State bailouts should come with strings attached

A debate is heating up in Congress about whether to send additional financial aid to state and local governments. This week, senators released a $500 billion state and local government bailout proposal. Congress already approved $150 billion in funding for costs directly related to the COVID-19 pandemic, but that money cannot be used to make up for revenue losses stemming from the economic fallout of the virus. 

On one side, proponents are pushing blank-check bailouts of hundreds of billions of dollars, arguing states need the money to fund essential services. On the other side, opponents worry that a federal bailout would unfairly punish responsible states and promote future financial mismanagement by shielding politicians from the consequences of their decisions.

Right down the middle is a compromise solution that would aid state finances while ensuring good money isn’t thrown after bad.  

Congress should offer to help cover state budget holes — but only if that aid comes with significant strings attached.

Conditioning bailouts on reform is already the norm across the world in both the public and private sectors. It’s the model used in the 2007-2009 bank bailouts, the corporate financial assistance under the recently passed CARES Act and the European Debt Crisis that struck in the wake of the Great Recession. 

In 2010, the government of Greece had taken on so much debt that public services were suffering and there was no clear path to repayment. The biggest financial challenge was the Greek pension system, which by 2012 absorbed more of the nation’s gross domestic product than did pensions anywhere else in Europe. 

So, when the “the Troika” — the European Commission, European Central Bank and the International Monetary Fund — stepped in with a rescue package, pension reform was chief among their conditions. Greece was asked to strengthen the link between employee contributions and payouts, raise retirement ages and consolidate its scattered funds. The changes drastically reduced the cost of pensions while making the system more sustainable for retirees. 

So, yes, the rescue included financial aid. But importantly, that aid was conditioned on significant financial reforms to fix the issues that created the debt crisis. 

Today, Greece is in a better financial position with stronger credit ratings and a pathway to lowering its debt burdens. 

In 2020, Illinois finds itself in a strikingly similar situation to Greece in 2010. The state’s pension crisis, measured by the ratio of debt to revenue, is the worst among U.S. states. That’s despite Illinois spending a higher percentage of its revenues on pensions than any other state and imposing one of the highest total tax burdens in the country.

Without strings attached, aid from Washington, D.C. will only prop up Illinois’ deeply indebted pension systems — not fund essential government services as intended. 

So what strings should Congress attach to aid? 

First and foremost, recipient states must have sound pension systems under generally accepted actuarial principles, meaning they are on a path to fully funding their promises over no more than 25 years without increasing taxpayer costs. States that cannot meet this condition should be required to reduce pension liabilities to the level they can sustain and afford within these constraints.

Second, Congress should require states to maintain end-of-year balanced budgets and prohibit counting intergovernmental transfers and short-term borrowing as “revenue” for that purpose. Illinois is one of just 11 states that doesn’t require the budget to balance in practice — the state constitution has a “planning only” requirement —which has allowed it to spend beyond its revenues for 18 consecutive years and accumulate a $7 billion backlog of unpaid operating bills. From 2003 to 2017, the budget was propped up by nearly $38 billion in one-time revenue gimmicks. 

Finally, states should be required to have rainy-day fund protections in place, including automatic deposits when the economy is growing and restrictions on when withdrawals can be made. In line with expert recommendations, states should have a target and a plan to hold 5 to 10 percent of their annual revenues in reserve. 

States would need to voluntarily apply for grants or low-interest loans and agree to the conditions to ensure the program does not run afoul of federalism and the constitution. Well-managed states should already meet all the conditions and won’t need to make changes.

And what should Congress avoid?

Most states entered the crisis with healthy reserves, with median savings of about 8 percent of their budgets. Illinois and the few other states desperate for federal aid are in that position because of their own financial mismanagement, not the coronavirus.

There will be an inclination to force some austerity on them, which translates into a combination of service cuts and tax hikes. That was a mistake in Greece, contributing to an economic contraction. Besides, in Illinois austerity has already been imposed by a pension system that for 20 years has crowded out core services while driving up taxes at the state and local levels.

Congress has an opportunity to rescue struggling states, but it should make lifelines out of strings that force states to help save themselves.

Adam Schuster is director of budget and tax research and Orphe Divounguy is chief economist at the Illinois Policy Institute.