Workforce Development

Tax Reform and Pension Reform

This appeared on PublicSectorInc.Org on March 11, 2014.

Congressman Dave Camp’s recently released tax reform draft has stimulated a much-needed national conversation about the U.S. tax code, attracting praisecriticism and skepticism. Buried in the plan is one tax change that could significantly influence the pension reform debate now raging nationwide at the state and local level.

Camp’s plan would require top earners to pay a surtax on previously untaxed municipal (muni) bond interest. Currently, state and local governments use tax-exempt muni bonds to fund capital projects such as bridges and new school buildings. The proposed surtax might negatively affect top bracket taxpayers’ willingness to invest in muni bonds.

Overall, eliminating this tax preference might be good tax policy. But in the near-term, the surtax will squeeze already tight municipal budgets. Adding a surtax to muni-bond interest—which effectively increases the cost of issuing muni bonds—could force state and local governments to choose whether to fund pensions or capital projects. Governments should act quickly to reform the greatest existing threat to their budgets: unfunded pension liabilities.

The cost cities pay for issuing debt has increased as investors realize that muni bonds are not quite as “risk free” as had been previously believed. The high profile bankruptcies of Detroit and Stockton, CA have caused investors to take a second look at the municipal bond markets.

One reason why state and local governments are struggling to properly fund pensions is because most still operate on a defined-benefit pension system. Under this system, the retirement benefits promised to employees are fixed, regardless of how well the investments performed throughout employees’ working career. Any shortfall must be made up, ultimately, by taxpayers and taxpayers alone. Most municipalities assume an 8 percent rate of return every year on pension investments. When the 8 percent rate of return is not realized, underfunding and increased taxpayer contributions are the result.

Some Detroit bondholders will likely receive less than they are owed, but the Stockton example is more troubling. When that city went bankrupt, the largest creditor was CalPERS, the California Public Employee Retirement System. While bankruptcy proceedings usually attempt to cut obligations owed to creditors in an equitable way, the City Council’s bankruptcy plan has promised CalPERS full payment while in turn promising as little as 20 percent payment to bondholders. Moody’s reacted to Stockton’s bankruptcy by immediately downgrading the credit rating of neighboring Solano County, and many more municipal credit downgrades are sure to come. The bankruptcy exit plan would also be the first time in many decades that a city reduced the principal on its debt. The plan seems to have the support of the federal bankruptcy judge, but bondholders  still plan to fight.

State and local borrowing costs are inevitably going up because of credit downgrades, unfair bondholder treatment and a possible surtax on interest for top earners. As for pensions, quick fixes are no longer enough to sustain the status quo.  Ending unsustainable defined-benefit plans and putting new hires into 401(k) style defined-contribution plans is the best way for municipalities to cap unfunded pension liabilities. Once capped, current obligations can be more easily paid off over time.

Municipalities should still meet their pension obligations for current and retired workers, but lawmakers must realize that defined-benefit pension plans are no longer viable options. Defined-contribution retirement plans are the most sustainable path forward if municipalities desire to keep their pension promises.

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