STANFORD – While central governments’ fiscal problems plague many economies, a parallel crisis is enveloping many subnational governments around the world. From Spain to China to the United States to Italy, these governments – regions, states, provinces, cities, and towns – face immense fiscal challenges. Higher levels of government are “on the hook” to bail out local insolvent governments, and may even suffer bond downgrades as a result; in Spain, Italy, and China, that role falls to the national government, and for US cities and towns, to their states.
There are many similarities within and among countries in terms of the nature and causes of these local fiscal calamities. Local officials used growing revenues during the boom to fund pet projects or boost pay and benefits, with little regard to future costs. In the downturn, revenues and subsidies from the central government collapsed and the bills came due. Creative accounting gimmicks masked the full extent of the problem. Now comes the reckoning.
To finance local businesses, Chinese local governments use local-government financing vehicles (LGFVs) to circumvent bans on direct borrowing. In Spain, housing and employment collapses have hammered revenue. Rumors of an imminent default swirl around Sicily, whose governor has resigned as borrowing soared after cutbacks from Rome. A new report from a task force co-chaired by former Federal Reserve Chairman Paul Volcker indicates that unfunded pension and health-care costs make many American states’ medium- and longer-run fiscal prospects bleak.
California’s fiscal crises may also provide lessons for subnational governments around the world. Three California cities have recently declared bankruptcy: Stockton, the largest American city ever to do so; San Bernardino, the second-largest bankrupt city; and Mammoth Lakes. Compton is rumored to be next; most observers expect more to follow.
The state faces another large budget deficit, yet Governor Jerry Brown’s budget this year includes a substantial spending increase. Brown’s ballot initiative this November would raise California’s top personal income-tax rate to 13.3%, the nation’s highest. According to Brown, the tax hike would be temporary, yet it would last seven years. Meanwhile, he claims to be tough on California’s notoriously well-paid and powerful public-employee unions by negotiating a 5% pay cut. But the details reveal a net 1.6% pay cut in exchange for a 5% reduction in work hours.
Cities are declaring bankruptcy to escape the pressure of exponentially rising pension and health costs. In contrast to the state, cities have even cut back essential services, including 20% reductions in police and fire personnel.
Bankruptcy should allow local governments to renegotiate their bond debt and, perhaps, their retired employees’ pension and health-care costs (that’s up to a bankruptcy judge). The state would be expected to take over essential public services from bankrupt local governments. But the state itself is in dire financial straits; one of the cities’ problems is the sharp curtailment of state funds to localities.
Despite these problems, Brown has committed California to a San Francisco-to-Los Angeles high-speed rail boondoggle. To get the cost projections down to $68 billion from a $100 billion estimate, some existing low-speed rail will be used, likely doubling the time it takes to travel from Los Angeles to San Francisco to 5-6 hours. California will most likely be unable to pay for the entire project, leaving little use for the first segment in the sparsely populated Central Valley. And, if the project somehow is completed, it will be a not-so-high-speed rail that will drain badly needed resources from other essential government services for many decades.
These sorry episodes reveal some important lessons. One-party government weakens accountability and breeds hubris. The California legislature has been controlled by the Democratic Party for decades, and it takes its cue from its party’s most powerful special interests: public-employee unions, environmentalists, trial lawyers, and teachers’ unions.
They have concocted an extremely progressive social experiment: with 12% of the US population, California has more than 30% of its welfare dependents. From the mid-1980’s to 2005, California's population grew by 10 million, while Medicaid recipients soared by seven million; tax filers paying income taxes rose by just 150,000; and the prison population swelled by 115,000.
The state income tax is not only uncompetitively high, but the revenues are volatile. In the economic and stock-market upswing, revenues roll in far more rapidly than incomes rise, owing to the extremely progressive income tax (in good years, the top 1% pays about half the state’s income taxes).
The legislature spends it as if the elevated revenues will continue forever. Then the inevitable recession and stock-market collapse plunges the state into crisis. The progressive social experiment has gone so severely off-track that the state cannot even dependably provide essential services, from courts to education, for the most needy.
Not surprisingly, California’s economy, which used to outperform the rest of the US, now substantially underperforms. The unemployment rate, at 10.8%, is almost one-third higher than the national average, and higher than every other state except Nevada and Rhode Island.
California still has great strengths in technology, entertainment, and agriculture. But citizens and politicians alike must agree to target services far more carefully; reform the tax system with lower rates on a broader base of economic activity and people (almost half pay no state income tax); and modernize inefficient state programs to spend less and produce far better outcomes. Not coincidentally, that’s a perfect prescription for bloated, debt-ridden central and subnational governments worldwide.