California's Budget Grades Show Conflict Between Today’s Costs, Yesterday’s Promises

Thursday, March 8, 2018

This article by Sarah Anzia, William Glasgall, and Sarah Swanbeck was originally posted by Bond Buyer March 7, 2018.

After California’s sale of $2.2 billion in general obligation debt on Tuesday, the lean days of a decade ago, when the Golden State paid some bills with IOUs and almost tripled its GO borrowings, have faded into memory. The world’s eighth-largest economy and its revenues and credit ratings have all bounced back smartly from the Great Recession.

Investors have greeted the recovery by pushing the penalty California pays over AAA-rated municipal debt maturing in 10 years close to its lowest level in two years, according to Bloomberg index data. At about 15 basis points over top-graded bonds, the yield spread on the state’s general obligations is about a quarter of its level of 2013 and a third smaller than that paid by Michigan, which, like California, carries an AA-minus grade from S&P Global Ratings. (A basis point is 1/100th of a percentage point.)

Yet California still faces daunting fiscal challenges, as outlined in Governor Jerry Brown’s 2019 budget, his last before leaving office on January 1, 2019.

The next governor will inherit an uncertain economic landscape: About $67 billion in deferred infrastructure maintenance; $76 billion in general obligation debt; changes in the federal tax code that will penalize many high-tax states such as California; and at least $174 billion in unfunded public-worker pension liabilities. Coping with these challenges will be especially difficult if the current U.S. economic recovery, the third-longest since the 1850s, should falter.

The Volcker Alliance, a New York-based nonprofit organization founded by former Federal Reserve Chairman Paul A. Volcker, in cooperation with the Goldman School of Public Policy at the University of California, Berkeley, analyzed California’s budgets for fiscal 2015 through 2017 as part of the Alliance’s recently published 50-state study, Truth and Integrity in State Budgeting: What Is the Reality? The study’s findings suggest that while California is reasonably prepared to withstand any future recession, it will still struggle in a downturn. And even in a growing economy, the state will have difficulty delivering essential public services, especially infrastructure, classroom education, and MediCal (the local version of the federal-state Medicaid program), while also meeting legacy costs built up over the decades.

Taken together, spending on MediCal, debt service, pensions, and other post-employment benefits (OPEB) such as retiree health care already consumes almost 30 percent of the state’s general fund, according to S&P Global, the credit rating firm. While that is less than comparable spending by fiscally stressed states such as Oklahoma, Pennsylvania, and Illinois, it still may not be sustainable for the long term.

Already, these rising costs are crowding out spending on essential public services and important investments for the next generation of Californians. For example, Brown estimates that the state has close to $187 billion in unmet infrastructure needs. Public higher education investment has also suffered: while state spending on pensions and OPEB have gone up 83% since 2011, state spending on for the University of California and California State University have increased only 27%.

Cities, too, are struggling with rising pension and OPEB costs – new research at the Goldman School finds that increases in pension expenditures by local municipalities from 2005-2014 were associated with employment reductions as well as reduced capital outlays. Moreover, the research finds that these effects are more pronounced in states that require collective bargaining and have strong public-sector unions.

The Alliance’s California Budget Report Card, one of 50 such state assessments released in recent weeks following the publication of the Truth and Integrity study, awarded California top A grades, on average, in three of five areas studied — reserve funds (a category Brown has pledged to continue fortifying in 2019); budgetary transparency (for example, California discloses the cost of deferred infrastructure maintenance); and budget maneuvers. Notably, over the three years evaluated, California was free of one-time revenue actions to pay for recurring expenditures and achieve budgetary balance, save for the use of some reserve funds in 2017.

In some areas, however, California could do better. The state received a C in the category of legacy costs, because it has not set aside what state actuaries say is the full cost of funding public worker pensions and OPEB. The California Public Employees’ Retirement System, for example, is only 68% funded—and that figure is based on what most finance experts agree are overly optimistic actuarial assumptions. With Governor Brown warning of “darkness, uncertainty, decline and recession,” and as fiscal pressures mount, transparent and sustainable budgetary practices only become more important for investors and the entire citizenry.

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