Wednesday, August 26, 2015

The Public Pension Crisis: Illinois, New Jersey and Puerto Rico

The US protectorate of Puerto Rico has captured headlines for several weeks now following its default on US dollar tax-exempt bonds. The default occurred on August 1, when the Commonwealth paid only $628,000 of a required $58 million payment due bondholders of its Public Facilities Corporation. The consequences of default for the island are severe, as seen most recently when a proposed new $750 million bond issue to fund needed improvements to its water system failed to attract buyers, causing underwriters to pull the sale.

For some time prior to the bond default, concerns with Puerto Rico's credit began to surface with high levels of debt and mounting unfunded liabilities of its employee pensions systems. These unfunded pension liabilities served to magnify the Commonwealth's already hefty public indebtedness. Puerto Rico is now faced with $72 billion of unpaid bonds, plus $33 billion of unfunded pension liability, or $105 billion in total obligations.  For an island with only 3.5 million people, that's $30,000 per capita.

What bond investors are now beginning to realize is that pension liabilities are tantamount to debt. They must be weighed equally in evaluating the level of government debt burden and its capacity to repay its obligations. This concern was highlighted by the outcomes of recent U.S. municipal bankruptcy cases, where public bondholders were paid as little as 12 cents on the dollar, only to see retirement obligations of the local government paid in full. This turn of events has the effect of investors not only recognizing that pension obligations are debt, but debt that may also be a superior obligation, to be paid first in a time of financial crisis.

This has us thinking about some more highly rated municipal credits, like New Jersey and the State of Illinois, and what their true debt burdens might be, considering unfunded pension liabilities. New Jersey, fortunately, fairs a little better than Puerto Rico, with $84 billion of State public debt and $87.6 billion of unfunded pension liabilities, or $171 billion in combined debt overall. Spread over 8.9 million residents, New Jersey total debt per capita is on the order of $19,000.

For Illinois, with $127 billion of bonds outstanding, debt burden is considered "moderate" by the bond rating agencies. But adding $167 billion of unfunded pension liabilities, brings their total amount due to creditors to a whopping $294 billion.  Measured on a per capita basis, this ranks Illinois with 12.8 million people and total debt per capita of $23,000 just behind Puerto Rico. Unlike Puerto Rico, however, residents of many cities (and counties) in Illinois have the added debt and pension burdens of their local governments to contend with, as well. In the case of the City of Chicago, this would add debt per resident of $23,000 to the Illinois state total, or a total debt per capita of $46,000, far greater than that of Puerto Rico.

Friday, August 21, 2015

Means Testing Social Security

Chris Christie's recent comments about means testing Social Security benefits set off a torrid of accusations of Republican cuts to Social Security. Leaving aside the obvious fact that Governor Christie is only one of more than a dozen candidates running for the Republican nomination, critics nonetheless seized the opportunity to indict the entire party for mistreating senior citizens. Social Security reform has been called the third-rail of American politics, and Christie received quite a jolt.

But what is means testing about and can it help restore the solvency of the Social Security Trust? As discussed in previous blog posts, the 2015 report of the Trustees of the Social Security Administration clearly spells out the trouble ahead for Social Security. By their estimates, Social Security will be insolvent by 2034, with the Disability Insurance component becoming insolvent next year. The Trustees point to the present value deficit of the Trust Fund, now running $10.7 trillion. Argue all you will about what to do, but clearly something must be done, unless our intent is to bury our heads in the sand and simply leave the mess to future generations.

With a deficit that large, there are only two possible avenues to cure the problem: increase payroll taxes to boost the income side of the equation, or reduce outflows. Those leaning left advocate the former, those leaning right, the latter. We've pointed out in other blog posts, though, the limitations and consideration with raising the payroll tax rate. So let's spend a few moments examining other options.

Means testing, as discussed by Governor Christie is an attempt to gradually reduce outflows of Social Security by reducing benefits for those who need them least: the wealthy. The idea is test the means of financial support of retirees, before providing scarce resources from an impoverished and soon insolvent Social Security Trust Fund. Left leaning opponents of this plan are quick to characterize means testing as a Republican attempt to cut benefits, when in reality, it is simply attempt to limit benefits to the wealthy. 

Paul Krugman blogged about this earlier this week from his platform as acting-editor of the New York Times in a sensational piece entitled, "Republicans Against Retirement". Catchy, no?  In bolstering his argument that means testing is impractical, he and other Democrats with political aspirations, point to just one study on the topic, a sloppy bit of economic research by Dean Baker of the Center for Economic and Policy Research. That study based upon 2009 data, concluded that means testing would save very little, as "more than 75% of Social Security benefits go to individuals with non-Social Security incomes of less than $50,000 per year". Sounds reasonable.

But let's stop and think about this. First, this is 2009 data, that comes at the depth of the greatest recession since the Great Depression. Second, Baker is not referring to those individuals with pre-retirement annual incomes of less than $50,000, but rather those in retirement claiming income for tax purposes of less than $50,000. So he is measuring retirement income from a combination of pension income, private investment income and capital gains, and taxable distributions from 401(k) and IRA accounts.

As you might imagine, retirees, like everyone else in America, are doing their best to manage their tax liability. Thus, retirees are only reporting investment income to the extent they must, often choosing tax-exempt investments like municipal bonds, and avoiding capital gains on stock investments. Thus, someone who has $10 million invested in tax-exempt bonds, and earned $500,000 in annual investment income, would record non-Social Security income of $0.00 (assuming they had no pension or other income). Similarly someone with an IRA of this same amount may choose to take distributions of $50,000, as a prudent way of managing income and tax liability.

But let's leave these obvious considerations aside (as does Mr. Baker in his analysis). Let's also ignore the fact that we're working with income data that is six years old. The point is, Baker's study still reports that 3.4% of Social Security benefits are provided to retirees with greater than $80,000 per year in non-Social Security income. With total benefit outflows of Social Security last year of just over $706 billion, were these benefits means tested and reduced, the annual savings to Social Security would thus be in the range of $24 billion per year. It may not fix the entire problem, but that ain't chump change to a system with a $10.7 trillion deficit. 

Wednesday, August 12, 2015

What's the Real Level of US Debt to GDP?

One of the most widely used metrics for analyzing the level of debt of a country or sovereign government is Debt to GDP. The idea is that in comparing the overall government debt of Japan to China, for instance, the absolute amount of government obligations needs to be viewed in the context of the size of the economy, as measured by Gross Domestic Product. Countries with larger economies, like the US and China, can sustain higher levels of debt, because the tax base available to them for servicing the debt is so much bigger than, say France or Portugal.

The World Bank publishes Debt:GDP ratios for all major industrialized nations as well as developing economies. Alarms began to sound in 2010 over excessively high levels of debt to GDP in Greece. By 2012, the last year of World Bank published data, the debt to GDP ratio for Greece had climbed to 167%. More economically stable economies like that of Denmark, Finland, Germany, Australia and Canada, have ratios in the range of 50%. 

While debt to GDP ratios in the West have been rising now for several years, developing economies like Bulgaria, the Czech Republic, Guatemala, Latvia, Nigeria, Peru and Uganda tend to evidence ratios that are far lower, generally below 30%. Of increasing concern, though, are industrialized nations of Europe like France, Italy, Ireland and Portugal, who along with Greece, each now report ratios of greater than 100%, a benchmark that signals distress.  

Of great concern are the debt levels of Japan, now roughly 200% of GDP, a level from which most economists believe it will not be possible for Japan to safely manage its debt, without risk of great financial calamity. Harvard Economics Professor Kenneth Rogoff and Carmen Reinhardt in their highly acclaimed work, "This Time It's Different" show that debt to GDP levels of higher than 90% lead to sharply lower rates of growth for economies, going forward.

Amidst these "problem" economies, the US shows a ratio of 96% as recently as 2013 in the World Bank analysis. This figure reports what is known to as "gross debt", a number that is also often reported on a net basis. The difference between net and gross is the treatment of debt the US government owes to "itself" or specifically Medicare and Social Security. This topic is discussed at length in other blogs on this site.

But here's the catch. While US debt to GDP is considered borderline and not as excessive as the troubled economies of Greece and Japan, the US debt, even on a gross basis is understated on a global comparative basis. This is because few countries of the world have sizable levels of governmental debt undertaken at the state and local level. But in the US, the combined debt of state and local governments now totals approximately $3.1 trillion. When added to the US Treasury gross debt of $18.1 trillion this brings total US governmental debt to $21.2 trillion. Based on US GDP of $17.8 trillion for the 2nd quarter of 2015, this would place the US debt to GDP ratio at 119% (on a comparable global basis) higher than any other World Bank monitored country, save Japan, Lithuania and Greece.

Add in other liabilities of the US government, like the $10.7 trillion present value deficit of Social Security or the estimated $14.4 trillion present value deficit of Medicare, and the ratio becomes a downright alarming 260%.

Tuesday, August 4, 2015

Will Raising Payroll Taxes Save Social Security?

The dire findings of the 2015 report of the Trustees of the Social Security Administration has stirred public debate about whether a hike in the payroll tax rate can save Social Security. The Trustees' report once again alerts Congress to the looming insolvency of Social Security, now estimated by 2034, and of the Disability Insurance program, projected to become insolvent next year. The most expedient solution, if not the most practical, is to simply raise the payroll tax rate. Indeed, many have advocated just this. 

Proponents of a tax hike claim that by raising the rate by 2.3%, we could insure the solvency of Social Security for another 75 years. But part of understanding the status of Social Security is recognizing the many assumptions and forecasts that are embodied in the Trustees' report. For instance, the Trustees' report projects that OASDI costs will rise to just 6.2% of GDP by 2089. Really, 2089? The Federal Reserve can't even predict GDP next quarter and the Trustees are projecting what GDP will look like 74 years from now? Let's get a grip, people.

When Social Security was originally imposed, payroll taxes were just 2% of the first $3,000 of wages and salary, or a maximum of just $60 per year (roughly $1,050 in current dollars). By 1960, however, the tax rate had already tripled, on its way to today's current level of 12.5% (with these amounts equally split between employer an employee). That puts the maximum worker contribution in 2015 at just under $7,500 (with an equal contribution by employers) or seven times greater than what the maximum worker contribution was when Social Security was first enacted (adjusted for inflation). In fact, payroll taxes have grown so dramatically it's now estimated that 82% of American households pay more in FICA payroll taxes than they do in federal income taxes. Yet despite this growth in payroll taxes, the 2015 Trustees report estimates that the OASDI, the Trust Fund for Social Security and Disability Insurance is underfunded on a present value basis, by $10.7 trillion

In planning to raise the tax rate, we must also consider that in 2010, President Obama championed the idea of temporarily cutting the payroll tax rate, as a measure of economic stimulus for a then struggling US economy. Indeed we did, and the IRS gleefully provided the following statement to taxpayers:

"Millions of workers will see their take-home pay rise during 2011 because the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provides a two percentage point payroll tax cut for employees, reducing their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid. This reduced Social Security withholding will have no effect on the employee’s future Social Security benefits." - IRS release, IR-2010-124, Dec. 17, 2010.

The New York Times ran a story that proclaimed,

"The biggest Christmas present that many people will get this year comes form the Federal Government, thanks to the tax bill that President Obama signed a week ago" - New York Times, December 24, 2010.

In 2011, pushing back on Republican opposition in Congress to extending the tax cut into 2012, President Obama challenged members of the GOP to "fight as hard for working class families as you do for those who are more fortunate". Who could resist?

So if a cut in the payroll tax rate provides economic stimulus by putting more dollars in Americans' pockets, particularly the pockets of working class families, wouldn't a tax hike do precisely the opposite, take money from workers paychecks and provide drag on the economy? Well, of course, it would. Americans like quick fixes, but I'm afraid solving Social Security will require a more elaborate plan than simply raising the tax rate.