California Voters Approve Tax Increases for Public Services, But Pension Payments and Debt May Eat the Money

Despite holding the record for the highest state sales and personal income taxes in the nation, many cities throughout California continue to feel the need to request additional increases from taxpayers, as evidenced by 254 local governments asking for tax hikes on last November’s ballot. Officials typically contend these changes are earmarked for expansions in public services, but municipal budgets show a clear trend pointing to rising pension costs as a major driver behind these tax increases.

Like most other public pensions plans across the country, the California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the country, saw a dramatic ramp-up in unfunded pension liabilities in the wake of the Great Recession. In part, this was caused by a failure to meet CalPERS’ investment targets and the resulting decline in the value of plan assets. Having been fully funded as recently as 2007, by 2017 CalPERS was only 71 percent funded and had $144.6 billion in unfunded liabilities. Policymakers and stakeholders are rightly concerned about the rapid decline in the plan’s solvency.

A pension system with a low funded ratio and high unfunded liabilities should be disconcerting to stakeholders for a few reasons. First, any plan that is less than 100 percent funded holds pension debt that requires expensive financing in the form of amortization payments. Second, carrying pension debt means future taxpayers must eventually pay for today’s public sector retirement benefits. Third, the funded ratio is likely to fall further and the unfunded liabilities grow if there are any negative market fluctuations, such as a financial crisis or recession.

As of June 30, 2017, CalPERS had just 71 cents for every dollar needed to fully fund the retirement benefits promised to public employees. This poses a number of issues. Most significant is that the nearly $145 billion shortfall was not available to be invested during the last decade of prolonged economic recovery. Properly funded pension plans funded over at 100 percent during good financial markets help provide adequate cushion for the downward cycles that are sure to come. If we experience a recession in the coming years, as nearly all experts predict, CalPERS will enter that declining market from a poorly funded position. Instead, CalPERS has a policy of amortizing the repayment of these debts over 30 years, which means that approximately $10 billion in interest — which must eventually be paid back — accrues each year.

The California Public Employees’ Pension Reform Act (PEPRA), approved in 2012, was the first step policymakers took towards starting to tackle the CalPERS systemic issues. However, it only covered a fraction of the 12-point pension reform plan released by Gov. Jerry Brown in 2017. Since then, CalPERS itself has taken a number of important steps to de-risk and modify actuarial assumptions in order to convey a more accurate accounting of pension debt, such as phasing in a gradual reduction in the system’s assumed rate of return from 7.5 percent to 7 percent over the next few years.

These changes have collectively been prudent steps to improve CalPERS’ solvency, but they also bring higher employer contribution rates. These increases are a result of adopting more conservative actuarial assumptions (to reduce exposure to market risk) and making supplemental contributions for the next 20 years to start paying down the current unfunded liabilities. Given the significant planned escalation in CalPERS contribution rates over the coming years, it should be no surprise that over 200 local governments sought tax hikes through either the legislative or ballot process to help make these contributions.

“With local pension costs outstripping revenue growth, many cities face difficult choices that will be compounded in the next recession […] Cities have two choices – attempt to increase revenue or reduce services,” the League of California Cities reported in January, before CalPERS’ summer rate increases.

However, despite the obvious increase in pension costs, policymakers tend to say that tax increases are intended to provide new public goods and additional services. “My residents don’t feel safe, and this is to hire more cops,” Garden Grove Councilwoman Ellery Deaton said of the 1 percent sales tax increase approved by voters in November. The city has battled a persistent and growing structural deficit—one likely to get worse in the upcoming years—prompting city officials to seek new revenue sources.

But not everyone is buying this messaging. Carolyn Cavecche, president of the Orange County Taxpayers Association, said ballot statements for local sales taxes tend to “list all these incredible things the money will go to – hiring police officers, infrastructure, addressing homelessness, clean drinking water. Dang, who can argue with any of that?” Public services and infrastructure may be the stated purpose of higher taxes in many jurisdictions but growing unfunded liabilities and the resulting increases in pension contributions are likely to take up a large part of that revenue.

According to Garden Grove’s most recent budget, the city’s annual contributions to CalPERS will be approaching $65 million by fiscal year (FY) 2024-25, more than three times the city’s $20 million pension contribution in FY 2016-17. The estimated 2025 contribution would require 37 percent of today’s total expenditures for the city of Garden Grove, far exceeding the 16 percent of the budget currently dedicated to pension costs.

This tax was presented as a revenue boost for new hires and road improvements, but the additional funds go into the city’s general fund, which is used for general government purposes. Voters can support increases for a variety of reasons, “but then the taxes go into the black hole of the general fund, where they become the new baseline,” according to Cavecche.

Similarly, the city of Roseville has struggled to balance its budget for years. The city budget for FY 2018-19 is balanced, due, in part, to service reductions prompted by an operational deficit in the general fund. “Since the Great Recession, we’ve been successful at closing the budget gap in ways that haven’t been too noticeable to the public, particularly through labor costs,” explained City Manager Dominick Casey. “But we’re at a point now where budget cuts will be increasingly noticeable in our community.”

Despite steady annual revenue growth, the city is facing a structural budget deficit of $4.2 million for FY 2019-20 that will grow to nearly $6 million by FY 2022-23. Roseville’s budget does not address a range of long-term liabilities, including maintenance, pensions, and retiree health benefits. If Roseville were to fully fund its long-term liabilities, the budget deficit would reach almost $14 million per year. However, city leaders continue to decry a “slowing increase in sales tax” as the primary reason for ongoing budget shortfalls. A closer look at the city’s CalPERS valuation reports paints a different picture.

With over $337 million in unfunded pension liabilities, the city’s annual required debt payments continue to rise at an alarming rate. Without the increased debt payments due in FY 2018-19 Roseville would have actually had a budget surplus. By FY 2022-23 the city’s CalPERS annual debt payment will increase $9.8 million from the FY 2018-19 payment. Again, absent the increase in debt payments the projected deficit would likely be a budget surplus. Roseville policymakers painted a grim outlook of severe budget cuts to residents – carefully avoiding any discussion of pension costs – who approved a half-cent sales tax increase in November.

Another example comes from the heart of the Central Valley, where policymakers for the City of Fowler have adopted a different approach to addressing its budget concerns. In a refreshing contrast to other cities seeking tax increases throughout California, Fowler took a more transparent approach in framing its rationale. Voters ultimately approved a 1 percent sales tax to help generate over $950,000 annually through a new sales tax to tackle an “escalating pension obligation,” among other things. Although the city’s budget for FY 2017-18 includes a modest surplus of almost $18,000 dollars, employer benefits payments consume 20 percent of the $4.27 million budget.

Larger cities across California are no exception and are also selling tax increases as ways to pay for services as they face growing benefits payments. “We have great aspirations in the city, but limited tools to achieve it,” said Sacramento Mayor Darrell Steinberg. “If we can go to the tax base, if we can create more jobs, create more revenue for police, fire and parks.” Notwithstanding Sacramento’s $487.9 million budget, which represents a 6.2 percent increase from the previous year, expenditures are scheduled to exceed revenue starting within the next five years despite the city’s proactive attempts to balance between efficiently delivering services and looking for opportunities to cut costs wherever possible. The pension costs are projected to be $134 million in FY 2024-25, which would mark a $66.9 million (or 99.6 percent) cost increase from FY 2017-18.

Local leaders would love for tax increase initiatives to go towards expanding public services. But with unfunded pension liabilities and mounting pension payments due to the needed increase in the contribution rate schedule, as set by CalPERS, within five years most of the additional tax revenues raised by these increases will likely be needed to be diverted to pay for rising pension costs. Although cities are actively working to balance lowering costs with providing enough services, pension contributions are going to continue to apply financial pressure on cities and counties that are already struggling to balance meeting pension obligations with providing public services.