Kentucky, and New Hampshire have funding ratios of just above 50 percent. Overall, 31 states have a funding ratio below 80 percent, a threshold for pension funds to be considered sound. The states contributed about $73 billion to their pension plans in FY2009—well below the actuarially-sound contribution of nearly $115 billion. Some researchers have suggested that certain states and cities could run out of their pension trust funds already by the end of this decade (Rauh, 2010, and Novy-Marx and Rauh, 2011), facing the risk of a cliff adjustment.

  • State constitutions often protect pension benefits of the existing employees. Almost all parametric changes require statutory amendments, with exemptions for employee contributions in some states. Three states have attempted to cut their commitments by modifying the price-indexation formula—these decisions have been challenged in courts, but judges in Colorado and Minnesota have recently dismissed these lawsuits. In the meantime, many states have streamlined benefits for new employees, raised contribution rates, and introduced hybrid plans with greater risk sharing (NCLS, 2011). In principal localities could use the risky strategy of Chapter 9 restructuring (a municipal equivalent of Chapter 11 for corporations) to reduce their unfunded liabilities despite the high costs of losing access to capital markets. However, Chapter 9 is generally considered an unattractive option by municipalities given its high cost and unpredictable results—the city of Vallejo, CA has been the case in point.3

7. The SLGs also have unfunded retirement health care commitments.4 These liabilities have been estimated at over $600 bn by the Pew Center, but are easier to resolve than the pension liabilities in most states—for example through tighter eligibility or higher co-pays—due to less strict regulations. That said, most states have made minimal contributions to their dedicated trust funds, which means there is no potential upside from rising asset prices. Trust fund assets were valued at $31 billion in FY2009, with Alaska and Ohio making up for than ½ of the total. Nearly twenty states continue to finance the health care benefits for their retirees on a pay-as-you-go basis. Overall, the states contributed about $30 bn less than the actuarially-recommended amount in FY2009, according to the Pew Center.

8. Similarly as the federal government, the SLGs finances will need to accommodate rising health care costs. While the recent health care reform is expected to bend the cost curve, the residual cost growth will keep pushing up the cost of state and local Medicaid program as at the federal level.

C. Financial Market Developments

9. Although the state and local finances remain under pressure, investors are well-protected compared with other stakeholders—vendors, employees, residents—who are being affected more directly.

  • At the state level, defaults are unlikely. The balanced budget rules have kept the debt and servicing costs low. Most debt is for infrastructure projects, has a long maturity (20- and 30-year bonds are common), and is often backed by the taxing power of the state (general obligation bond) or a specified revenue stream (revenue bond). Debt repayments on general obligation bonds are often prioritized by state constitutions over other spending—notably, the two states with the lowest ratings put the debt service either on top of the priority list (Illinois), or second in line (California). As a result, even the most troubled states have retained high ratings, providing them with relatively cheap finance.5 After the last state technical default—an Arkansas highway bond during the Great Depression in 1933—investors were eventually repaid in full.

A07ufig05

Rating Distribution of U.S. States and U.S. nonfinancial Companies

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A007

Source: Moody’s and Fund staff estimates.
  • Defaults on municipal debt have been rare and the default rates are likely to remain low. The past defaults were typically associated with project mismanagement or inherently risky projects by quasi-government institutions in housing or health care. If in financial difficulties, cities and counties can in principle opt for a Chapter 9 restructuring but this does not automatically imply a default on their bonds.6 There were only 54 total municipal defaulters among Moody’s-rated municipal issuers during 1970–2009, mostly among below investment-grade securities.7

10. Limited exposure of financial institutions and foreign investors to the U.S. state and local debt limits financial spillovers. The bulk of the $2.9 trillion state and local credit market is owned by the retail sector—often high net worth individuals who benefit from the tax breaks on municipal securities, mutual funds, and insurance companies. The direct commercial bank and dealers’ exposure is about $300 bn, with another over $300 bn held by money market funds. The recently-expired taxable Build America Bonds program broadened the investor base, but overall foreign holdings of municipal bonds remain small ($75 bn).

11. Despite the inherent stability of the state and local debt market, investors perceive even AAA-rated SLG paper as riskier than the Treasuries. Notably, the SLGs have failed to fully benefit from safe haven flows amid the European debt crisis, with their spreads widening during bouts of risk aversion. In fall 2010, spreads have been pushed higher by uncertainty over the extension of tax breaks for the Build American Bond program, and concerns about the long-term unfunded liabilities. However, the situation has calmed down significantly as the bond supply dropped off, tax collections improved, and the least-rated states took measures to balance their budgets.

D. Conclusions

12. The SLG fiscal adjustment is likely to continue in the near term. The SLGs will put a modest drag on the ongoing recovery, with downside risks from renewed declines in house prices and a phase-out of federal aid.

13. The SLGs should consider improving their budgetary frameworks, including the rainy day strategy. Rainy day funds could be allowed to accumulate beyond the pre-recession levels to limit pro-cyclicality and consideration could be given to saving revenue overperformance from highly cyclical revenues such as capital gains taxes (as in the case of Massachusetts). Many states remain on a one-year budget cycle, with only about 20 states having reported their FY2013 projections to NASBO. A move toward multi-year frameworks would be welcome. Some states are pursuing deeper institutional changes—notably, in California.8

14. The SLGs need to focus on gradually reducing their unfunded liabilities. The SLGs face a difficult trade-off between spending on social services for their residents (such as education) and their commitments to the employees. The SLGs should start making actuarially-sound contributions to their pension systems, continue their push toward more risk sharing, streamline benefits when warranted, and avoid bets for resurrection through high-risk/high-expected return strategies. The states should also strive to base their projections on realistic assumptions. Any remaining states financing their retirement health care benefits pay-as-go should preferably start saving into dedicated trust funds.

References

  • Center on Budget and Policy Priorities (CBPP), 2010, “An Update on State Budget Cuts”, Washington, D.C.

  • Collins and Rettenmaier, 2010, “Unfunded Liabilities of State and Local Government Employee Retirement Benefit Plans”, National Center for Policy Analysis, Dallas, TX.

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  • Moody’s Investors Service, 2010, “Why U.S. States are Better Credit risks Thank Almost All U.S. Corporates?”.

  • National Association of State Budget Officers (NASBO), “The Fiscal Survey of States”, June 2011.

  • National Conference of State Legislatures (NCLS), 2011, “Pensions And Retirement Plan Enactments in 2011 State Legislatures”.

  • Novy-Marx, Robert and Joshua D. Rauh, 2011, “The Crisis in Local Government Pensions in the United States”, forthcoming in Growing Old: Paying for Retirement and Institutional Money Management after the Financial Crisis, Robert Litan and Richard Herring, eds., Brookings Institution, Washington D.C.

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  • Rauh, Joshua D., 2010, “Are State Public Pensions Sustainable?” Why the Federal Government Should Worry About State Pension Liabilities” National Tax Journal (Forum) 63(10).

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  • The Pew Center on the States, 2010 “The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform”, Washington, D.C.

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  • The Pew Center on the States, 2011, “The Widening Gap: The Great Recession’s Impact on State Pension and Retiree Health Care Costs”, Washington, D.C.

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1

This chapter was prepared by Martin Sommer with research assistance from Geoffrey Keim.

2

Additional federal funds have been provided for infrastructure spending which however cannot be used to balance the operating budget.

3

Weighed down by union contracts, Vallejo filed for a Chapter 9 bankruptcy in 2008. The city has renegotiated agreements with the key unions, but the process has been protracted and associated with significant legal costs and severe cuts to services. The municipality will likely continue the existing pension payouts, although the pension benefits have been cut for new employees.

4

There benefits accrue to SLG retirees before they become eligible for Medicare—a federal program.

5

The frequently-discussed case of California’s IOUs in 2009 was good news for bondholders to the extent the scheme helped conserve cash for debt service.

6

After the bankruptcy of Orange County, CA in 1994, the creditors were eventually paid off fully using revenue from bonds backed by car registration fees, sales taxes, and other collateral.

7

According to Moody’s, the average 5-year historical cumulative default rate for investment-grade municipal debt is 0.03 percent, compared to 0.97 percent for corporate issuers, while for speculative-grade debt the rates are 3.4 percent and 21.4 percent for municipals and corporate issuers, respectively. Historical recovery rates for defaulted US municipal bonds are higher, on average, than those for corporate bonds. The average historical 30-day post-default trading price for municipal bonds is $59.91 relative to a par of $100 for the period 1970–2009, much higher than the $37.50 average recovery for corporate senior unsecured bonds over the same period.

8

Voters approved a Proposition which allows passage of the state budget with a simple majority of votes, down from the previous 2/3. The 2/3 majority is still needed for tax and fee increases.

United States: Selected Issues
Author: International Monetary Fund