State & Local Governments: Employee Pay a Key Budget Issue

New York City's government fiscal year begins July 1, so work on its budget is in full swing. A friend and I have both recently participated in making our views known about a couple of proposed spending cuts. She took part in a demonstration at City Hall urging restoration of funding for grants for English-as-a-Second-Language classes at a community center in Queens. I wrote to our City Councilman and State Assemblywoman to protest the proposed closing of fire stations, particularly the one closest to the thriving DUMBO neighborhood in Brooklyn.

These issues are unfortunately typical at present of dilemmas facing state and local governments all over the country. These governments, unlike the federal government, generally cannot enact budgets that would result in deficits; they must at least aim for fiscal balance. Even the federal government, of course, has lately learned that citizens and credit markets want it to have a budget that at least attempts to rein in its deficit. So the activities of all governments are coming under scrutiny.

Recession Cuts Receipts, Raises Spending Needs
The state and local situation is a direct result of the financial crisis and recession. These caused their aggregate tax receipts to fall 9% from the economy's peak to its trough. The subsequent recovery only brought receipts back to their previous high late in 2010, and even that mild move had support from hikes in property tax rates. Income and sales taxes have remained sluggish and are still below their pre-recession amounts. The stock market drop has also hurt the values of these government's pension funds; this factor has put additional upward pressure on spending, and our discussion here will describe that additional weight on budgets.

Spending pressures in general grow inexorably, causing dilemmas and hard decisions for many government officials. We looked at the introductory budget statements several mayors wrote to accompany their budget submissions. Most bemoan the cuts and layoffs they have ask for. Even in such a relatively prosperous area as Houston, Mayor Annise D. Parker says layoffs are needed in the Fire Department. However, she explains that these will be administrative personnel, and she thanks the firemen's union for their flexibility in negotiating a compensation package which prevented the layoffs of firemen themselves.

Employee Pay a Big Part of These Governments' Outlays
Such an emphasis on compensation packages is important. State and local governments are structured differently from the federal government. Federal outlays are dominated by benefit payments and grant programs. During calendar year 2010, these were $2.3 trillion of the total federal expenditures of $3.9 trillion, right at 60%. The federal government had about 4.3 million employees and their total compensation was $456.2 billion, just under 12% of the spending total, even including the military. By contrast, state and local governments' main activities are providing services, such as education and law enforcement, that mean they employ many workers, 19.5 million all told. Their main outlay is thus compensation, which during 2010 was $1.0 trillion and accounted for 47% of their total spending. The most direct way to control spending is therefore through controls on compensation, and if wage and benefit rates cannot be constrained, then the way to cut is by laying people off.

This isn't very attractive, and until the last couple of weeks, efforts at limiting spending have been marked by emotional rhetoric and demonstrations, such as crowds packing into the Wisconsin State Capitol Building and hanging over its balconies, not by serious efforts at cooperative solutions. How can we approach this quagmire? Can we do anything to clear out some of the muck?

We've always had the impression that state and local government workers were really not very well paid anyway. So we looked at some data on this from the U.S. Bureau of Labor Statistics; their figures on compensation by industry and occupation will shed some light on this question. These are hourly pay rates for an individual, "average" worker as of this past March.

Managers and professionals collect about $2 less in hourly cash wages than similar workers in the private sector, but their benefits are actually about $1 higher, especially for insurance and retirement plans. As well, over the past five years, the state and local retirement plan costs have grown much more, 35%, than those for private sector workers, 11%. Insurance costs have risen 23% for state and local managers since late 2005, but they've gone up even a bit more, 24%, for private sector managers. Government managers' cash wages have increased only 5.5% across the whole of the last five-year period versus about 13% for private industry managers.

Office and administrative support personnel in these governments do much better than similar workers in the private sector. They make about $1.25 more an hour in wages, and their benefits are $4.25 more; retirement, insurance and vacation benefits are all much higher. Notably, retirement benefits have ballooned by 41% over the past five years for state and local office workers, but only about 9% in the private sector. Cash wages for these state and local workers have risen 12.5% compared to about 10.5% in the private sector.

Now, in trying to prescribe solutions to the state and local government budget squeeze, we can certainly talk about what programs we want to cut. This involves serious discussion about what the functions of these governments should be, the same approach we need to use for the federal budget, as we highlighted here back in April. But in addition, it's pretty obvious that we need to work on compensation arrangements; benefits seem outsized compared to private sector workers and they're generally expanding much more rapidly. It also seems that, at least for managers, wages are already being restrained as some offset. Health insurance costs are increasing, but this is the case for everyone, and probably needs its own separate solution.

Retirement Plans a Major Source of Concern
What we're left with here as a special case is the retirement plans. We wrote back in the fall about Social Security and the need for reform there. The same kind of situation holds true here. Nearly all of state and local governments have so-called "defined benefit" plans for their employees. Private companies used to have them too, in which the arrangement calls for a pension benefit that's some percentage of wages earned. For the employer to pay this targeted amount, they have to set aside some "contribution" now which, after investment, is expected to provide the required amounts of money in ten or twenty years when current employees are retired. This works as long as stock prices and other asset values rise or if other types of income, such as bond interest, are large enough to generate the required amounts. But if stock prices have fallen and interest rates are low, this may not result. Actuaries make projections of what will be needed and employers should raise their contributions to make up any projected shortfall. If government funds are not available, the amount of the "unfunded liability" may grow. Estimates of state and local governments' current such liability range from $1 to $3 trillion, as calculated by analysts at the Pew Center on the States and professors at three prominent universities.[*] Ouch.

Many private companies get around these circumstances by changing to "defined contribution" plans. They make no promise about the eventual size of pension payments to retirees. Instead the vast majority of private plans are now 401(k)-type programs, with both employer and employee investing funds; the size of the pension benefit will be some portion of whatever funds are actually available when they are needed. This may sound skimpy at first, but we'd guess that the outcomes well down the road may be very similar, since the funds that are really available depend on how asset values do in the future, regardless of which type of plan there is.

First Signs of Building Sentiment Toward Retirement Plan Changes . . .
In the meantime, for state and local governments, these are very messy issues, and the processes for altering any pay arrangement are very complex. They often involve union negotiations and legislative actions, both of which are subject to complicated political trade-offs. Until very recently, we had little reason to be optimistic about orderly solutions. Often, the most direct solution is to reduce the government's obligations by cutting the number of employees, that is, simply laying them off.

However, as we indicated earlier, union leaders and the Mayor's office in Houston figured out how to smooth a path to reform that minimizes layoffs. Then a couple of weeks ago, New Jersey Governor Chris Christie, Republican, and some Democratic legislative leaders worked out a different kind of deal for that state's employees. Further, while it's one thing to have a Republican governor propose such reforms, now Democrats Andrew Cuomo of New York and Jerry Brown of California have started to work on similar moves for their states; Brown even vetoed his legislature's first pass at its 2012 budget and sent it back for them to try again.

Even from AARP!
Then, just last Friday, June 17, a group who's a major representative of seniors' issues, the AARP, indicated that it may be changing its position on social security reform. They realize that something must and will be done to alter the social security program, and they decided that they want to be part of the process. This ends years of blunt refusal to support any movement on that front. While this move isn't directly related to state and local government budgets, it may help everyone understand better that all of these baby-boomer retirement issues are serious and need more planning and care than they've had until now.

So there will be much more to these stories, and we didn't even talk about state and local governments' service priorities and programs, such as Medicaid and education, just how their employees are paid. But that is just as important a first step toward fiscal renewal and balance throughout government.

[*]The Pew Center on the States. "The Widening Gap: The Great Recession's Impact on State Pension and Retiree Halth Care Costs". www.pewcenteronthestates.org. April 2011.

Jeffrey Brown, Robert Clark and Joshua Rauh. "The Economics of State and Local Public Pensions". National Bureau of Economic Research Working Paper 16792, www.nber.org/w16792. February 2011.