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Why Public Sector Union Compensation Matters

e21 | 01/12/2011 |

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Taxpayers, including unionized private sector workers, are becoming increasingly aware of the generous benefits secured by public employees and the way the escalating cost of public employee benefits are compromising business environments across the nation. This political backlash not only threatens the political sustainability of public employees’ compensation schemes, but also risks opening a divide among the labor movement itself as private sector counterparts see the tax implications of public sector largesse as compromising their own employment prospects.

Defenders of public employee unions have fought back to combat these perceptions. They make two basic arguments: (1) the problem is not excessive public sector pensions, but rather inadequate retirement benefits for private sector workers; and (2) current strains on state and local budgets are not caused by excessive spending, but rather by a dramatic decline in revenue resulting from the economic crisis caused by Wall Street. In their telling, the supposed excesses of public employee compensation are a manufactured crisis that disappears once pension benefits are measure relative to historic norms and the cyclical decline in tax receipts are taken into account.

These arguments are unpersuasive. Close analysis of the relevant data make three points abundantly clear: (1) state and local government spending has doubled as a share of the economy over the past 50 years; (2) this spending is increasingly directed away from traditional state and local responsibilities, like roads and local infrastructure; and (3) the recent decline in state and local tax revenue is actually quite modest and not the key driver of the current pension crisis. Moreover, while the terms of public employee pensions may not differ materially from corporate pensions from an earlier era, increases in life expectancy mean the market value of these annuities run into the millions of dollars. Public employee unions are not being made scapegoats for the economic troubles; sober analysis of state and local budgets simply reveals unsustainable compensation expenses that need to be reigned in to restore fiscal sanity.

According to BLS, 7.9 million public sector workers belong to unions, more than the 7.4 million private sector unionized workers. Of these 7.9 million unionized public employees, less than 2.75 million are federal workers. The remaining 5.1 million – nearly two-thirds of the total – are state and local employees. As a consequence, if escalating compensation costs are a main driver of government spending, one would anticipate seeing larger increases at the state and local level.

That is precisely the case. Measured from the end of the Korean War (1953) to the year before the financial crisis (2007), federal spending had actually declined as a share of GDP, from 20.4% to 19.6%. Since the 1960s, federal spending has exhibited no persistent upward or downward trend. Periods of rising federal expenditure have been followed by periods of declining outlays, measured relative to GDP. The federal government has grown substantially over the entire period, of course, but this growth has been roughly in line with that of the overall U.S. economy. By contrast, over the past 60 years, state and local government expenditures have doubled as a share of the economy, from 7.7% of GDP in 1950 to 15.5% in 2009. Since 1950, state and local spending has grown at an 8.1% annual rate, fast enough to double the size of state and local government every 8 or 9 years.

Perhaps this growth might not be so bad, depending on where those incremental expenditures are allocated. If the much higher spending were directed towards improved infrastructure, perhaps it could be considered money well spent. But that’s not the case. Data from the BEA shows that Gross state and local investment – spending on things like roads, hospitals, prisons, highways, ports, and transit systems – has virtually flat-lined as a share of GDP since 1950 while the rest of the state and local spending has increased by 130% since then (see green “Non-investment expenditure” line in graph below). In 1950, gross investment was equal to 26% of all state and local spending. Since 1990, gross investment has fallen to just 15% of all state and local spending.

(Chart 1)

The biggest driver of the increased public sector outlays is Medicaid spending. A close second is all-in employee compensation, especially pension funding. This is often not readily apparent because compensation costs are often hidden in political attractive accounts. Only four states fully exclude pension funding costs from their education spending totals, allowing the rest to claim larger pension funding burdens as boosts to education spending. Most states lump pensions in with “all other” expenditures, which is now the largest state budget category, equal to more than one-third of all state spending. The state of California saw its pension funding costs double from $2.4 billion per year to $4.8 billion from 2003 to 2009. The city of New York has seen its pension obligations triple over the same period.

Would this cost growth be sustainable if revenues had not fallen as a result of the economic crisis? No. In fact, the decline in state and local tax revenue (as of year-end 2009) had actually been much less dramatic than the fall in federal revenue. The chart below scales 1999 tax receipts-to-GDP to 100 to allow for direct comparisons between changes in federal and state and local tax revenue in the subsequent decade. Federal taxes as a share of GDP in 2009 were 14.8%, or just 75% of their level in 1999. While much of this is attributable to policy changes, the 20% decline since 2007 was virtually all economic. Conversely, 2009 state and local receipts are almost exactly the same as the level that prevailed in 1999 – 8.97% of GDP compared to 8.98%. Measured relative to GDP, the fall in state and local revenues from 2007 was only 3%. In short, the argument that the state fiscal crisis is caused by a collapse in revenues is false. Even the windfall revenues at the peak of the economic cycle were insufficient to keep pace with spending growth.

(Chart 2)

Finally, it is worth taking a moment to consider the argument that pensions are only excessive relative to the dramatic decline in corporate defined benefit plans, or that pension opponents pick extreme, unrepresentative examples to make their case. While much of the attention on pension excesses tends to focus on oddities, like the City Manager of Bell, California who is set to retire to a $1 million annual pension, a closer look at more modest public sector pension packages reveals the systemic nature of the problem.

Consider the most basic standard benefit formula in California: 50% of an employee’s highest final salary starting at age 55 (the pensions for firefighters, police, highway patrol, and others are considerably more generous). According to the Social Security Actuary, life expectancy at 55 is about 28 years. Assuming the public employee earns twice the average national wage, his or her annual retirement benefit would be $41,335 in 2009. This benefit is indexed for inflation.

(Table) High Cost of Public Pensions

It is difficult to ascertain precisely the market value of this benefit without knowing risk premiums charged by private sector financial institutions to account for the chance that the retiree will live well beyond 83 (longevity risk), as well as the cost of the liabilities issued to fund the benefit (market risk). The table above provides an estimate of the cost to the government of providing the annuity for 28 years. Based on the assumptions listed in the table, the present value of the benefits is $879,661, with the true market value likely much greater. How much would a similarly-situated private sector worker have to save over his or her 25 year career to fund a similar package? Based on the same interest and inflation rate, it would require average annual contributions to a pension fund of $12,032.69 per year. While this only accounts for 15% of the worker’s final salary of $82,000, the bulk of the contributions to fund a 2009 pension would have come in the distant past, when annual earnings were much lower. In 1984, a salary of twice the national wage was $32,270, which means $12,032.69 would equal 38% of the worker’s pre-tax income. In all, funding the same pension would require defined contributions equal to 23.5% of the worker’s pre-tax income. This suggests that this pension benefit is likely to be two-to-three times greater than what a private sector worker with a similar lifetime income could expect to receive in retirement.

As Bill McGurn points out in a recent Wall Street Journal column, public sector unions don’t just have to worry about a taxpayer revolt. They also must be concerned about a mutiny among private sector unions. Private sector unions with insight into corporate balance sheets and market competition recognize that $1 million pensions are unrealistic burdens to place on employers. Attempts to change the subject and blame “corporate greed” simply do not resonate. Put simply, it is difficult to conceive a way to address the current – and projected – state fiscal crisis without dramatic reductions in state and local employee benefits.


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