Sunday, January 23rd, 2011

The Urgency of Reform

Never let a serious crisis go to waste. What I mean by that is it’s an opportunity to do things you couldn’t do before. – Rahm Emanuel

Rahm Emanuel took a lot of heat for that statement because some people didn’t like the policies the Obama administration tried to use the crisis to implement, but it’s absolutely dead on. We know there have been all sorts of things in our state and local governments that have needed to be addressed for years. But special interests and politics have kept us from doing a lot of them. Now that we’re facing fiscal Armageddon at the state and local level a lot of previously unthinkable things have gotten, well, a lot more thinkable.

This is the opportunity and imperative that are before us. The cities and states that step up and take this opportunity for reform are the ones that will put themselves at a competitive advantage for the long term. Those who simply try to muddle through may end up wandering in the wilderness longer than they think. It’s not just about jobs and balancing budgets in the here and now. It’s about setting the stage for the future.

That to me is the disappointing thing about the Illinois income tax increase. Rhetoric aside, even the business community there realizes that a tax increase had to be part of the equation for the righting the fiscal ship. The structural problems are so vast – a $15 billion structural deficit in the state’s budget and a $160 billion unfunded long term pension liability – that there’s no way to bring things back in balance through cuts alone. But the cuts and reforms have to be made anyway, and the state didn’t make them. In fairness, it did change pension rules for future hires, and did some minor tweaks to things like free rides for seniors, but this is no where close to what is needed. Now that the tax rate was increased as a first option, reform just got a lot more difficult.

It all starts with pensions. This is the root of the fiscal mess in many places. Defined benefit pensions are indefensible in an era of such long life spans, and when future medical technology means it is physically impossible to predict how long people might live. Also, the notion that you spend your entire career with one employer, even a government one, is an anachronism. Today, once you’ve got X number of years in, you are almost handcuffed to your government job for the duration even if you hate it because the value of that pension is so high. That’s why you always face a battalion of surly employees when you go to renew your driver’s license. Also, it creates a recruitment issue. Lots of people might want to spend some time in public service without making it a career, but it can be hard to do. In many places (though by no means everywhere), government pay is below market on a cash basis, with the balance made up (often more than made up) by generous pensions. So for someone who might want to spend say 3-7 years in government, that’s a huge disincentive. They would be paid below market and not get the pension. If they were paid market and had a 401(k) they could take with them, that’s a lot more attractive option. So this reform is critical to recruiting the skills we need in public service from the marketplace. Also, the scenario I described right now is why elected officials simply can’t be trusted to manage pensions for the long term. They are able to both pay less in cash now and make big promises to employees that someone else will have to deal with down the line. And even if pension reform gets implemented, it is way too easy to retroactively sweeten the pot down the road. Only a defined contribution plan enforces real truth in budgeting and real funding of the liabilities.

Alas, few places seem likely to really go this route. Even Indiana isn’t looking at it, despite their huge unfunded pension liability and a reform minded governor. It would likely mean a politically unpalatable raising of the bare bones public sector pay there. But the places that are able to do this will reap an enormous gain over the long term, both fiscally, and from a government talent management perspective.

Beyond that, there are a whole host of other areas where reform can be put through. Indiana Gov. Mitch Daniels, for example, unveiled an ambitious reform agenda in his state of the state address. Among these:

  • Local government restructuring/mergers. This includes completely eliminating over 1,000 township units of government. I don’t think merging general purpose governments saves money – arguably the opposite. But lots of states have tons of special purpose entities like Indiana townships. These are often cesspools of cronyism (in Indiana’s case rampant nepotism) and maladministration. There’s enormous opportunity here. For example, Brookings laid out a number of consolidation proposals in their report on restoring prosperity in Ohio.
  • Criminal Justice Reform. It’s no secret that we vastly over-incarcerate people in US. Indiana also has a criminal justice revamp on the table that would see many non-violent drug offenders sentenced to treatment instead of prison, among other reforms. This would incidentally save a billion too. In a world where no politicians ever lost votes by being “tough on crime”, it’s a amazing that the sheer cost of incarceration is forcing many states to reconsider their approach to sentencing.
  • Education Reform. Possibly nothing is more important to our long term competitiveness than education. Daniels proposals are of the conservative variety so many folks won’t agree with them. But increasingly education is no longer a Democrat/Republican issue and there are a variety of serious proposals from across the political spectrum looking to address the issue of education.

These initiative all face headwinds. In particular, townships may survive because the political class sees township organizations as their “farm team.” But at least Daniels is pushing hard. Even if you don’t agree with what he’s doing, he’s at least trying. And he’s not the only one. Jerry Brown is already making people mad with his proposals such as eliminating local redevelopment authorities in California. Andrew Cuomo in New York is starting to talk about new ways of doing business in Albany. Again, there’s no guarantee of success – Ed Rendell failed in his quest to lease the Pennsylvania Turnpike, for example – but at least these places are swinging the bat.

That’s the key. Every state and local government needs to be taking advantage of this (hopefully) once in a lifetime opportunity caused by the fiscal meltdown to pursue and implement reforms with a long term benefit. This includes of course creating fiscal sustainability, but also positioning them economically and from a service delivery standpoint. The places that pull it off will be among the ones to watch in the future.

20 Comments
Topics: Public Policy

20 Responses to “The Urgency of Reform”

  1. Alon Levy says:

    At the risk of channeling Krugman too much, I’ll say you’re confusing 2 separate issues, one short-term and one long-term. The short-term issue is that the deep recession has caused a huge deficit, which needs to be plugged. Ideally it should be plugged with deficit-funded federal support, to provide economic stimulus. Mayors and Governors should be requesting this, while at the same time preparing Doomsday plans for tax hikes and spending cuts in case federal support doesn’t materialize.

    The long-term pension liability issue is different. It’s irrelevant right now; it becomes more important in 20 years, and should be solved on that time frame, with budget fixes in times of growth, when there’s more breathing room and it wouldn’t cause an economic collapse. Fiscal austerity when the economy is growing is less sexy and doesn’t make you look like a Very Serious Person, but is correct economic policy, and is even one of the ten policy planks of the Washington Consensus.

    As an aside: 401k’s are a really bad way of investing savings. The stock market has high long-term returns, but is an unsafe investment, even over multiple decades. If you’d bought stocks in 1929, then you’d only have seen positive real rate of return in the 1980s, by which time you’d have been dead. The government should instead be encouraging people to put their savings in federally-insured savings accounts (and should insure more than $100,000 for long-term savings), or in federal bonds. The rate of return may be a little lower, but at least it’s certain you’ll actually get it when you’re in your 60s.

  2. Alon, every 401k I’ve been a part of has had the option of a bond fund and a money market fund. A 401k is simply a type of tax-deferred account, not a way to necessarily invest in the stock market.

  3. Also, I believe you underestimate the extent to which pensions are driving the fiscal problems. Virtually all of the municipal property tax collected by the city of Chicago already goes to pension contributions, for example. And this is what has torpedoed the credit ratings of states like Illinois and California. Investors aren’t crazy. Almost all sovereign debt issues originate in an excess of long term liabilities that the market figures out aren’t going to be repaid, triggering a crisis of confidence.

    Heck, the federal government paid $413 billion in interest on debt in FY10. That’s got to be bigger than (or close to) any deficit the government ran in its history up until the Bush II administration. Think about what our budget deficit would look like if we didn’t have that massive interest burden.

  4. Vin says:

    This is something of a political point, Illinois has taken quite a bit of heat nationally for the big tax increase, and justifiably so, to a certain extent (though I should note that their state income tax remains lower than many others). However, I think its really poisonous that, while Illinois gets skewered for raising taxes, people like Chris Christie and Rob Johnson get praised for taking that option off the table entirely. They’re making the “tough decisions.”

    This is a bunch of crap, frankly. In the US today, it’s raising taxes that is the tough decision. At some point we are going to have to do that, and the sooner we come to terms with it, the better off we’ll be. Being honest about taxes is possibly the single best thing we can do for our country’s fiscal future – even more important than reining in pension obligations, maybe.

    That’s not to say that we shouldn’t reform public sector pensions, or look for other ways to save money, like merging governments or criminal-justice reform, among other things. But while a 67% tax increase does seem extreme, I don’t see how it is any more extreme than flatly refusing to raise taxes. That those who do the former are pilloried while the latter are praised means that we are quite far, indeed, from thinking seriously about fiscal policy.

  5. Alon Levy says:

    Aaron, the problem with the 401k model is that by default, the investment is in stocks – often your employer’s. As soon as the employee needs to exercise investment judgment to move the money elsewhere, pensions are no longer guaranteed. If everyone invested smartly, bubbles would not exist. Better would be for the government to let people defer taxes on money they put in a long-term savings account – and to make sure such accounts are federally insured.

    Unfunded pensions existed in 2007, too, at which time mayors and governors raised spending or cut taxes because of all the surplus money they got. The reason they’re not an urgent issue is that they don’t have to be fixed right now. They’ll have to be paid out over the years in the future, but they don’t add to the debt interest burden today. Kicking them down to when austerity is wise is simply avoiding pain for pain’s sake.

    The interest the US paying on its debt is surprisingly low – about 3% of GDP. It’ll get higher once the economy starts growing again, but then growth will erode the debt, unless Obama splurges like Reagan and Bush Jr. did.

  6. Robert Munson says:

    Another thought-provoking post. Thanks.

    You’ve made me think about a structure to discuss this Crisis. It will be on the front-burner for a decade or longer. This structure quickly needs to produce an alternative to the Christie/Tea Party reaction.

    Think of this alternative as a New Deal for reforming local government so it is sustainable in the 21st Century.

    So my take-away on you quoting Rahm, this fiscal Crisis is our best opportunity to remake local government.

    The core problem is local taxes and services are backwards for the emerging sustainable economy. With that summary analysis, we can remake local government so it, too, is sustainable.

    Of course, we never seem to get to the core problem unless we attack it in stages. Here they are.

    The short-term Crisis manifests itself as state and local governments being broke because of the recession.

    But because of the economy’s long recovery, the immediate Crisis can only be resolved if the mid-term problem is attacked. That mid-term Crisis is the pension liabilities local and state governments cannot pay.

    These solutions quickly will spill over into the long-term reform which is that 20th Century land use laws created a sprawl that we can no longer afford to maintain since they create such high costs for services.

    Now, the Reaction clearly is winning during today’s fiscal Crisis.

    The alternative we need to propose to taxpayers is to attack the mid-term and long-term problems.

    So before taxpayers bail out their governments, we need to shape the reforms within the context of their New Deal. For example, Illinois’ income tax increase is only half the bail-out. The other half needs to be government efficiencies, some of which you list… but pension reforms are a clear favorite.

    Your post gives us a start. Thanks. But let’s make sure the discussion spills into attacking the costs of sprawl.

  7. cbd says:

    Illinois has a second pension problem: many pensions are not taxable income.

  8. Mike Swanson says:

    I have far more often felt under-served than overtaxed at the state and local level–national too, but that’s another story. The problem is that we don’t as citizens see a clear connection between our payments and our rewards. Would I pay more for well-maintained sidewalks? Yup, I wood. Would I pay more to de-consolidate schools, build smaller, more efficient, and more user-friendly ones, simultaneously decommissioning the fleet of yellow road hogs which are leaving us the most obese generation of kids ever. Yup, I’d pay more for that, too. I’d pay a higher rate on unoccupied land within urban areas. A generous but not too generous ratio of footprint of house to size of yard, above which in goes a luxury tax. That would be a good tool against sprawl. I wouldn’t take a whip to workers and their pensions. Maybe I’m fortunate: I don’t find the people at my city hall particularly crabby–except when I encounter them after they’ve had an encounter with someone who would make ANYONE crabby. So how about this for a proposal?

    Before anything else, post a sign on every municipal structure of any kind. This building cost $x to build in ______ In today’s dollars that would be $Y. The maintenance of this building cost $Z last year. Delaying maintenance would have added XX% to the cost of repairs ultimately. Replacing this building with its equivalent would cost $YY. Making clear connections between what citizens get and the tax bills they pay would make whatever discontents remain far more rational, and decisions made far more democratic.

  9. It’s ironic that you quote Emanuel, given the inconvenient news Rahmbo got today

  10. Robert Munson says:

    I like Mike’s point about Americans feeling more under-served than over-taxed. And as the axe falls on more programs that have organized constituencies, more and more Americans will feel the same way.

    While the Republican leadership may seem mean-spirited, I don’t think mainstream Americans are. Like the great consumers they are, Americans just want value for their tax dollars.

    Mike’s comment makes me think further about how we need to repackage services by selling the benefits. Too infrequently are Americans told of the benefits and how their tax dollars are invested well.

    In part, this is the monopoly nature of government services. Why sell the benefits when there is so little choice? No where is this more obvious than with transit monopolies.

    Hence, the Sustainable Deal for taxes and services needs to include alternative service delivery. This is a major part of the push for Public-Private Partnerships.

  11. I think the key issue that’s missed here is that there’s no perceived link – and frankly too often no real link – between taxes paid and services received. Taxes have gone up but service quality has gone down and everyone has read about the boondoggles. The success of referendums on bond issues for specific, named capital projects such as stadiums, light rail lines, or schools show that the public is often willing to pay more, if they know what they are really going to get for their money.

  12. Robert Munson says:

    Correct about bonds being easier to connect tax dollars and benefits in voters’ minds.

    Thanks. I couldn’t have said it better myself!

  13. Curt says:

    Great post Aaron!

    Something that scares me about reform is the broad sweeping stroke that delivers reform. As an advocate of the urban form, you have to agree that there are reforms that when enacted, would deal a stifling blow to some economic development tools that cities use. Most specifically, the Federal bill to reduce spending targets a lot of programs that are urban in nature. Transit. Community development, etc. Things of that nature that we living in cities look to as a tool for improving the quality of life.

    I hope that the conservative nature of our governing bodies consider this when swinging the sword. I fear we will lose a lot, but hope we can sustain.

    Again, good post.

  14. Chris Barnett says:

    Alon, there also exist retirement vehicles called IRAs in the US. Those are tax-deferred like 401k’s and can be invested in almost anything, including insured CD’s. There are also tax-deferred whole-life and annuity contracts. Your contention that ending defined-benefit pensions would put retirees at the mercy of the stock market is a dangerously false assertion.

    Defined-benefit pensions should not be offered to anyone in public/government service (other than the US Armed Forces, police, and firefighters, who risk their lives on our behalf). Defined-benefit pensions, as Aaron correctly points out, will bankrupt the public purse. (NYC Deputy Mayor Goldsmith knew this when he began privatization in Indianapolis in the 90’s. Sure, he sold it as cost-reduction, but the real benefit was getting city employees and their pension liability off the taxpayers’ backs.)

    This extends to “Social Security”. It should be phased out in favor of mandatory personal pension accounts. However, I’m not a crazy libertarian: the government should simply be honest about making transfer payments to the truly needy who are elderly, sick, or disabled instead of lumping them into the public pension system.

  15. J.P. Katigbak says:

    Is it really wise to have a proper public debate about the merits of a reform package within the U.S., including the idea of replacing the current social security system with a mandatory personal security account?

    You know, there is no sign of balanced discussions about the pros and cons of especially replacing the current setup of social security with the one based on personal accounts that must come into fruition in the U.S. as of now. Too bad that both sides of the public debate are not honest enough to know the truth behind the excessively political and cultural blame-games over such issues related to social reforms.

    Therefore, both sides of the political spectrum have to be honest about the need for better social reforms in the U.S. Otherwise, the situation is currently getting worse in the latter part of the days, or even months.

    And finally, please respect U.S. families who must be grateful to have love anyone else who needs much more than you thought. However, don’t glorify them too much please, I tell you: there is no time to talk too long.

    Besides, action speaks lounder than words in tackling the real aspects of either reforming or even replacing the current American social security structure, and other areas of reform, including local reform measures.

    Time to get going please, thank you very much.

  16. Ben says:

    I usually enjoy your posts Aaron but I thought this one wasn’t as well thought out and researched as it could have been. Let’s discuss:

    You said “Defined benefit pensions are indefensible in an era of such long life spans, and when future medical technology means it is physically impossible to predict how long people might live. ”

    By that measure, we should also get rid of social security in its current form. Remember, public employees are PROHIBITED from paying into social security, so why should they have to ride the uncertainty of market investments or bonds? Remember how everybody thought General Motors bonds were as safe as you could get? Now if you want to talk about raising retirement age for public employees, that’s a good discussion to have.

    “Today, once you’ve got X number of years in, you are almost handcuffed to your government job for the duration even if you hate it because the value of that pension is so high. ”

    In Ohio, public employees can now choose a defined contribution 403b (or maybe some other number) plan, a defined benefit plan, or a combination of the two. If this isn’t present elsewhere, it really should be.

    “In many places (though by no means everywhere), government pay is below market on a cash basis, with the balance made up (often more than made up) by generous pensions. So for someone who might want to spend say 3-7 years in government, that’s a huge disincentive. They would be paid below market and not get the pension. If they were paid market and had a 401(k) they could take with them, that’s a lot more attractive option. So this reform is critical to recruiting the skills we need in public service from the marketplace.”

    This I mostly agree with. Many local governments in Ohio pay the both the employer and employee share of pension contributions while base salaries are WAY below market rates. I often hear pundits complain about “gold plated compensation” for civic servants. While I disagree that their total compensation package is exceptionally generous, its easy to cherry pick details like the aforementioned free pension to give the public the (mostly erroneous) impression that public employees are overpaid.

  17. J.P. Katigbak says:

    It is too easy to propose a different sort of retirement-age hike for civil servants in the U.S., if you like. But I personally have no favors from those who don’t want the current U.S. social security structure to be continued.

    I suspect they just have that system abolished outright and then give way to a sort of personal account that is said to have benefits from a new kind of system devoid of any pension whatsoever. This is what I call “the end of the U.S.’s social security system”. So much for the so-called free market – one without a proper public debate, that is.

    Also, as to whether the American people would like to have someone imposed a salary hike or not, that is a different story to tell. All they have to is to do research on the implications of what Mr. Ben (I personally do not know the last name, though) said about the government employee pension scheme in the form of, say, a defined contribution (depending on some amount in billions in U.S. Dollars(what?!)), a defined benefit plan, or even both.

    Now go ahead, tell some people about hiking up the retirement age for U.S. civil servants before they stopped becuase your life is short in justifiying the salary hikes for them to work hard in government service and prove that the “free market” will win the day, whatever the undesirable consequences may be!

    It is time have you emotionally challenged to prove that reforming social policies in the U.S. is not a panacea to various issues such as inequality, unemployment, miserabilism, growth skepticism, etc.

    Finally, only an honest assessment on the effects of victimhood would do more to act on the current situation there in the U.S. where examples of this phenomenon would occur on a daily basis.

    It is time for you to know about any real social issue that must be tackled with respect, integrity, forsight and, above all, trust. Time to act now – before the current situation happens in reality, NOT OVERNIGHT, heaven forbid!

  18. J.P. Katigbak says:

    Correction: It must be reminded that hiking up the retirement age for U.S. civil servants would do more to stay working in government service because life is short in justifying the salary hikes for them. Only an honest assessment would do more in reflecting the real implications of victimhood on U.S. contemporary society today.

    Remember: prepare to be warned! Face the consequences! Otherwise, you may not see the true meaning of enhancing and producing real wealth that help move contemporary society slowly but surely in the right direction not just in the U.S. but also elsewhere around the world. There should be no fake (or paper) wealth, I say.

    Time to get going and face the reality, guys!

  19. Alon Levy says:

    @Chris: in the past, attempts at privatizing social security have ended in disaster. Singapore, which has exactly the mandatory pension accounts you propose, has 70-year-olds scrubbing tables. This despite very large mandatory savings (30% of income, down from 36% until a few years ago) and high yields (the money is invested by a sovereign wealth fund). By all means let’s have welfare that guarantees everyone a minimum standard of living, but none of the current plans to phase out social security actually provide that.

    A country with a stable or growing population should be able to pay its seniors’ retirement. The countries that have the biggest impending crises are those with extremely low birth rates, like Japan and Poland. Countries with near-replacement birth rates, like the US and the Scandinavian countries, have no such crises, or in the US case could avoid any future crises with mild tax increases.

    There’s nothing wrong with defined-contribution pension programs. But such programs should work like defined-benefit except that the contract says, “You’ll get a contribution of $X,” which is maximally simple. People shouldn’t need to know anything about where to invest their money to be guaranteed a good pension. Workers who think they know better should be able to choose higher salaries in exchange for no pension benefits – either through personal choice or through different standards in industries where people are expected to know how to invest.

  20. Chris Barnett says:

    Ben, municipalities may opt into or out of Social Security: http://www.ssa.gov/slge/overview.htm. Some local employees do in fact pay into that system.

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