For previous editions of The Week in Public Finance, click here.
What the Stock Market Dive Means for Governments
This week saw big stock market losses, raising questions about how downward prices will impact state capital gains revenue (the profits that investors make when they sell assets).
Historically, California has been the most vulnerable to such swings. In the 2008 recession, the state's total revenue took a nosedive, dropping 20 percent in a single year, largely because its capital gains tax collections were cut in half.
California is home to a higher-than-average number of wealthy people, which means it collects a lot of capital gains taxes in good years and not so much in bad years. New York and Massachusetts also share this trait, but California sunk so much more in 2008 because its capital gains income is calculated through the state’s progressively-structured personal income tax, rather than as a separate flat tax. This makes California’s income tax extremely volatile -- not a great scenario when the state relies on income tax for about half its total revenue. Other states separate out their capital gains taxes, resulting in more predictable income tax collections.
But the Golden State has made some key changes since 2008 that aim to buffer its revenue collections from the capital gains volatility. In 2014, voters approved several savings measures, including a reserve fund that would be partially funded by excess capital gains revenue. In years when the state sees a surge in such revenue, it deposits much of that extra money in its reserve fund, so it's not relying on that boost in the following year’s budget planning. In years when its income tax collection is down significantly, the fund may become a one-time option to fill that hole.
Public pensions, however, have no such buffer from investment earnings. Many plans reported dismal earnings at the end of their 2015 fiscal year on July 31. With the stock market slide in August and the current one this month, it’s a good bet that pension liabilities will increase in many places by the close of fiscal 2016. August’s slide alone caused unfunded liabilities to increase by $268 billion, according to data from the Federal Reserve Board.
Pension funds generally smooth in such fluctuations in their funding plans so as not to cause big spikes in what governments owe them from year to year. Still, this week the Rockefeller Institute of Government calculated that if the July-September shortfall were spread over 30 years, it would be roughly equivalent in size to a 3.9 percent surcharge on state and local income taxes for 30 years, or a 15 percent cut in highway capital outlays for the same period. That's no small change in an era of tight budgets and slow growth.
More Strain in New Jersey
New Jersey Gov. Chris Christie would probably rather forget about this week. He surprisingly vetoed a rescue package for Atlantic City, teeing up accusations from city leaders that he’s pushing the former gambling mecca into bankruptcy.
Now, Atlantic City is left with a $33.5 million budget gap, and it’s projected to run out of cash in April. Meanwhile some lawmakers are pushing for a state takeover of its finances.
Christie, who is spending much of his time campaigning in Iowa and New Hampshire for the Republican presidential nomination, gave no reason for dumping the rescue bills. His move came after he conditionally vetoed an aid package in November but suggested changes. This week’s package included his alterations, but he pocket vetoed it, meaning he took no action on it before the signing deadline.
Christie has other problems at the state level, where increasing pension liabilities continue to plague his administration. This week, Moody’s Investors Service released an analysis warning that an unfavorable ruling by the state Supreme Court on the pension changes enacted in 2011 could hurt New Jersey's already vulnerable credit rating.
At issue is the freeze on cost-of-living adjustments, which decreased the state’s liability by 22 percent. If the court reverses the freeze, Moody’s estimates it would increase the state’s unfunded pension liability 33 percent -- from $40 billion to $53 billion.
New Jersey hasn't been able to pay its full required contributions to pensions for years. So any increase in liability would stress the state’s budget further and likely lead to the pension fund paying out more money to retirees than it’s receiving from the state and its investment earnings, said Moody’s.
Why is it so troublesome when government debt gets downgraded? Illinois recently provided a few examples.
Governments with lower credit ratings tend to pay a higher interest rate back to investors when they sell their bonds in the municipal market. Illinois’ Jan. 14 sale of $480 million in general obligation bonds cost the state $53 million more than would have been the case if the state were in better fiscal shape, according to an analysis by the University of Illinois Institute of Government and Public Affairs.
At BBB+, Illinois has the lowest state credit rating in the country and is just three rating steps above junk status. Its most recent downgrade was in October for failing to pass a budget (which it still hasn’t done) and for its increasing pension liabilities. This so-called “financial condition penalty” could more than double in future years, eventually topping $400 million per year, according to the study.
“Even in the context of the overall state budget, this $424 million is a significant annual amount of money, especially given the dire fiscal straits the state finds itself in today,” writes Martin J. Luby, a visiting senior fellow at the institute. “For example, this $424 million would provide a substantial amount of the extra funding that the Chicago Public Schools is requesting from the state to address its budget deficit.”
The same week that Illinois sold its bonds, Chicago -- which Moody’s rates at junk status -- sold $500 million in bonds and paid a hefty penalty because of its own budget and pension woes. The city is paying an average interest rate of 4.5 percent on the bonds, roughly twice what a top-rated, AAA government entity would have to pay.