Pain Yes, Bankruptcy No

With many cities and states facing huge debts and budget deficits, pundits have begun throwing around the dreaded word -- "bankruptcy." The threat of default seems particularly real in the Midwest: Hamtramck, Michigan, has warned it may default, and some Midwestern states -- especially Illinois -- are trying to dig themselves out of huge holes.

I'd suggest that everyone take a deep breath and chill. Bankruptcy for either many cities or any states is not impossible: nothing's impossible. But the likelihood of any rash of defaults is slim. We have real problems to worry about, but civic and state bankruptcies probably aren't one of them.

For one thing, state bankruptcy is not legal. Cities, counties and other jurisdictions can file for bankruptcy under the so-called Chapter 9: about 600 have done so in the past 75 years, about 250 in the past 30 years, about 15 since this recession began -- not negligible but not exactly a stampede either. Federal law, however, treats states as sovereign and any attempt to change that may be unconstitutional.

For another thing, if bankruptcy is a cure, it's better to have the disease. The last American state to default was Arkansas, in 1933. According to a recent New York Times story, Arkansas didn't have much choice. It was down to its last $4.62 and, with the Depression on, a tax increase wasn't possible. So it defaulted and, as a result, shut itself off from the bond markets for more than a decade, forced to wallow in backwardness until it could borrow again in 1949. Any state that tried the same route now would face the same result: if it could borrow at all, the interest it would have to pay on its bonds would be crippling. 

For a third thing, the situation -- even for states like Illinois -- may not be as bad as they look. As a recent report from the Center on Budget and Policy Priorities (CBPP), most state deficits are caused by short-term revenue shortages caused by the recession: this is no fun and has forced most states to trim vital services. But it hasn't affected their ability to meet long-term needs like bond payments, pension obligations or retiree health insurance.

States like Illinois and California are in a special category, where their debt does imperil these long-term needs. But these states have a lot of alternatives before even thinking about bankruptcy. We'll get to these alternatives in a minute.

But given all these hurdles, why has the spectre of state bankruptcy even raised its ugly head? Mostly because some people who should know better have let their mouths run ahead of their brains. Some may see state bankruptcy as a path to other political goals, like making sure that public employees don't get their pensions.

First among these is Newt Gingrich, who has made a career of talking now and thinking later. After the November elections, the former Speaker of the House said in a speech that he hoped "the House Republicans are going to move a bill in the first month or so of their tenure to create a venue for state bankruptcy."

An article by a Pennsylvania law professor in the conservative Weekly Standard suggested ways to achieve this. Sen. John Cornyn (R-Texas), in a Senate hearing, asked the Federal Reserve Bank chairman Ben Bernanke about the possibility of state bankruptcy.

In December, a celebrity banking analyst named Meredith Whitney went on "60 Minutes" and predicted that 50 to 100 counties, cities and towns will go broke this year under "hundreds of billions" of dollars in losses. Whitney wrote a bearish but accurate report on Citigroup three years ago, so her "60 Minutes" appearance got a lot of attention. Critics later pointed out that the record municipal bond default in any year is $8.2 billion, not "hundreds of billions," but Whitney's prediction rattled the muni market and focused attention on the possibility that not only cities but states could go bust. One of Whitney's biggest supporters is Henry Blodget, the former Merill Lynch analyst who was fined $4 million by the Securities and Exchange Commission and banned from the securities industry for life for issuing fraudulent research. 

All this has drawn a political line through the state bankruptcy issue. Republicans like Gingrich are more favorable to the idea, not least because it would enable states to escape pension obligations to state employees. Democrats and the employees union, the American Federation of State, County and Municipal Employees (AFSCME), oppose any discussion of the idea and deny that long-term pension obligations have anything to do with the state's current budget problems.

As noted above, that's true for most states. But what about a state like Illinois? As the Center on Budget and Policy Priorities points out, most states have got themselves into jams for a variety of reasons -- the recession, a reluctance to raise taxes, waste, taking on too many services, high medical and pension costs, outdated revenue systems. Most states are going to have to fix these problems, and most of them can probably do so fairly easily.

Illinois, as it says, "is an extreme example of the implications of the failure to fix these types of problems." It has a flat tax system at a relatively low rate, even after the recent tax increase. Its sales and services tax system is out-dated. And it has preferred borrowing rather than adequate funding to prop up its pension system.

The solution is not bankruptcy but new fiscal practices that are as possible in Illinois and California as anywhere, but will simply be more painful in these more delinquent states.

What are these new fiscal practices? Well, let us count the ways. 

First is higher taxes. Sad but true. Illinois learned that, if it's going to keep any of its services going, it's going to have to pay more for them. So have at least 33 others states in the past couple of years. All have raised one sort of tax or another, some, like Illinois, by 5 percent or more.

Second is trimmed services. During the recession, state spending on universities already is down 43 percent, on K-12 down 34 percent, on health care 31 percent. More than 400,000 state and local employees have lost their jobs. Some of these cuts will be restored, but not all.

Third is divesting some services altogether, merging them with other states, or finding other ways to do more for less. A recent posting on this blog discussed this approach.

Fourth is a smarter, up-to-date way for raising money, through taxes or fees. The CBPP report says that most states' revenue system "have remained largely the same for the last 40, 50 or 60 years," while their economies have changed radically.

For instance, too many states, like Illinois, have a flat-rate income tax, not a progressive or graduated tax that taxes higher earners at a higher rate. In an era of growing inequality, when the majority of economic growth and wealth is going to the top 1 percent, while the bottom half is seeing its standard of living falling in real terms, these flat rates are neither fair nor efficient.

Sales taxes, especially on services, are another area where revenue gains can be maximized with minimum pain. Over the years, services have accounted for an increasing percentage of sales compared to goods. Yet goods are still taxed, but most services aren't.

In Illinois, for instance, services made up 32 percent of the state's economy in 1970, but are 44 percent today. But the tax structure hasn't kept pace. The state taxes 17 services, compared to 158 in  Washington and New Mexico. The Illinois services left untaxed include haircuts, plumbing, storage facilities, pet grooming, limousine, health clubs, lawyers, yacht marinas, debt collectors, private eyes, pinball machines, parking garages, bowling alleys, doctors, dentists, video rentals, movies, dry cleaning and many others.

Even funerals are tax-free. If death is inevitable, taxes apparently are not.

The income from a broad-based services tax would go a long way toward plugging Illinois' budget gap. The state faces a $15 billion deficit this year. The recent income tax increase is expected to close about half of that -- $6.8 billion. A 2009 report by the Commission on Government Forecasting and Accountability, which provides revenue forecasts for the legislature, said its services tax suggestions could bring in another $7.3 billion, effectively balancing the budget. 

The suggestion of a broad services tax is anathema to the businesses that would be affected, many of them small businesses, and their representatives. But we have sales taxes on a broad range of goods, without noticeable effects on sales. If a 6 percent sales tax was placed on services, a $20 haircut would go to $21.20, a $7 movie would go to $7.42, and a visit to the dentist or a visit from the plumber would be only marginally more expensive than it is now.

Prices on many of these services have been soaring in recent years, as anyone who's parked in a public garage or had a root canal knows. It's hard to imagine that a 6 percent increase would lead anyone to let their hair grow or stay home from the movies.

None of this is pleasant to contemplate. Neither is bankruptcy or the threat of bankruptcy. Illinois and other states are in tough shape now because they've shielded their residents from the realities of running a government. Those days are ending now. 

For more information on economic competitiveness in the Midwest, visit the In the News section of the Global Midwest Web site.

Comments

[Aaron M. Renn]

I think part of the political logic for national republicans on bankruptcy is to forestall a call to bail out bankrupt blue states like Illinois and California.

Illinois is an interesting case because as near as I can tell, the state government doesn't do much. (Contrast Ilinois' local property tax funded schools with the Indiana approach where all school operating expenses come from the state's general fund and ask which place is more progressive). The combined state-local tax burden isn't that great, but I don't think the state only component is very high. I suspect Illinois state government is leaner than people think.

For me the risk to Chicago is exactly the opposite of what people like Scott K. Walker and Mitch Daniels think it is. Yes, businesses are probably better off leaving downstate for Indiana, but it's not realistic to think a business will decamp from the Loop to Indianapolis.

But in my view really the biggest thing Chicago has going for it is cost. Lower real estate costs are lower taxes are the fundamental thing that makes it worth living in Chicago vs. New York or California. When you start jacking up your income tax rates, at some point the differential makes those places look a lot more attractive. I'm making this calculation myself, esp as I see a blizzard outside that is unlikely to strike a place like San Francisco. Plus at the low end creative types like my brother (an actor and freelance graphic designer) are getting killed because of the regressive taxes here. He might be forced to leave.

From what I've seen, financial crises almost inevitably take the form of a panic or sudden collapse of confidence. Look at what is happening over in Europe or the numerous emerging market debt crises. You look like your debt is high but manageable, but you're on the bad track and one day the market wakes up and figures that out. I think the federal government itself is here because while the current debt is manageable, when you run trillion dollar deficits every year and project to do so more or less forever, the end won't be long in coming.

[Scott Reetz]

I'd like to explain why state bankruptcy might look attractive to working persons in the private sector. They can't retire until they're 65, and then they find out some workers in the public sector can retire earlier with full health benefits and pensions. Taxes will have to go up to cover these costs. That's a very bitter pill to swallow. I have never understood why people say that people in the public sector make less than those in the private sector. That may be true for some very rare skills, or it may be true for those who are the best of the best, but for most of us mediocre persons, we have done very well financially in the public sector. I carved my niche in universities (I'm working at my third one) and there is absolutely no way I would be making more in the private sector. I often wonder at the fairness of it--people in the private sector get 2 weeks vacation per year, and I get 4-5 plus numerous holidays. I can't help feeling that it is not right that taxes have to be raised to cover the benefits I get when most other people don't have those advantages.