Illustration by Tomi Um
Illustration by Tomi Um

Imagine a company that allows its employees to take nothing in salary this year in exchange for promissory notes to pay them twice as much in 10 years. Although there would be no immediate cash outlay, the company would still be required to accrue expenses reflecting the promises.

That “accrual basis” treatment is important, because without it a company could present a false picture of its finances. If it didn’t have to show the cost of promised future expenditures, the company could present itself as breaking even or making money when neither was the case. Creditors, suppliers, customers and employees dealing with the company would be unaware of the risks they were taking.

Yet this is precisely the accounting sleight of hand that state and local governments are permitted to use with “cash-basis budgeting,” which, according to the State Budget Crisis Task Force, led by Richard Ravitch and Paul Volcker, “recognizes expenditures only when cash is actually disbursed.” 

Cash-basis budgeting leads to nonsensical outcomes, such as Governor Chris Christie’s New Jersey being able to claim a balanced budget simply by pushing a $3 billion payment from one fiscal year into the next, or Governor Jerry Brown’s California reporting a $2.4 billion surplus even though it incurred an additional $15.8 billion of unfunded retirement promises in the same year.

Because of cash-basis budgeting, expenses will only show up in future budgets when cash is required to meet the promises. And when they do show up, the amount of cash diverted from those budgets will be many times higher than what was promised because of compound interest. 

This form of budgeting creates absurdities on the revenue side, too. Under cash-basis budgeting, a state or local government can claim a balanced budget even if 100 percent of its revenue is borrowed because revenue is defined as cash received, regardless of the source.

According to Ravitch and Volcker, “cash-basis budgeting is a major enabler of budget gimmickry.” Worse, a politician who wants to put money away to meet future promises is forced into a dilemma: Do the right thing but show a degraded budget, or ignore the obligation and show healthier books. 

As Chicago Mayor Rahm Emanuel has pointed out, that city wouldn’t have to dismiss teachers if past mayors had set aside enough money to meet pension promises. Those mayors would have had to admit to running deficits and possibly pay the price with voters.

The same dynamic is at work in San Jose, California, which is spending more on its police department while fielding fewer officers because past mayors didn’t set aside enough money to meet retirement costs. Ditto Los Angeles, where retirement costs consume 20 percent of budgets, up from just 3 percent a decade ago, leaving residents with fewer services and gouging them with rising fees. And there’s Detroit, where half the city’s $18 billion debt consists of retirement promises that should have been reflected in earlier budgets. Across the U.S., citizens are just now learning about hidden promises made by their politicians.

Governments need to replace cash-basis budgeting with accrual-basis budgeting, which would allow the public and legislators to “easily discern how revenues earned in the fiscal year relate to obligations incurred in the same year,” according to the 2012 Ravitch and Volcker report. The change wouldn’t completely eliminate budget gimmickry, but it would be a very big step. Had this type of budgeting been employed 20 years ago in Chicago, Detroit, Los Angeles and San Jose, those cities wouldn’t have been able to report balanced budgets even as they were making the promises that are now coming due. 

These hidden promises hurt our society’s vulnerable citizens, including public employees who rightfully expect their government to honor its obligations. These obligations also mean reduced police and fire protection, closed libraries, fewer teachers and higher tuition, with taxpayers paying more but getting less.

It is too late to undo the damage of decades, but we can ensure that the buck stops here.

(David Crane, a former financial-services executive, 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. Follow him on Twitter.)

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

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.