How to Reduce the California State Budget by $40 Billion

As of a few days ago, high-wage earners have a new reason to leave California: their state income taxes are no longer deductible on their federal income tax returns. Can California’s union-controlled state legislature adapt? Can they lower the top marginal tax rates to keep wealthy people from leaving California? The short answer is, no, they cannot. They cannot conceive of the possibility that California’s current economic success is not because of their confiscatory policies, but in spite of them.

Comparing Federal and California State Retirement Exposures

Californians may be accustomed to living with the specter of a public pension crisis. But the federal government’s problem with its retirement system – including Social Security – is far worse, and yet none of the three remaining major-party candidates for president has a plan to do anything about it.

The California Policy Center generally focuses on state and local issues. But with just days left before California’s June 7, we offer this comparison of California and federal exposure to pension liability.

State Retirement Expenditures

According to the governor’s May Budget Revision, the state will make a total of $8.1 billion in pension contributions during the 2016-2017 fiscal year. This amount represents a sharp increase from the current fiscal year level of $7.1 billion and fiscal 2014-2015 contributions of $6.3 billion. (These numbers exclude Other Post Employment Benefit payments.)

The rapid increase is attributable to lackluster stock market performance, more conservative actuarial assumptions implemented by CalPERS and a teacher’s pension reform that increased the state’s responsibility for CalSTRS. However, even the newly increased contribution levels are unlikely to resolve chronic underfunding in both CalPERS and CalSTRS because these two systems assume a 7.5% annual rate of return, which seems unrealistic in today’s slow growth, low interest rate economy.

Figures 1 and 2 provide a longer term perspective on the growth of state pension costs. These graphs go back to the 1999-2000 budget year when the governor signed SB 400, a bill that provided a large, retroactive increase in pension benefits. In that year, pension contributions were only $1.2 billion.


Figure 1


Figure 2

Because of inflation and the growth of the state economy, it may be more helpful to look at state pension contributions in relation to some broader economic indicator. In previous CPC studies, we have shown pension costs as a percentage of overall government revenue – identifying a number of California cities and counties that devote over 10% of their income to retirement plan contributions.

The state’s position is much better than that of the most burdened counties and cities. In 2014-2015 (the last year for which audited financial statements are available), $6.3 billion of pension contributions represented 2.29% of total state revenues – including general fund revenue, other governmental fund revenue and business type activity revenue – which totaled $276 billion. We project that this ratio will rise to about 2.76% in 2016-2017.

For those interested in general fund statistics only, pension contributions accounted for 5.57% of general fund revenue (on a budgetary basis) in 2014-2015 and are projected to rise to 6.49% in 2016-2017. These ratios overstate California’s pension burden, because many employees are compensated with resources outside the general fund.

On the other hand, some California state spending effectively subsidizes pension costs incurred by city, county, school districts and special districts. For example, most of the state’s $87.6 billion education budget for 2016-2017 will be distributed to local educational authorities, which will use some of these funds to make employer contributions to public employee pension systems.

As Ed Ring reported in a recent CPC study, total California government employer pension contributions in 2013-2014 were $21.2 billion. While only one quarter of this total was directly paid by the state government, some portion of the local government share would not have been made in the absence of state aid payments.

Ring’s report also offers some insight into how much state pension contributions would have to rise if more realistic return assumptions were used.  For example, if pension funds used a 5.5% return assumption, pension fund contributions would have to triple from current levels.

Social Security

The vast majority of federal retirement expenditures take the form of Social Security benefits. Because most American workers are eligibility for Social Security, the program is quite large. In the current federal fiscal year, Social Security expenditures are projected to be $911 billion or just over 27% of federal revenues. About 83% of these costs take the form of retiree and survivor benefits, 16% goes to disabled workers and under 1% covers administrative expenses.

Each year, the Social Security Board of Trustees publishes an actuarial report. The report includes short- and long-term projections, with an emphasis on the status of the Social Security trust fund. The latest report shows that the trust fund contained about $2.8 trillion in assets at the end of calendar year 2014. The report also projects that the trust fund will be exhausted in 2034 based on a set of intermediate cost assumptions. The report also includes projections based on two alternative scenarios: one reflecting higher-cost assumptions (such as greater longevity) and lower cost assumptions. Under the high-cost scenario, the trust fund would be exhausted by 2030, while under the low-cost scenario the trust fund maintains a positive balance throughout the report’s 75-year projection horizon.

Although discussion of Social Security often revolves around the trust fund, this emphasis is misplaced. Unlike CalPERS or CalSTRS, the Social Security trust fund does not contain real assets. Instead, it holds special-issue U.S. Treasury bonds. Since the trust fund is part of the federal government, its assets are merely IOUs issued by its owner. The situation is analogous to an individual removing money from his piggy bank and replacing it with a note showing the amount he plans eventually to put back.  This may be a good commitment device, but any financially knowledgeable third party would not consider the note a meaningful asset.

One might argue that the Treasury bonds in the trust fund represent a claim on federal assets, but as shown in its latest audited financial statements, the federal government has a negative net position. Total federal assets of $3.2 trillion are easily exceeded by $13.2 trillion of federal debt securities held by the public and $8.2 trillion of other liabilities. So the IOUs held by the Social Security trust fund compete with claims held by many external parties for a relatively small pool of federal assets.

While the trust fund assets are not economically meaningful, they do have a legal significance – but even that is less than meets the eye. Under current law, if the trust fund is exhausted, benefit payments must be immediately reduced so that they are equivalent to Social Security revenues, which mostly derive from Federal Insurance Contribution Act (FICA) taxes paid by employees and employers. Under the trustee’s intermediate scenario, benefits would fall to 79% of the then-current level when the trust fund is exhausted in 2034.

However, this sudden, sharp reduction is extremely unlikely. Given the large number of Social Security recipients, the high voting propensity of older voters and the power of AARP, the benefit cut would almost inevitably be reversed, with additional costs borne by the general fund. There is a recent precedent for general fund transfers of this type: when Congress temporarily reduced FICA taxes in 2011 and 2012, the loss of trust fund income was offset by general fund transfers.

Rather than view Social Security through the trust fund prism, its fiscal impact is better understood in terms of its net impact on the consolidated federal budget. In other words, we should look at the difference between Social Security revenues and expenditures. The trustee report includes interest on the Treasury bonds held by the Social Security trust fund, but this notional income should be disregarded: the interest is paid and received by the same entity, the federal government.

Figure 3 shows Social Security’s net cash flow in constant dollars back to 1957. Projected revenues are depicted by three lines, with shaded areas in between. The middle line reflects the trustee’s intermediate assumptions, with the low cost and high cost scenarios shown by the lowest and highest lines respectively. As the chart shows, program revenues and expenditures were roughly equal for the first three decades. Between the late 1980s and the last decade, revenues exceeded expenditures, often by large margins. In the late 1990s, this surplus helped balance the federal budget; later, it offset budget deficits that developed under the George W. Bush Administration.


Figure 3

Increased disability insurance claims associated with the Great Recession and the beginning of baby boomer retirements ushered in a series of negative net balances beginning in 2010. These deficits are expected to continue under all three trustee scenarios, and to become quite large under the intermediate and high cost assumptions. By 2040, the shortfall reaches $371 billion under the intermediate scenario and $610 billion under the high cost scenario – in 2015 constant dollars.

Unprecedented deficits of this magnitude have very serious implications for the federal budget, especially when combined with escalating Medicare and Medicaid costs. Last year, the Congressional Budget Office projected that the ratio of publicly held debt to GDP will increase from 74% currently to 107% by 2040.

Federal Employee Retirement Programs

The federal government also has a large number of employees and retirees eligible for defined pension benefits. According to its latest annual report, the Civil Service Retirement and Disability Fund, paid $81 billion of retirement benefits in fiscal year 2015, or 2.49% of federal revenues. The system reported an Unfunded Actuarial Liability of $804.3 billion and Assets of $858.6 billion, implying a funded ratio of only 51.6%. Further, the fund’s assets are almost entirely invested in U.S. Treasury securities. Similar to the Social Security Trust Fund, the economic meaning of these investments is questionable.

The Defense Department also provides retirement benefits. The latest available actuarial report shows $54.8 billion of benefits paid in fiscal year 2013 and a 35% funded ratio. Last year, President Obama signed a Defense Authorization Bill containing a military pension reform. Instead of a straight defined-benefit plan, new recruits joining the armed forces after January 1, 2018 will be placed in a hybrid plan containing a 401(k)-style component with an employer match. The defined benefit component will remain, but will be reduced by 20%. This reform should improve the program’s funded ratio, but won’t reduce military pension costs by very much – if at all. Under the current system, service members must remain in the military for 20 years to become eligible for pension benefits. Vesting in federal matching payments under the new defined contribution plan will begin after two years.

Comparing the Federal and State Governments

Overall, the federal government has much greater exposure to pension costs that does the state of California. Civilian and military pension benefits consume a proportionately larger amount of the federal revenue than the share of total state revenue absorbed by CalPERS and CalSTRS contributions. Further, the federal government is responsible for providing most American workers pension benefits through Social Security, which absorbs more than a quarter of federal revenue and has an inadequate level of pre-funding, even if one considers Treasury securities to be an acceptable investment vehicle for a federal retirement system.

That said, it is worth considering some advantages the federal government has relative to the state in dealing with pension costs. First, the U.S. constitution does not provide a right to accrued benefits. In an emergency, Congress and the president could cut or terminate benefits to Social Security recipients, federal civilian retirees or veterans. This is not the case for the state of California.

As Alexander Volokh points out: “In California, when a public employee begins work, he not only acquires a right to the pension accumulated so far — presumably zero on the first day, and increasing as he works longer — but also the right to continue to earn a pension on terms that are at least as generous as the ones then in effect, for as long as he works. And if pension rules become more generous in the future, then those more generous terms are the ones that are protected.”

As I discussed earlier, I do not expect Social Security benefits to be reduced when the trust fund runs out, so the fact the Social Security recipients do not have access to the courts may be a distinction without a difference.  But it is still true that the federal government has a tool for reducing benefit costs – especially during a fiscal emergency – that is not available to the state.

Further, there is a widespread belief that the federal government is less vulnerable to a fiscal emergency than California because it has access to the printing press. In other words, if the federal government cannot obtain enough tax revenue to pay retirement benefits, it could do so with newly created money.

While this is a fair distinction, it comes with a couple of caveats. First, at the national level, money creation has become the role of the Federal Reserve, which has some degree of political independence.  Strictly speaking, the president cannot order the Fed Chair to create money. Second, U.S. state and local governments have been able to create circulating IOUs in the past. During the Depression, numerous cities issued scrip, while, in 2009 the state issued IOUs to vendors amidst a budget crisis. These IOUs were eventually traded on a secondary market.

These caveats notwithstanding, it is true that a central government controlling an international reserve currency does have more fiscal flexibility than a state which is legally obligated to balance its budget each year. So the federal government’s ability to absorb pension obligations is greater than California’s. This is fortunate, because the federal governments exposure is so much greater.


We have seen that both California and the federal government face high and rising pension costs, and that each has not fully accounted for these obligations. The drivers of these problems are similar, and are duplicated throughout much of the developed world:  retirement of the large baby-boom generation, increased longevity and a failure of political institutions to deal effectively with long-term problems.

While the specific policies to improve pension sustainability differ across jurisdictions, the basic ideas are similar. These include:

  • Paring back benefit levels, especially for the most highly paid, most affluent beneficiaries.
  • Increasing retirement ages and then indexing them to longevity.
  • Increasing employee contributions.
  • Replacing deceptive accounting techniques and rosy actuarial assumptions, with conservative, fact-based financial reporting.

Finally, libertarians and fiscal conservatives working on these issues should re-evaluate their tactics. In 2005, George W. Bush’s strategy of using the impending Social Security crisis to justify a partial switch to personal accounts was roundly rejected by Democrats and Republicans alike. While many of us in the public-sector pension reform community like the idea of 401ks, we need to understand that employees – especially those who are risk-averse or financially unsophisticated – prefer defined benefits. Rather than attacking defined-benefit plans, we should try to fix these plans so that they don’t bankrupt the governments that offer them.

Government Unions Need Property Tax Increases to Fund Unsustainable Pensions

Let’s be honest.  When politicians and pundits discuss the state budget, very little is about the impact on homeowners. Notwithstanding the fact that a person’s home is their most important asset, this lack of perspective is understandable. When people think about political issues impacting their status as homeowners, they are far more likely to focus on local taxation – fees for utilities, parcel taxes, local bond debt, etc.

But state finances in California can – and do – have a profound impact on one’s status as a homeowner and, unfortunately, it is rarely in a good way. First, homeowners should be aware that there is no bright line between local governments and the state. State laws on school finance, redevelopment, law enforcement, natural resources and transportation have a huge impact the budgets of cities, counties and special districts.

Take schools, for example. Because of California Supreme Court rulings in the 1970’s, local school districts have lost a great deal of local control over their budgets. (Contrary to urban legend, loss of local control had very little to do with Prop 13). Much of K-12 funding now comes from the state. And the amount of that funding has a lot to do with whether a local school district is “rich” or “poor.”

The complexity of the relationship between state and local governments leads some to tune out issues about the budget believing that it is not relevant to their lives. That would be a big mistake. Homeowners should be aware that this year’s proposed budget reflects a significant five percent increase over last year. Not only has state spending increased every year except one during the recession, that spending has gone up 30% in five years. California now has a $113 billion general fund budget and that doesn’t even include special funds and money from the federal government.

One of the driving forces behind higher state spending is an effort by Governor Brown and others to corral the massive obligations to the state’s pension funds and government retiree healthcare. Brown should be applauded for his efforts to reduce debt but some of us can’t help but feel he is trying to remove sand from a beach with a pair of tweezers.  California’s accumulated debt in all forms is staggering.  In a recent piece in the Wall Street Journal, Steven Malanga of the Manhattan Institute noted how unfunded pension costs, not just in California but nationwide, are gobbling up all of the new revenue coming in to state and local governments from the economic recovery and higher taxes.

And some of those tax hikes in other parts of country are huge. But here in California, we already have the highest income tax rate, the highest state sales tax rate and the highest gas tax in America.  In short, the tax and spend lobby is running out of options. So who is the last remaining target?  You guessed it:  Homeowners.

And the only thing standing in their way is Proposition 13.  While other states have some limited protections for homeowners, none are as effective as California’s landmark Proposition 13.

Homeowners need to be on guard.  All those proposals to lower the 2/3 vote on local parcel taxes and bonds repaid only by property owners are just the beginning.  As the demands to make good on California’s hundreds of billions worth of debt become clear, those who are blessed with home ownership need to pay attention, not only to local politics, but to the state budget as well.

Jon Coupal is president of the Howard Jarvis Taxpayers Association — California’s largest grass-roots taxpayer organization dedicated to the protection of Proposition 13 and the advancement of taxpayers’ rights.

Has Sacramento really balanced the state’s budget?

Thanks to Proposition 30 with its retroactive tax increase and an improving economy, the state claims that it has balanced its General Fund budget.  This may be technically correct but ignores some very unpleasant realities.

Claiming to have balanced the budget ignores the growing unfunded liabilities associated with public employee pensions and other unfunded retirement benefits, mainly health care.  This also ignores the fact that the state has fallen behind in maintenance and expansion of its infrastructure.

Ignoring these liabilities is possible because state and local governments in California use cash accounting.  Except for very small companies, private sector businesses are required to use accrual accounting under which increases in liabilities are required to be recorded in profit and loss statements and major assets have to be depreciated with depreciation showing up on the profit and loss statement.

Under cash accounting, only the year’s actual cash outlays are recorded in the budget.  If the state or local government doesn’t make a pension payment, it is not recorded as part of the year’s expenses.  For retiree health care, these expenses typically aren’t even funded. Even though these obligations accumulate indefinitely and are the obligation of future taxpayers, they are not required to be recognized on public agency balance sheets as long term liabilities. Similarly, the cost of  deteriorating roads and other infrastructure aren’t recorded anywhere in state and local governments’ financial statements.  There aren’t any depreciation schedules and the accumulating costs of deferred maintenance and essential expansion of the state’s infrastructure are not recorded.

How bad is this problem?  Until recently, it’s been very difficult to find and summarize these financial problems.  However, as highlighted in a recent Los Angeles Times article by Marc Lifsher, California Pension Funds are Running Dry, there is a new data source thanks to the efforts of the California state controller John Chiang (who was just elected state treasurer).  The Controller’s office has assembled data from 130 state and local pension funds and other data at

The following are two charts from the state controller’s website under the heading “Interesting Charts.” They are annotated to illustrate the problems that should concern us.

Total California Public Pension Fund Assets
Change Between 2003 and 2013


As can be seen on the above chart, statewide defined benefit pension fund assets suffered a loss of 30 percent in the 2008 recession. Five years later, they have not even recovered to their pre-recession values. During this time pension liabilities have continued to grow.  How big is this problem?

Total California Public Pension Unfunded Liabilities (Officially Recognized Amount)
Change Between 2008 and 2013


This second chart, above, shows that during the five year period between 2008 and 2013 the official unfunded liabilities of these defined benefit pension funds has grown 200 percent from $65 billion to $198 billion.  This is almost twice the size of the state’s current year General Fund budget of $107 billion.

Even this total understates the problem.  For example:

(1)  The state’s pension funds assume an investment return of 7.5 percent per year or higher and also assume there will be no recessions such as in 2008.  Single-employer private sector pension funds assume a more conservative rate of return closer to 5.0 percent per year.  California’s unfunded pension liability would increase by another $200 billion or more if a more conservative investment rate of return is used such as 5 percent (ref. “Calculating California’s Total State and Local Government Debt“).

(2)  Retiree health care expenses are largely unfunded but are an obligation for the state’s taxpayers just like pension benefits.  The best estimate we’ve see for unfunded retiree health care is $150 billion, approaching the value of unfunded pension obligations.

(3)  What about infrastructure maintenance and expansion to meet the state’s growth requirements?  The current year’s value of these costs would be reflected as depreciation expenses under accrual accounting that is required for private sector financial statements. In 2012 the American Society of Civil Engineers estimated the current unfunded infrastructure requirement necessary to upgrade California’s roads, bridges, ports, rail, dams, aqueducts and other civil assets at a staggering $650 billion (ref. “2012 Report Card for California’s Infrastructure“).

In addition to these state obligations we can’t ignore unfunded entitlements for federal Medicaid and welfare payments.  These are beyond the scope of this article but add to the problem we’re concerned about, rapidly growing unfunded obligations that will bury future taxpayers and crowd out other essential public spending.

We should also note that state and local government pension systems are not covered by Employee Retirement Income Security Act (ERISA) that single-employer private sector pension plans must conform to.  ERISA has strict requirements for minimum funding of pension plans, defines what is a reasonable rate of investment return in valuing pension fund assets, and dictates actions that must be taken if pension fund assets drop below a certain level.  None of these rules apply to California’s public employee pension funds.  ERISA also requires that pensions be funded during an employee’s working years. The cost of benefits earned today cannot be passed on to future pension fund contributors or taxpayers as can happen with public employee pension plans.

There is also an equity issue.  Should future taxpayers be required to pay for retiree pensions and health care that were earned years earlier?  The earlier taxpayers got the benefit of the public employees services without paying the full cost of these services.  These future costs will crowd out spending on schools, infrastructure, and other items.

Are we anti-public employee for questioning the level of post retirement benefits or their underfunding?  That’s not our intention.  Politicians and unions are not doing these employees any favors by underfunding their retirements.  Future taxpayers will not be able to cover the costs of these underfunded benefits and also maintain the schools, infrastructure, and other government services they need.  There will be a day of reckoning when it’s clear that there isn’t enough money set aside for these obligations and we can’t raise taxes enough to cover the difference.  We’ll be forced to recognize that all our debts and unfunded obligations can’t be met.  There won’t be any winners when this day arrives.  Nationwide, the amounts of unfunded retirement benefits, debts, and entitlements are too large for a federal bailout.

There is also an element of “heads I win tails you lose” to this issue.  The true cost of public employee retirement benefits, pensions and health care, are understated by using optimistic financial assumptions and by passing on a significant portion of these costs to future taxpayers.  However, as it stands today, the bill for any shortfall is totally the taxpayers responsibility.

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About the Author:

William Fletcher is a business executive with interests in public finance and national security. He retired as Senior Vice President at Rockwell International where most of his career was spent on international operations and business development for Rockwell Automation. Before joining Rockwell, he worked for Bechtel Corporation, McKinsey and Company, Inc., and Combustion Engineering’s Nuclear Power Division, and was an officer and engineer in the U.S. Navy’s nuclear program. His international experience includes expatriate assignments in Hong Kong, Europe, the Middle East, Africa and Canada. In addition to his interest in California’s finances, he is involved in organizations dealing with national security and international relations. Fletcher is a graduate of Tufts University with a BS degree in Engineering and a BA degree in Government. He also graduated from the U.S. Navy’s Bettis Reactor Engineering School.