The effects of tax and expenditure limits on municipal pension and OPEB funding during the great recession.

Author:Maher, Craig S.
Position::Report
 
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  1. INTRODUCTION

    The Great Recession of 2008-09 drew national attention to the scale of pension and other post-employment benefit (largely retiree healthcare) underfunding (Joyce, 2013). It is estimated that in 2009 the 61 largest cities in the US had unfunded pension and retiree health benefits liabilities equal to $217 billion (The Pew Charitable Trusts, 2013). Pension costs have been cited throughout the recession period as one of the most challenging--second only to health care and higher than public safety and infrastructure costs--for city officials to manage (Hoene and Pagano, 2013). To mitigate losses most states and many local entities made modifications to their pension plans including changing benefits and/or rate structures, cuts in cost-of-living adjustments for current retirees, and/or pursuing the issuance of pension obligation bonds (Munnell, Aubry and Cararrelli, 2014). These efforts coupled with the financial market rebound has resulted in the recovery of most pension losses. The fact remains, however, that pension funding was not and has not been maintained at levels necessary to meet anticipated obligations (Martell, Kioko and Moldogaziev, 2013).

    The primary interest driving this study is the effects of institutional structures and constraints on pension and OPEB funding at the municipal level. Whether it is the attention received during the recession and/or the discussion of recent pension and other post-employment benefit (OPEB) fund reporting standards (GASB 43/45 and 67/68) (1) that spurred these works, several recent studies of pension and OPEB funding have helped our understanding of institutional influences on their funding levels. In addition, scholars have also begun to study locally administered pension plans which is important since 3,196 of the 3,418 state and local administered plans are managed by local governments (Martell et al., 2013). According to Martell, Kioko and Moldogaziev (2013), "The financial health of any government is inextricably linked to the funded status of all its defined benefit plans and other post-employment benefit (OPEB) programs" (29). This study complements and expands on existing research by focusing on cities (as opposed to states), using a cross-section of fiscal data that extends well beyond the largest US cities and incorporates institutional variables not yet thoroughly examined within the context of pension funding. The paper follows with a review of existing research on pension and OPEB funding, an explanation of our TELs measure, methodology, results and concluding remarks.

  2. LITERATURE REVIEW

    The theoretical framework in which this paper is couched is the intersection between institutional effects and professional governance theory applied to pension and OPEB funding during periods of fiscal stress. Fiscal stress literature has thoroughly examined the array of actions taken by governments during periods of economic downturns. One of the more frequently cited is Levine's article, "Organizational Decline and Cutback Management" (1978). Levine's works during that era (1978, 1980, Levine, Rubin and Wolohojian, 1981) postulates that the actions taken by governments to counteract fiscal stress are contingent on the degree of stress faced by the entity. More recent studies have found similar results (Nelson, 2012; Scorsone and Plerhoples, 2010; Maher and Deller, 2007). One of the more recent and detailed studies by Hendrick (2011) finds similar response strategies by local governments in the Chicago metropolitan area. According to Hendrick, at the least severe level of fiscal stress public entities are able to manage through short-term fixes such as drawing down fund balances and reducing capital expenditures (2011). In more severe cases, entities close facilities, lay off personnel, sell assets and increase visible taxes such as property taxes (2011). In between those extreme cases of fiscal stress, Hendrick suggests that common strategies include increasing employee costs for benefit and retirement, and reducing pension contributions (2011).

    The effects of fiscal stress on pension funding have been studied over the years and the findings are consistent with Hendrick's assertion: during periods of fiscal stress, public entities look to modifying pensions as a strategy for reducing short-term expenditures (Inman, 1982; Mitchell and Smith, 1994). Eaton and Nofsinger's (2004) cross-sectional study of state and local defined-benefit pension funding finds that entities with relatively worse fiscal position --measured as debt and interest costs as a percentage of revenue--tended to have poorer funded pensions and more optimistic accounting assumptions. Similarly, in their study of Public Choice Theory, Schneider and Damanpour (2002) argue that in response to public desire for fully funded pensions, plans that are affected by political pressure, such as through the composition of the entity overseeing the plan's management, will tend to be better funded. However, when the costs associated with fully funding pensions are high, i.e., when facing fiscal pressures (measured as debt levels), plan funding will decrease. Chaney, Copley and Stone (2002) offer similar findings, but add institutional constraints to the discussion of pension funding. In their state-level study, it was found that, ".... fiscally stressed states that are required to balance their budgets both underfund their pensions and select discount rates which obscure the underfunding" (287). The authors conclude that in the spirit of forcing fiscal discipline, balanced budget requirements may also have unintended consequences which, in this case, includes underfunded pensions (288).

    The effects of institutional constraints on fiscal outcomes is extensive and goes well beyond balanced budget requirements. One of the more commonly examined is tax and expenditure limitations (TELs). Studies have examined how governments have responded to the imposition or presence of a TEL (Joyce and Mullins, 1991; Mullins, 2004; Mullins and Joyce, 1996; Pagano and Johnston, 2000; Skidmore, 1999; Lowery, 1983; Shadbegian, 1999; Maher and Skidmore, 2008 and 2009; Kioko, 2010). Studies have also examined impact of TELs on outcomes, such as the quality of infrastructure (Deller, Amiel, Stallmann and Maher, 2013 a) and economic performance (Stallmann and Deller, 2010, 2011; Deller, Stallmann and Amiel, 2012; McGuire and Rueben, 2006).

    Within the context of long-term liabilities, there is another body of literature examining how TELs have influenced government debt levels (Kioko, 2010; Kiewiet and Szakaty, 1996; Bennett and Dilorenzo, 1982) and borrowing costs (Bayoumi, Goldstein and Woglom, 1995, Johnson and Kriz, 2005). Deller, Maher, Amiel and Stallmann (2013 b) find that more restrictive TELS on either expenditures or revenues are associated with higher levels of state debt. States with more restrictive TELs that cover both revenues and expenditures have lower levels of debt. There likely is interdependence between debt levels and credit ratings and our focus is on credit ratings themselves. It thus appears that TELs have unintended consequences that affect long-term liabilities and that the structure of the TELs can affect the direction of that relationship.

    Aside from the previously noted Chaney et al. (2002) piece, there is limited research on the direct relationship between institutional fiscal constraints and pension or OPEB funding. St. Clair (2013) was interested in the relationship between pension payments and state budget stabilization fund rules. According to St. Clair, "... both budget stabilization funds and pension contributions are part of a state's response to fiscal stress" (p. 56, 2013). He asserts that while there is extensive evidence in the broader field of public financial management that institutions matter, there is limited research in the area of pension funding. St. Clair (2013) finds that in states with strict budget stabilization fund deposit rules, states make contributions to pensions at higher rates and that strict withdrawal rules are associated with lower actuarially required contribution (ARC) payments. Note, however, that St. Clair doesn't account for the political dynamic affected by fiscal stress.

    The work by Martell, Kioko and Moldogaziev (2013) offers another perspective on our theoretical question. The authors seek to assess the effects of pension funding levels on fiscal outcomes, specifically state bond ratings. The authors assert that pension (and arguably OPEB) funding ratios are similar to general obligation (GO) debt and as such, should be associated with state credit ratings. In fact, the authors contend that pension liabilities are more concerning than GO debt because while both are funded primarily by general fund revenues, pension liabilities get much less scrutiny and have fewer restrictions (2013). The authors find evidence that poorly funded pensions can have a negative impact on state credit ratings (p. 45, 2013).

    The significance of Martell, Kioko and Moldogaziev's (2013) work from our perspective is the modeling, more specifically the inclusion of several measures of institutional constraints: voter approval for the issuance of general obligation debt, tax and expenditure limits and "procedural TELs" (36). The point for including these measures is to assess the effects of institutional constraints on state credit ratings. While their models found no evidence of an association between these institutional measures and state credit ratings, Stallmann, Deller, Amiel and Maher (2012) did find that revenue limits and combined revenue and expenditure limits were associated with lower state credit ratings, whereas state spending limits were positively associated with credit ratings (2012). The point is that if we agree with Martell, Kioko and Moldogaziev's statement that, "... pension obligations are akin to general obligation debt" (2013, 28) and studies of state debt levels...

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