Illustration by Joshua Checkley
Illustration by Joshua Checkley

Governor Jerry Brown’s proposed $50 billion tax-increase initiative won’t solve California’s budget problems. Neither will anything else on the state’s ballot in November, nor will more cuts to child care, courts, parks, college and welfare programs repeatedly slashed by the state Legislature.

Solving California’s budget woes requires addressing five root causes: unfunded health-care promises to retired employees, excessive incarceration rates, a boom-and-bust revenue system, underfunded pension commitments and fast-growing spending on Medicaid.

Except for alterations to Medicaid (which requires agreement from the federal government for material changes), the Legislature and governor have all the power they need to address these causes. They just need to use it.

This article looks at the role of retiree health care, technically known as “other post-employment benefits.” Visible state spending on these benefits grew at a 12 percent annual rate from fiscal year 2001-02 to 2011-12, but there is even greater invisible spending.

The state promises post-retirement health and dental coverage to its employees as part of an exchange for employee services rendered. Accounting standards suggest that these benefits be financed when the exchange occurs (known as “pre-funding”) rather than after the employee has left active service (this is called “pay as you go” or “pay-go”).

Double Whammy

If the cost isn’t pre-funded, then the cash has to come out of later budgets that get hit with a double whammy: The state gets no benefit from the services it is paying for and has to cut other programs or employees and/or increase taxes to make room for the payment. That is what is happening now.

California isn’t alone in facing this challenge. According to the Pew Center on the States, states owe more than $600 billion of unfunded liabilities for retiree health-care benefits. A few states, such as West Virginia, have taken meaningful steps to pre-fund them, but California is one of 17 that set aside no money. In 2011, it even abandoned a commitment made in 2010 to do so.

The pay-go system used by California means state budgets don’t report the financial effects of the benefits until they are actually paid. According to the Governmental Accounting Standards Board, which sets standards of accounting and financial reporting for U.S. state and local governments, that means those budgets don’t reflect full costs as they are incurred, liabilities for promised benefits for past services or -- of particular relevance to California’s proposed tax increase -- growing demands on future cash flows to meet those promises.

California’s budget for the last fiscal year (ended June 30, 2012) illustrates this misleading practice. The budget reports that $1.5 billion was spent on retiree health care, but the full cost -- $4.74 billion -- is found in a report issued by the state controller. The difference -- $3.2 billion -- is just as much of a cost as the reported expense. But since it wasn’t paid in cash, it becomes an unfinanced liability that will demand payment from future budgets.

These retiree health-care promises at the state level, which aren’t approved by voters, now amount to more than $60 billion in California, almost half of the general-obligation bond liabilities approved by voters. Deliberately or otherwise, the health-care obligations aren’t well publicized by the state, showing up on the controller’s obscure report but not on a report issued by the state treasurer that claims to measure the state’s debts. Like off-balance-sheet debt in the corporate world, these liabilities are findable only by those who know where to look.

Eliminated Benefits

They are a big drain on budget cash, as has been made painfully clear in cities such as Stockton -- which also financed the retiree health care of its public employees on a pay-go basis and recently entered bankruptcy partly because of these obligations. Starting in 2013, retiree health benefits in Stockton are set to be eliminated, according to the terms of the city’s bankruptcy budget.

At the state level in California, these liabilities have big implications for the proposed tax increase. Proponents claim more tax revenue will help services. But this seems unlikely, given the increasing amounts of cash needed to meet existing liabilities and new unfinanced benefit costs that will add up to more than 40 percent of the revenue from the seven-year tax increase.

Worse, the structure of California’s budget, which pays for K-14 education and debt service ahead of everything else, means that increases in health-benefit spending have an outsized impact elsewhere. Areas such as parks, courts, child care, welfare, the University of California and California State University are the first crowded out by higher spending on post-employment benefits.

As one example, even though state revenue grew more than 50 percent over the past 10 fiscal years and taxes were raised in 2009, state spending on the University of California declined 20 percent over that period partly because outlays for retiree health benefits more than tripled and consumed more than $11 billion.

Solving this problem will require more short-term budget pain because one way to lower total costs is to finance the promises upfront, as they are made. As State Controller John Chiang points out, “even slight amounts set aside will help lessen the impact on future generations.” But that solution is only partial and puts the entire burden on taxpayers and programs. A full solution would also require substantial contributions by employees during their working years, changes to benefits, and reforms to reduce health-care costs.

Raising taxes in November without first fixing the retiree health-care benefits system is akin to providing capital to the pre-financial-crisis Lehman Brothers Holdings Inc. without first demanding that it address its off-balance-sheet debt.

This would continue a callous pattern by California legislators of raising taxes and slashing programs but not addressing root causes. And that means even greater cuts and tax increases down the road.

(David Crane, a former financial-services executive and a Democrat, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011. The opinions expressed are his own.)

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To contact the writer of this article: David Crane in San Francisco at davidgcrane@gmail.com.

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.