Pennsylvania Gov. Tom Wolf's proposed $30 billion budget brings new ideas to the table but faces stiff political headwinds, capital markets observers said.
Wolf, a Democrat who unseated Republican Tom Corbett last November, submitted to lawmakers two weeks ago a spending plan like no other.
In addition to Wolf's controversial call for $3 billion in pension obligation bonds, he called for sweeping changes in state taxes and more spending on education while closing a $2.3 billion deficit for fiscal 2016.
Wolf has proposed increases in the state sales tax to backstop nearly $4 billion in property tax relief for local school districts. Wolf also wants a 5% Marcellus Shale tax on natural gas drilling companies. He also proposed property tax reductions.
"This budget reflects a fundamentally different approach to state government and puts back on the table a number of legislative ideas," said William Rhodes, public finance chairman at Philadelphia law firm Ballard Spahr LLP.
The bond rating agencies are scrutinizing all aspects of Pennsylvania's finances. Moody's Investors Service, Standard & Poor's and Fitch Ratings downgraded the commonwealth last year, citing the pension liability and budget imbalance. Moody's rates the general obligation bonds Aa3, while S&P and Fitch both assign AA-minus ratings.
Wolf said his budget closes a $2.3 billion deficit.
"We've seen a lot of this before, but not all in one state budget," said Rhodes, who also leads Ballard Spahr's municipal recovery initiative. "It will take an incredibly complex political dynamic to see this through."
Wolf must wrestle in Harrisburg with a Republican majority in both branches of the legislature.
"Not a weak majority, but a strong majority," said Rhodes. "Can he strike a grand bargain? I don't know."
Despite Wolf's election, Republicans widened their lead in the Senate and House to 30-20 and 119-84, respectively. The Senate GOP then drew a harder conservative line, replacing the moderate Dominic Pileggi of Chester with Jake Corman of Bellefonte as majority leader. Mike Turzai of Marshall Township remained House speaker.
"Finding agreement by June 30 will prove to be a challenge," said Richard Dreyfuss, a Hummelstown, Pa., actuary and adjunct fellow with the Manhattan Institute for Policy Research, referring to the fiscal deadline.
"The proposed budget is complicated and not easily reconciled to past budgets," said Dreyfuss, a former Hershey Foods executive who oversaw the company's compensation packages. Dreyfuss cited the transfer of the state's contribution to its two major pension funds, the State Employees' Retirement System and the Public School Employees' Retirement System from the general account to a separate account.
The two pension funds' aggregate funding rate is about 63%, with the state facing about $50 billion in unfunded liabilities.
Wolf's budget would reverse $1 billion in cuts to public education that occurred under Corbett.
"I think school funding will improve. Everything from pre-kindergarten to local colleges should be strengthened," said Rhodes.
Better funding for education and the Marcellus Shale tax were the lynchpins of Wolf's campaign.
Dreyfuss said the status of state-owned liquor stores and an inability to effectively reduce the unfunded pension liability will further complicate the budget process. "In summary, is appears to be a complex budget which attempts to increase state government and increase debt while targeting income redistribution."
The House has voted to dismantle and sell the system of state-run liquor stores. The legislation now sits with a Senate committee. Even if it passes, it may not have enough votes to override a Wolf veto. The governor said revenue from an expanded state liquor store system could help pay for the $3 billion in pension bonds.
"There is not one good or service that is safe from being taxed," said David Fiorenza, a Villanova School of Business professor and former chief financial officer of Radnor Township, Pa. "States and municipalities have been too quick in the past to increase taxes to fund services instead of other methods such as performance management and budgeting for outcomes."
Wolf's call to reduce Wall Street management fees might be an easier sell. His plan would slash investment costs for SERS and PSERS by shifting more assets into low-cost index funds, also called passive funds.
According to state Auditor General Eugene DePasquale, such a move could help localities. While the commonwealth's pension liability woes have eclipsed those of its municipalities, that dynamic could change, say, if Scranton goes bankrupt or the fortunes of a headline city such as Philadelphia worsen.
DePasquale last week warned that Scranton, the 77,000-population seat of Lackawanna County, could file Chapter 9 in two to four years without pension relief. DePasquale favors consolidating local government pension plans into a statewide system plan segregated by different classes of employees, such as police officers, firefighters, and non-uniformed employees.
"Absent plan consolidation, all plans should consider using a low cost, conservative method of investing based on index investing," said DePasquale. "Such a practice would eliminate wild fluctuations or poor investment returns. Investment companies such as Vanguard Group [and] Fidelity all provide index investing at an extremely low cost to the pension plan."
Wolf modeled his pension fee-reduction proposal after Montgomery County, which includes Philadelphia's northwest suburbs. Cutting banker fees there was part of an overall plan to erase an operating deficit, reduce debt and replenish its reserve fund.
Montgomery ended 2014 with a $1.15 million surplus, its second straight year in the black after five years of operating deficits, chief financial officer Uri Monson said two weeks ago.
"Uri and I were of the general belief that too many money managers were sucking too much out of our finances. We weren't getting the bang for our buck," said Josh Shapiro, chairman of the three-member Montgomery County Board of Commissioners, an executive committee member of Wolf's transition team and a former state representative.
After a bidding process for a vendor, the county invested 90% of its roughly $500 million portfolio in Malvern, Pa.-based Vanguard. County officials say fees have dropped by more than two-thirds, saving Montgomery more than $1.3 million annually.
Not surprisingly, Shapiro encountered headwinds from the bigger firms. "Look, anytime you change the status quo, someone's going to lose," he said. "The firms that were left out were pretty angry. They said we'd come crawling back to them."
Shapiro said the diversified index fund portfolio Montgomery chose had annual average returns of 10.11% over 30 years, well above the assumption target of 7.5%. "Our system of investing last year beat SERS," said Shapiro, who urged SERS and PSERS to adopt Montgomery's model.
