Find Me the Money

In an era of uncertainty, states and localities are looking to some unusual options.
by | June 2004

The good news on economic recovery is slow to make its way to statehouses and city halls. For the most part, states and localities just cannot seem to catch their fiscal breath, and where their finances are headed is a matter of uncertainty.

A large part of the problem is that over the past decade, governments were not attentive in keeping their tax systems tuned up to the changing times. This has often resulted in pinched, fractured and phlegmatic systems that are subject to hyperventilating during bubbles and lapsing into a stupor when times are slow. Meanwhile, cash management--the short-term investment of everyday funds--is mired in low interest rates, leaving financial officers few options to capitalize on those sums of money. In addition, both state and local governments have been taking nasty blows to the balance sheets of their pension funds, and that has led the funds to either demand more cash or head toward aggressive--and therefore riskier--investment bets.


Most state and many local tax systems are dependent on how well the "median" wage-earning household--that is, the one in the middle of the pack--is doing. A key factor in the slow economic recovery nationally and the lack of resiliency in state tax systems has been the lack of growth in wages. The share of the national income going to wages and salaries is now at just over 50 percent, which is its lowest point in at least 50 years. While returns on investments and profits are growing as productivity increases, these do not have the same impact on state and local revenues as fatter pay envelopes do. Meanwhile, corporate income taxes have been in a prolonged swoon, and the sales tax, which had been a steady and relatively innocuous performer, no longer is. Nationally, sales tax rates have been creeping up to an eye-popping 8.5 percent, but the base to which the sales tax is applied has been getting narrower. Over the years, legislators have slashed that base by exempting an increasing array of items and almost all services.

The real estate property tax continues to be both the most cursed and productive of taxes. As of late, it has been the only tax to enjoy a boost in its base, and the results have been impressive. During the period of 2000 to 2003, the property tax alone accounted for almost 90 percent of the $55.8 billion increase in total state and local revenues.


Many states have been raising just about every fee, charge and special tax in sight. In fact, a jumble of other taxes, such as those on alcohol and tobacco and various other selective excise and license fees, has grown by $17 billion in the past three years, which is more than the general sales tax has grown. A major line of attack has been on increasing "sin" taxes--those taxes that are levied on activities presumed to be unhealthy, frivolous or otherwise contrary to public interest.

As alluring as sin taxes are, they have a major drawback: They cannot produce enough revenue to close the gaps. All told, sin taxes on alcohol and tobacco produce only about 2 percent of state government revenues and even a doubling of rates would not increase revenues by more than 4 percent of any state budget.

As to gas taxes, states are in a pickle. In the good old days, federal highway aid was generous and gas prices were low. The tables are turned now. The federal transportation bill reauthorizing the federal aid programs for highways and mass transit spending is stalled in Congress. War in the Middle East and production cutbacks by oil- producing countries have brought both current shortages and future uncertainties. Many states see their transportation funds lagging and their pennies-per-gallon revenue systems falling out of date. With oil prices spiking, the thought of raising gasoline taxes is politically unpalatable.

A few jurisdictions, the Commonwealth of Puerto Rico being one, have taken an innovative approach to handling the ups and downs in fuel prices. A part of the gasoline tax is designed to increase as the price of oil decreases and to decrease when the price goes up. This leveling out helps maintain steadier gasoline prices at the pump overall while boosting revenues fairly painlessly when world prices drop. Averaging $150 million to $200 million a year in revenues, the inverse oil tax helps build a lot of highways in Puerto Rico.


Despite the crunch in revenues, state and local governments still have a lot of cash to manage and typically have about a trillion dollars or so that is invested primarily for liquidity purposes. A favorite haunt has been U.S. government and agency securities, which offer large, liquid markets and safety, even if the yields are low. Episodes with more aggressive investing in the early 1990s that went awry (Orange County, California, comes to mind) definitely have lent a conservative tinge to investment practices. The state of California, for example, instituted stricter controls over short-term investment practices and even changed the name of the local government Debt Advisory Commission to Debt and Investment Advisory Commission to get the oversight idea across.

But as rambunctious as earlier periods were for some governments, for the past several years short-term investing by governments has been something of a yawner. The major problem is that interest rates are very, very low. With yields on U.S. government short-term securities at less than 1 percent and acceptable competing paper not yielding much more, the rewards for actively managing cash balances have been greatly reduced. In fact, since 2001, yields on short-term investments of less than one-year maturity have not even been high enough to offset the rate of inflation, even though that rate itself has been very low.

This situation is intentional, of course. Chairman Alan Greenspan and the Federal Reserve crew have been anxious to encourage spending to fire up the economy and to make the cost of borrowing as low as possible. But, like the pensioners who pine for higher returns on their fixed income investments, the hapless cash managers have seen their once sparkling returns on investment dimmed to near nothingness.

The temptation is always there to extend the maturity on investments in hopes of getting a little more yield. For example, 10-year U.S. treasuries are now yielding 3 percentage points more than one-year treasuries. But the risks are great, especially in times of super-low interest rates. If interest rates rise, as most are anticipating that they soon will, then the market prices of outstanding longer-term securities will take a serious dive. For example, take a 10-year U.S. government bond now yielding around 4 percent. Were interest rates to rise to 6 percent, it would be worth only 85 cents on the dollar, quickly wiping out any short-term advantage from the higher yield. So, most cash managers have chosen prudently to stay short (and keep their jobs). The risk just isn't worth it.


State and local pension systems, which were among the high-flyer investors of the late 1990s, took a real beating in the stock market downturn. As a result, state and local governments are having to scramble to rebuild the systems' balance sheets. At another time, this might have been accomplished by increasing contributions to the systems. Today, though, cash-strapped governments are reluctant to raise taxes for that purpose. More likely, they are entertaining thoughts of borrowing from the funds, either directly (which is both difficult and unseemly) or indirectly (which means skipping or reducing contributions).

With some 15 million members and beneficiaries, public pensions have a large and often attentive audience. Moreover, pension benefits are almost always guaranteed, which means that governments are on the hook to pay them, no matter how investments pan out. Pension systems face a difficult choice. Do they stick with aggressive investment policies (or even intensify them) in the hope of achieving higher earnings, or do they pull in their horns and achieve steadier performance? The latter choice has been made less attractive in the low interest rate environment, where bond yields are at an all-time low. Furthermore, the happy bounce in the stock markets in 2003 appeared to vindicate a policy of continuing to invest in stocks. But, overall market performance has been erratic, to say the least, and many pension funds have a lot of ground to make up in meeting funding requirements.

So public employee retirement funds are up to some new tricks. In an effort to improve returns on investments, some systems are forsaking the conventional securities markets and plunging into private equity markets. Variously dubbed "alternative" or "targeted" investments, these can range from direct ownership of companies that are in need of a turnaround to high-stakes real estate transactions or participation in hedge funds. Since pension liabilities are long term in nature, it is often argued that the funds can afford to take more risk.

Many funds are now testing that theorem out, big time. State pension systems in Louisiana, Michigan, Minnesota, Pennsylvania and Washington now have 12 percent or more of their assets in private equities. When the deals work out, double-digit returns can be earned. But that is because they entail lots of investment risk. Another risk is that the private deals can be secretive and entail highly paid consultants and advisers, an environment that often collides with public disclosure and conflict-of- interest laws and can open the door to political influence.

A contrarian view is being taken by some pensions. They are matching future liabilities with conservative fixed-income investments that assure the money will be around when future pensions are drawn down. The price of such prudence is that it requires more assets to meet future liabilities, since there is little margin for capital gains and the rate of return is known throughout the life of the investment. On the other hand, the money will be there and is not dependent on future fluctuations in prices. Maine, which is one of the few states to formally adopt the matching approach, has placed about one-third of its pension portfolio into matched investments such as long-term inflation-indexed bonds. The state is willing to forgo the big gains and the possibility of reduced contributions in the future in exchange for protection against the possibility of huge losses and a demand for higher contributions of a more volatile portfolio.