Pension problems remain quite large
Editor's note: In an interview with News Bureau business and law editor Phil Ciciora, finance professor Jeffrey R. Brown, who is also the director of the Center for Business and Public Policy in the College of Business and was a senior economist with the President's Council of Economic Advisers from 2001 to 2002, discusses Illinois' pension reform law.
Does the new pension law eliminate the estimated $100 billion in unfunded pension liability within 30 years, or is it just delaying the day of fiscal reckoning?
Brown: To begin, let's be clear what we mean by the unfunded liability. This is the actuarial value of benefits that have been promised in excess of the money we have put aside to pay for them. So it is completely unrealistic for any reform to eliminate this instantaneously. The only way to do so would be to immediately confiscate $100 billion of taxpayer wealth or to default on $100 billion of promised benefits, or some combination of the two. Obviously, neither of those is going to happen.
What this reform attempts to do is to address the problem in three ways. First, it reduces the value of already earned benefits by reducing the cost-of-living adjustment (COLA) and raising the retirement age. Of course, the fact that it does this may be unconstitutional — an issue that will be up to the courts to decide. Second, it reduces the benefits that will be promised in the future. One can view this as a form of, "If you are in a hole, the first thing you should do is stop digging." By reducing future benefit promises, this will free up future cash flows and thus reduce fiscal pressure on the state. Third, it includes provisions to force the state to more adequately fund the pensions in the future, including providing a new mechanism by which the retirement systems can try to force the state to make required contributions.
The problem, of course, is that it is never possible for a legislature to bind all future legislatures. So there is no guarantee that these funding commitments will be honored.
Who will be hurt the most by these changes?
Brown: In percentage terms, those hurt the most are employees in the defined benefit plan who have earnings over the new pensionable earnings cap and who still have another couple of decades of employment ahead of them. Absent other changes to offset some of the harm, some of these individuals just had their pension benefit cut not just in half, but by two-thirds or more. The danger to institutions such as the University of Illinois is that some of these individuals will simply choose to go elsewhere, taking their grant money, their labs and their intellectual capital with them.
The increase in the personal and corporate income tax rates will expire on Jan. 1, 2015. The revenue from those increases account for $7.5 billion a year. Can the Legislature let those tax increases expire?
Brown: As a legal matter, they certainly can. As an economic or fiscal matter, I have no idea how they could possibly allow it. Even with those "temporary" rates in effect, we have been unable to close the fiscal gap. It will only widen without those revenues. For perspective, the pension reform is expected to reduce spending by only about $1.5 billion per year in the short run, so it is only a small fraction of the additional revenue raised by the higher tax rates.
Does Illinois need a progressive income tax?
Brown: First, we should recognize that the system is already progressive according to the standard definition, which means that the average tax rate rises with income. Even though we have a flat marginal rate, there are deductions and exemptions, which mean that a higher fraction of income is exempt from taxation for lower-earning households. An easy way to make the system more progressive under the current flat marginal rate scheme is to raise the personal or household deduction. Of course, this reduces revenue.
But what most people have in mind is to add even more progressivity by having a multirate structure, with higher marginal rates on higher incomes. I am opposed to this on economic grounds. Although average tax rates matter for distributional purposes, it is marginal tax rates that are important for economic efficiency and productivity.
High marginal rates are a sure way to drive high-income workers, entrepreneurs and employers across state lines, which would further erode our tax base. Illinois is already pretty low on the list of attractive places to start a business or a career because of our dysfunctional political system and our high level of indebtedness. I don't know why anyone would think it is a good idea to make this state even less attractive to the highest earners by levying even higher taxes on them. Let's keep in mind that this is on top of a progressive income tax system at the national level. Plus, higher-income households tend to own more expensive homes, which means they are also paying substantially more in property taxes, which are quite high in Illinois.
Is there anything that the state of Illinois can learn from Detroit's situation?
Brown: Yes, there are several lessons.
The first is that poor fiscal management over many decades can end very badly. We Americans are a pretty optimistic people, and so we often have a view that we can fix anything if we just set our mind to it. Most of the time, that serves us well. But Detroit shows us that you can sometimes dig a hole so deep that there really are no good solutions. Illinois has a stronger overall economic foundation than Detroit, but we have done an equally bad job of managing our finances. People should not assume that just because the Illinois General Assembly passed pension reform that we are out of the woods. The problems here are still quite large, and the solutions will be difficult and will require sustained focus over many years.
A second lesson is specific to pensions. Public sector unions in Illinois have long been advocates of defined benefit systems and have been somewhat hostile to defined contribution systems. This is because it is generally thought that the employer (in this case, the state of Illinois) bears the risk in a defined benefit system, whereas that risk gets shifted to employees in a defined contribution system.
The recent ruling by a bankruptcy judge in Detroit shakes the very foundation of this belief. The court ruled that pension rights receive no special seniority in bankruptcy, and thus are treated like any other creditor. This dramatically increases the risk to participants in public defined benefit systems, at least at the local level where municipalities have a formal bankruptcy option.
Indeed, one could even argue that public defined benefit systems are now even more risky than corporate plans because the latter are insured by the federal government, whereas public plans are not.
Thus, in a state like Illinois that seems to have few effective mechanisms to force the state to fund the system, it is not at all clear that a defined-benefit system is safer.
It may take a while, but I suspect more and more public employees will come to the conclusion that a well-designed and fully funded defined contribution system is more secure than an unfunded promise from the state's politicians.
Professor Jeffrey R. Brown can be reached at email@example.com.