Magazine | September 20, 2010, Issue

Crisis Made Locally

California is a penniless state full of penniless cities

California famously competes with Illinois for the title of the most fiscally dysfunctional state. While residents of most states are enduring only their second or third year of fiscal crisis, Californians have been suffering since for more than a  decade — they recalled Gray Davis in part because of their dissatisfaction with his fiscal management, and matters haven’t gotten any better under Arnold Schwarzenegger. This year, the state faces one of the country’s biggest budget deficits: $19 billion, more than a fifth of its total budget.

Less noted is that California’s municipal finances are among the bleakest in the country, too. Up and down the state, municipal leaders are openly discussing the possibility of declaring bankruptcy — including in the state’s two largest cities, San Diego and Los Angeles. Over the next few years, a bankruptcy trend that started in the suburbs of San Francisco could go statewide.

Vallejo, Calif., a city of 117,000 northeast of San Francisco, declared bankruptcy in 2008. The driver of Vallejo’s insolvency wasn’t excessive bond debt but unsustainable pay and benefits costs: For example, the average Vallejo firefighter had a compensation package worth $171,000, and police captains could make over $300,000 in pay and benefits. Meanwhile, weak tax revenues impaired the city’s ability to cover this bill, even after cuts in staffing. Like most California municipalities, Vallejo devotes a huge majority of its budget to pay and benefits, so the main options for saving money are employing fewer workers or paying them less. When public-employee unions refused to agree to significant pay cuts, the city council chose bankruptcy as an avenue to get out of union contracts and cut compensation.

Vallejo’s case — both in terms of the extravagance of employee compensation and the fiscal impact of the recession — was extreme. But after two more years of tough economic conditions, other California cities are now looking at drastic action to fix their books.

Oakland, where the average police officer receives total compensation of $162,000 per year, laid off more than 10 percent of its police force this summer. In an attempt to scare city officials out of making the staff cuts, the police chief announced that the department would stop responding to certain less-serious crimes, such as grand theft. This did not deter the city council, and the layoffs went forward in July.

Other cities are throwing around the B-word, too. In May, officials in Antioch (another medium-sized city near Vallejo) warned that they might resort to bankruptcy if cost-cutting efforts failed to balance the books. In June, the Grand Jury of San Diego, an official investigative body formed by the city’s government, urged city officials to investigate bankruptcy as a way to discharge crippling pension obligations.

Most alarming of all, former Los Angeles mayor Richard Riordan has warned that the largest city in California is on a path to bankruptcy by 2014. As with Vallejo, Los Angeles’s financial difficulties are not principally a problem of excessive bond debt, though residents have been fairly cavalier about approving new issuances in the face of the recession. The problem is unsustainable growth of employee compensation, especially benefits.

Today, the City of Los Angeles is spending more than $17,500 per employee per year just on retirement benefits; if you exclude employees of business-type municipal activities (such as the airport and utilities), that figure rises to nearly $24,000. And these expenses are poised to soar: By the city’s own estimates, costs for pensions and other post-employment benefits (mainly retiree health care) will rise from $924 million in fiscal year 2009 to nearly $1.5 billion in FY 2015 — and the city has no real plan to meet them.

#page#Why are retirement expenses going up so much? Partly, they reflect the severe stock-market drop that began in 2008 and battered the value of pension-plan assets. Pension funds recognize unusual gains or losses gradually, over a period of years, so the full effect of recent investment troubles won’t show up in the city’s required payments until mid-decade. But the rising pension expenses are also driven by the city’s creation, backed by Riordan, of a new, more generous tier of police and firefighter benefits back in 2001. While the average Tier 4 retiree gets a starting pension of just over $45,000, the typical figure is $83,000 in the new Tier 5. At the time, because of the strong stock market, this looked affordable; now, not so much.

The ballooning pension contributions that strain Los Angeles’s municipal finances would be even higher if the city had not used an accounting trick to delay the pain: In the wake of the stock-market crash, the city lengthened the period over which it recognizes extraordinary asset-value changes from five years to seven, allowing it to increase contributions more slowly. But this delay will undercut the pension system’s financial strength over the long term. (It also may not endear the city to financial regulators — the SEC recently sued New Jersey for failing to adequately disclose some shady pension-accounting practices, including a maneuver similar to Los Angeles’s.)

While these irresponsible fiscal decisions and ballooning pension costs are alarming, they are not unique to California. Many states, including New York, New Jersey, and Illinois, juiced up their benefits around the same time that Los Angeles did. So why is bankruptcy talk so much more prevalent in California than elsewhere in the country?

The differences are structural. One of them is the unusually heavy political clout of public-employee unions in California. They have managed to negotiate compensation packages on par with (or better than) their peers’ in higher-spending states such as New York and New Jersey. The state manages to combine sky-high salaries and moderately high spending by restraining non-personnel costs or by employing fewer people; for example, California pays the country’s second-highest teacher salaries but also has the second-highest student/faculty ratios.

In a sense, the high-profile case of Bell, Calif., is the exception that proves the rule of how Golden State cities overspend. Bell’s fiscal mess was driven by insanely high salaries paid to a handful of non-unionized city employees, including the city manager and the city council. Once these facts were publicized, Bell responded by cutting loose its high-paid managerial staff, and the city council will be turned out by voters. (For more on the sorry tale of Bell, see Daniel Foster’s report on this page.) But in most cities, the problem is not a few egregiously overpaid non-union employees; it is a large number of somewhat overpaid union employees, and they will not give up their rich compensation packages so easily. When you can’t cut compensation per employee, and you do not start with an especially high headcount (should California go for even higher student/teacher ratios?), then your budget-cutting options are severely limited.

In other states with similarly intractable unions, municipalities can tax their way out of the fiscal holes created by high compensation. But California’s Proposition 13 stringently limits property taxes at 1 percent of assessed value, which is often significantly lower than market value. Unlike in many states with property-tax caps, such as Massachusetts, California voters cannot override the cap and allow for higher taxes. The property-tax levy can be (slightly) increased to finance new bond issues, but not to pay for current operations.

While California municipalities have a tougher time raising taxes or cutting spending than their peers in other states, they have relatively easy access to bankruptcy. A California city can go bankrupt simply by convincing a court that it cannot meet its current obligations — and the Vallejo case showed that it need not first maximize taxes or cut services to the bone. With these sorts of standards, strained cities in other states — such as Newark, N.J., which faces an $85 million gap in a budget of approximately $600 million and is about to lay off 20 percent of its police force — might find bankruptcy very appealing. But New Jersey does not allow municipal bankruptcy, so Newark is instead discussing a property-tax increase of more than 20 percent.

#page#Back in May, Riordan laid out a plan to keep Los Angeles out of bankruptcy, and much of his advice would also be sound for other municipalities (including Newark): Move new employees to 401(k) plans instead of defined-benefit pensions, raise pension contributions for existing employees, and raise retirement ages. Riordan also suggests staff cuts, which would be appropriate in some cases; in others, it would be better to freeze or cut salaries.

Officials all over California already know this is what they need to do. Vallejo tried to achieve similar savings before its bankruptcy filing but could not get union approval. While Riordan frames his proposal as a way to avoid bankruptcy, it reads more like a list of items to be included on a reorganization plan after declaring bankruptcy. Over the next several years, as costs rise and revenues most likely remain anemic, actions based on the Riordan plan — and the bankruptcy filings to make them possible — will look more and more appealing. Naturally, employee unions are fighting in Sacramento to subject municipal bankruptcies to approval by a union-influenced state board; so long as the state has a Republican governor, that, fortunately, is unlikely to happen.

Bankruptcy has its downsides. Municipal bondholders will lose money, and a lot of them are individual investors in California attracted by the tax benefits. Further, if more cities start defaulting on their bonds, interest costs will rise for municipalities across the state and perhaps the country.

The right solution isn’t to cut off the bankruptcy option and leave cities trapped with unsustainable costs they can’t discharge. Instead, California should implement structural reforms that help municipalities control costs. This has been a key focus for New Jersey governor Chris Christie, who has correctly noted that you can’t control local taxes without controlling local spending. Key options include tenure and civil-service reform, a requirement that public employees’ health benefits track the value of private-sector benefits, and even a prohibition on public-sector collective bargaining, which has helped Virginia municipalities maintain moderate cost growth.

Without such reforms, bankruptcy will be essential as cities’ last viable path to solvency — and as a credible threat to bring unions to the table. If those threats do not work, and if Sacramento does not bring structural reforms that strengthen municipal officials’ hands, then California’s local fiscal crises may lead to a series of municipal bankruptcies that would unsettle markets around the country. California has long been a national trendsetter — but this is one we’d do well not to follow.

– Mr. Barro is the Walter B. Wriston fellow at the Manhattan Institute.

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