Debt and Unfunded Liabilities

When conversations come up regarding government debt, the focus is usually on the national debt. The $34 Trillion national debt (not to mention the $80 trillion in unfunded obligations from Social Security and Medicare) is crucial to understand, but that often means debts incurred by state and local governments stay out of the limelight. 

State and local governments owe trillions of dollars in debt as well. As Jon Miltmore eloquently explained, the national debt represents a significant cost to taxpayers. State and local government debt is no different. 

When looking at state and local debt, there are two types of debt to consider: bonded obligations and unfunded liabilities. Understanding these two types of debt and how they are measured reveals the true cost to taxpayers, especially future generations. 

Bonded obligations are the debt commonly associated with “public debt.” States and municipalities issue bonds for various purposes, bond investors purchase the bonds, and the government pays the bond investors back with interest using taxpayer dollars. These debt payments can be tracked in state and local financial reports and by the Municipal Securities Rulemaking Board (MSRB).According to calculations by the Securities Industry and Financial Markets Association (SIFMA) state and local governments owe a total of $4 trillion (about $12,000 per person in the US) in outstanding bonded obligations.  

As described by economist James Buchanan, when a government takes on debt, it shifts the tax burden from the present to future generations. Taxpayers in the present enjoy the increased spending without a tax hike. Although bond investors buy bonds, they can expect to be paid back with interest. Future generations are the ones paying for the past spending with a “genuine sacrifice” to their income. 

A liability for a public pension or other post-employment benefit (OPEB) plan is a benefit promised to public employees (such as a pension or retiree health insurance) that is expected to be paid out when that public employee retires. When benefit plan assets (made up of contributions from employees, taxpayer dollars, and investment returns) are less than total promised benefits, the remaining promised benefits are considered “unfunded liabilities.” Totaling up these unfunded liabilities is more difficult than determining total bonded obligations. 

How Much Do States Owe in Unfunded Liabilities? Depends on Whom You Ask 

To determine whether or not a benefit plan has unfunded liabilities, one must calculate the present value of the total liabilities. The present value shows the value today of those promised benefits in the future, which depends on the discount rate. The higher the discount rate, the lower the present value, and vice versa. The present value of those promised benefits is also sensitive to discount rate changes. Even if the discount rate is changed by fractions of a percentage point, that could result in the present value of unfunded liabilities changing by millions of dollars. 

Debate continues over which discount rate to use when measuring the present value of promised benefits. Under current government accounting standards, plans are allowed to measure the promised benefits covered by plan assets using a high discount rate (based on a plan’s assumed investment rate of return) and the unfunded portion of promised benefits using a low discount rate (based on the yield curve of tax-exempt municipal bonds). These two discount rates are then averaged to get a plan’s “blended discount rate.” According to the American Legislative Exchange Council, the average pension plan used a discount rate of 7.17 percent for Fiscal Year 2022. 

On the other hand, others, such as Joshua Rauh, Eileen Norcross and Daniel Smith, and Jonathan Williams and I have argued that using a lower discount rate would provide a more accurate measurement of unfunded liabilities based on the yield curve of US Treasury bonds.  

This lower discount reflects the inability of states to back out of pension promises, known as a risk-free liability. Every state has legal protections for public pension benefits whether through common law, state statute, judicial precedent, or even state constitutional amendments. This means that many states will still be required to pay out pension benefits, even in the event of a fiscal crisis. For OPEB plans such as retiree health insurance, legal protections vary but it is safe to assume that a state will be expected to keep the promises it made to public employees. 

The disagreement over discount rates means that unfunded pension liability estimates range from $1.35 trillion (about $4,200 per person in the US) using government accounting assumptions to $6.96 trillion (about $21,000 per person in the US) using a risk-free discount rate. Unfunded OPEB liabilities range from $655 billion (about $2,000 per person in the US) using government accounting assumptions to $959 billion (about $3,000 per person in the US) using a risk-free discount rate.

No matter how you measure unfunded liabilities, they stress state and local budgets and signal painful future tax increases just as much as bonded obligations. As government debt rapidly grows at all levels of government, policymakers and taxpayers will no longer be able to ignore them.  

So, What Happens When State Governments Fail to Pay Debts? 

When a state cannot pay its debts, it is highly likely that lawmakers in that state will first try to get a bailout from Washington and make the state’s fiscal woes a burden for every American. This is exactly what state lawmakers in Illinois attempted in April 2020. Just a few short weeks after the CARES Act passed, members of the state senate and the Senate President mailed a $46 billion federal bailout request to Congress. As Wirepoints Illinois reported, most of the requested funds “amount[ed] to a national bailout of Illinois’ pre-pandemic failures.” This included $15 billion for a “no-strings-attached block grant,” $6 billion for the state unemployment trust fund, $10 billion for state pensions, and $9.6 billion in “unrestricted aid to Illinois municipalities, again for pensions.” Since receiving federal funds from these various programs, Illinois has not made any improvements to its fiscal condition, boasting the worst credit rating among the 50 states. 

As Peter Earle discusses, trying to predict when a state fiscal crisis will occur is a futile endeavor, but showing the consequences of runaway debt can be an effective strategy. When states can no longer pay their debts, it is likely that state lawmakers’ first move will be to head to Washington, hoping to shift the burden to taxpayers around the country.