Task Force: States Face Six Key Fiscal Threats

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WASHINGTON — States face six primary fiscal threats that include underfunded pension plans, ballooning Medicaid spending, and narrow, eroding tax bases with volatile tax revenues, the State Budget Crisis Task Force said in a report Tuesday.

The other major dangers cited by the report are federal deficit reduction, fiscal stress on local governments, and state budget laws and practices that hinder stability.

“Our goal was not to say that the apocalypse is around the corner,” said former New York Lieut. Gov. Richard Ravitch, co-chairman of the task force. “But that it will be a hell of a lot more expensive to deal with these problems five and 10 years from now than to deal with it now.”

Ravitch and former Federal Reserve Board chairman Paul Volcker, who serves as co-chairman, created the task force in April 2011 under the auspices of the Research Foundation of the City University of New York.

The task force issued a 112-page report that analyzes the current fiscal situation of six states:  California, Illinois, New Jersey, New York, Texas and Virginia. The six states were profiled because they account for more than a third of the nation’s population and almost 40 cents of every dollar spent by state and local governments. In addition, they all face major threats to their ability to provide basic services to the public, such as welfare and environmental protection and making investments in education and infrastructure, the report said.

“The conclusion of the task force is unambiguous: the existing trajectory of state spending, taxation and administrative practices cannot be sustained,” Ravitch said. “The basic problem is not cyclical, it is structural.”

The report didn’t offer solutions to the fiscal problems but recommended ways states can sharpen their fiscal tools and improve their budget woes. The threats to states’ fiscal sustainability have put at risk essential state functions, such as funding K-12 education, investing in infrastructure and borrowing to adjust cash flows, according to the report.

“Essential infrastructure spending is now crowded out by more immediate spending pressures, pushing essential investments off to the future and increasing the risks to the public health and safety and economic growth,” the task force wrote.

The report warns that extensive misuse of state borrowing, such as for financing current spending, could diminish state credit ratings, increase interest costs and further limit the ability of states to borrow for much-needed capital projects.

States’ increasing reliance on economically sensitive taxes and the rising volatility of revenues produced by those taxes have caused state tax revenues to plunge in the last two recessions.

Tax revenues have become more volatile in part because income taxes have become increasingly dependent on the financial markets and on the states’ highest earners.

Between 2008 and 2010, state tax revenues declined by more than 12% when adjusted for inflation, far greater than any past recession, the report said, adding: “Severe fluctuations can open up budget gaps that are large even in comparison to longer-term structural gaps.”

To mitigate recent trends in eroding tax bases, states should seek reforms that make their tax structures more broad-based, stable and productive.

In addition, the federal government should make it easier for states to collect existing taxes on goods and services sold over the Internet, the report said.

It found that there is a “disconnect” between the federal government and the states, with no formal mechanism for evaluating the impact of proposed federal policies on states.

The report suggested there should be a permanent, national-level committee to consider the ways in which federal deficit reductions or major changes in the federal tax system will affect states and localities.

Before such a committee is created, the report said, Congress should require the Congressional Budget Office to prepare analyses on the ways major legislative proposals are likely to affect the fiscal situation of state and local governments.

For example, scaling back deductibility of state and local taxes would raise the effective burden of state and local taxes, especially in states that base their own tax systems on the federal system.

Similarly, if the federal government were to expand the income tax base by restricting other types of deductions or exclusions, that would also hurt state coffers.

Unfunded public pension liabilities are estimated to be at $3 trillion or more. “The most significant reason for pension underfunding is that investment earnings have fallen short of what was assumed,” the task force wrote.

Over the last five years, state and local governments have underpaid contributions by more than $50 billion.

California, Illinois and New Jersey, with 19% of the nation’s population, accounted for more than half of the shortfall in contributions, according to the report.

The task force recommended that states and their retirement systems should develop and adopt rules for management of their pension programs to ensure required contributions are paid. States should also begin to use dedicated systems of reserves in order to provide ongoing benefits to retirees.

Fiscal pressures have also increased the number of local governments that are encountering stress, the report said.

“While local government bankruptcies and insolvencies remain rare, municipal bond downgrades for governments greatly outnumber upgrades and the threat of outright fiscal crisis among localities is increasing,” the task force noted.

Few state governments have effective procedures for monitoring the fiscal conditions of their local city and county governments to help resolve their fiscal problems before they threaten insolvency or bankruptcy.

The task force recommends that states seek out monitoring and intervention procedures.

The report comes as San Bernardino became the third California city to move toward bankruptcy.

The city is considering filing for Chapter 9 protection after Stockton and Mammoth Lakes both declared  bankruptcy. Stockton is the largest U.S. city to do so — for now.

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