Pennsylvania's New Governor Faces Serious Fiscal Problems

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Tom Wolf will inherit a host of economic problems, sliding credit ratings and a thorny political situation when he takes office Tuesday as Pennsylvania's 47th governor.

Wolf, a Democrat from York and former state revenue director, promised a fresh start during his successful campaign last year to unseat Republican incumbent Tom Corbett. Wolf hammered away at school funding levels and the state's sputtering economy.

"Voters bought into the idea, but we are not so sure if this 'fresh start' will improve the commonwealth's credit quality," said Tom Kozlik, a director and municipal research analyst at Janney Capital Markets in Philadelphia. "The bad news is that the commonwealth has a steep hill to climb to revive its ratings."

Pennsylvania last year received downgrades from Moody's Investors Service, Fitch Ratings and Standard & Poor's, all of which cited the roughly $50 billion unfunded pension liability of the Keystone State's two major pension plans, the State Employees Retirement System and the Public School Employees Retirement System. Their aggregate funded rate is about 63%.

S&P and Fitch now rate Pennsylvania's general obligation bonds AA-minus. Moody's rates them Aa3. Fitch and Moody’s affirmed their ratings Friday.

"Pennsylvania credit quality is sure to weaken if left on its current course and then more downgrades will follow," said Kozlik.

Under the radar a bit but no less distressing is the pension liability at the local level.

On Wednesday, state Auditor General Eugene DePasquale said 562 of the commonwealth's 1,223 local pension plans are distressed and underfunded by at least $7.7 billion. Total underfunding of distressed plans went up by $1 billion in two years, according to DePasquale.

"The problem is not going away," said DePasquale, who invoked Detroit, where a federal judge cut retiree benefits under Chapter 9. "The deteriorating solvency of local governments throughout the country and the potential threat of bankruptcy are challenging long-held assumptions [of constitutional protection]."

Various proposals to overhaul Pennsylvania's state pension system gained no traction the last couple of years, including a Corbett plan that would have merged traditional defined-benefit plans with 401(k)-style plans for new employees.

Wolf has said he wants to see the last pension law, the so-called Act 120 in 2010, play out before tackling more serious overhaul, but Hummelstown, Pa., actuary Richard Dreyfuss said the collared payment rate provision of that law effectively lets the unfunded liability worsen.

"Then the credit-rating agencies are certain to notch down Pennsylvania more," he said.

Wolf must deal with an increasingly conservative Republican leadership within the state House and Senate, raising the specter of gridlock or watered-down compromises, according to Dreyfuss, an adjunct fellow at the Manhattan Institute for Policy Research. "The legislature is more conservative and the governor is more liberal. I don't know how they can find common ground just to do the budget," he said.

Wolf will inherit a $1.9 billion budget deficit for fiscal 2015-16, according to the Harrisburg-based Independent Fiscal Office, which said the gap could widen to $2.6 billion by 2019-20. Meanwhile, the state's rainy day fund is exhausted.

"In addition to underfunding its pensions, the state is relying on a substantial amount of one-time revenues to close the budgetary gap for fiscal 2015," S&P analyst John Sugden wrote in September, when the bond-rating agency lowered Pennsylvania.

Kozlik said Pennsylvania's tax base is not expanding quickly enough to keep pace with spending levels. Financial benefits from Marcellus Shale natural gas hydraulic fracking have been less than expected and according to Kozlik, a shale gas severance tax, which Wolf and many other Democrats favor, "is not a significant part of the solution, either."

The new governor also wants to change the state's income tax from flat-rate to progressive.

Dreyfuss said pension overhaul could again get lost in myriad other statewide issues, including school funding, health care and welfare.

"At the end of the day, pensions could come in fifth on the list of four," he said.

The Philadelphia, Chester Upland and York school districts are under state oversight, York having entered receivership late last month. There, receiver David Meckley has free rein from the state's education department to covert many schools to charters under an agreement with private operator Charter School USA of Fort Lauderdale, Fla.

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