Debt and Taxes: Arizona Taxpayers on Hook for $66 Billion Tab, Part 5

| April 29 2012

Investigative report by Mark Flatten
Goldwater Institute 

Positive Cash Flow

The tactics used to balance the budgets came with consequences. Mortgaging state buildings made Arizona the butt of jokes from late-night comics. More importantly, credit agencies responded by downgrading the state’s debt, raising the cost of future borrowing.

Only two states now have a worse credit rating than Arizona.

Moody’s and Standard & Poor’s have both upgraded the state’s outlook from “negative” to “stable” since December. Both credit ratings agencies cited improved state finances and projections that with revenues inching upwards, the state is anticipating a surplus of about $600 million in the current fiscal year.

Treasurer Ducey said Arizona does not have a surplus. It merely has positive cash flow and needs to begin paying down some of its debt. Ducey also wants the state to establish an emergency reserve account so it will not have to resort to new debt and accounting tricks to weather future rough patches in the economy. The Legislature also needs to develop a long-term plan to pay down state debt and publish it on the Internet, Ducey said. It would not bind future legislatures, he said. But it would create political pressure for them to deal with the unpaid balances rather than use money in good times to expand the government.

“The only difficulty about paying down debt at the government level is the temptation from politicians who want to please constituents by spending money on their behalf,” Ducey said. “That’s the only disincentive to paying down debt, and it’s the wrong incentive.”

Arizona’s bond rating, while low among the states, is still considered high quality and safe for investors, said Jacobson of Moody’s. When rating government bonds, Moody’s considers a variety of factors in addition to debt, including the long-term strength of the area’s economy, budget history and debt levels. It also looks at how well a jurisdiction manages its long-term finances, not just how it is doing at any given point in time, he said.

So while state or local governments may use unusual methods of balancing their budgets in any given year, what is important for ratings agencies is whether investors can count on being paid back over the long term, he said.

Risks Rising

Municipal bond defaults remain extremely rare, according to recent studies by Moody’s and other credit rating agencies. The riskiest government debt was used to help finance things like hospitals and low-income housing complexes, both of which make up a large share of the portfolio issued by industrial development authorities in Arizona.

But there have been some high-profile government bankruptcies and dire warnings about the future of the municipal bond market over the past few years. Jefferson County, Ala., filed for bankruptcy last year in large part because it could not repay more than $3 billion in bonds it issued to pay for upgrades to its sewer system. So did Harrisburg, Pennsylvania’s capital, when it could not keep up with payments for a trash incinerator it bought by issuing debt. Stockton, Calif., and Detroit are teetering on the brink of bankruptcy because their debts are deemed unsustainable. In the last couple of years there was speculation that Los Angeles might have to declare bankruptcy to restructure its finances.

Federal law does not allow states to go bankrupt, though there has been some talk in Congress about allowing them to do so.

No local governments in Arizona have declared bankruptcy.

In February, Moody’s maintained a negative outlook for most of the state and local bonds it rates, meaning they faced the likelihood of having their ratings downgraded. It is the fourth year in a row that local debt has been deemed to have a negative outlook, the fifth year in a row for state debt.

Governments in general are under stress because of the overall economy, Moody’s concluded. Some regions, including Arizona, are especially hard-hit because of the collapse of the housing industry.

Another troubling sign from Moody’s is that downgrades of state and local debt significantly outnumber upgrades, an indication of eroding confidence in municipal bonds. The reasons for the gloomy forecast include the nation’s overall struggling economy, sluggish sales and property tax collections, and the fact that many governments have used up most of the reserve funds they built when the economy was strong, according to Moody’s.

As a result, “budgetary tradeoff decisions are getting tougher,” Moody’s noted in its February, 2012, report on local governments.

“Many local governments will be forced to choose between cutting core services, raising taxes, or significantly depleting their remaining financial cushions,” the report says. “Spending priorities and levels that were once considered inflexible are now on the table for cutback.”

The report goes on to warn that “we could see an increase in the number of municipalities that file for bankruptcy, although we still expect this will be a very small number.”

Pension Predicament

As volatile as government bonds are, they are only one part of the debt that state and local governments will eventually have to pay. Governments also face billions more in other shortfalls. But they are harder to calculate than bonded debt, where it is relatively easy to figure how much will have to be paid back at any given time.

As with revenue bonds, lease-purchase, certificates of participation and budget rollovers, those other obligations do not meet the constitutional definition of debt.

The most significant is pensions for government workers.

Most government workers in Arizona pay into one of four state pension plans: one for public safety personnel like police and firefighters; one for regular government workers and teachers; one for corrections officers, and one for judges and elected officials. Phoenix and Tucson also have their own pension plans for general city workers, though both cities use the state retirement funds for public safety employees.

Technically pension plans do not have debt. They do have unfunded obligations. That figure is calculated by taking the current value of each plan’s assets, figuring out how much it will grow in the future as it is invested; then comparing it to the benefits that will have to be paid out to retirees over a given period of time, typically 30 years.

The difference is reported in comprehensive financial reports as unfunded actuarial liabilities.

Officially, the four state pension accounts are underfunded by about $12.5 billion, according to the most recent Comprehensive Annual Financial Reports, which give a snapshot of the funds through the 2011 fiscal year that ended in June.

Other retiree benefits, mainly health insurance premiums the pension funds will pay, add another $769 million in unfunded obligations, for a total of $13.2 billion.

Ducey said more recent figures put the unfunded obligations of the four state pension funds at more than $16 billion.

The combined deficiency of the Phoenix and Tucson pension funds, including post-employment benefits, is about $1.7 billion.

So the total unfunded balance of the six funds is almost $15 billion, according to their own financial reports; $18 billion if the newer numbers cited by Ducey for the four state funds are used.

Government pension funds have come under greater scrutiny in recent years because of the optimistic assumptions used to calculate unfunded liabilities. Because there is no firm figure as to what is owed – as there is with bond debt – pension fund debt is figured using estimates as to how much their current assets can be expected to make through investments in the future. All of the government pension funds in Arizona assume an annual earnings rate of 8 to 9 percent.

Unrealistic Expectations

That is unrealistic, said Byron Schlomach, director of the Goldwater Institute’s Center for Economic Prosperity.

Since the prediction of unfunded liabilities can rise or fall based on the assumptions of how much interest will be earned over the next 30 years, changing the expected earnings rate a few percentage points can alter the predicted revenues by billions of dollars.

Because pension benefits are guaranteed, the rate of return used to calculate the value of current investments should be based on what the market is paying for low risk debt instruments such as treasury bills, Schlomach said.

“You have a highly certain, guaranteed promise to pay people in the future with an extremely uncertain asset base,” Schlomach said. “They have constantly lost ground, year after year, basically since 2000; demonstrably so and pretty extremely so.”

The volatility of the investments made by state pension funds is evident in their earnings history. Over the last 10 years, the average rate of return for the Arizona State Retirement System, the largest public pension fund in the state, is 5.2 percent; not the 8 percent used by fund managers to calculate unfunded obligations. Last fiscal year, it was 24.6 percent. Year-by-year figures show the fund’s earnings over the last decade have varied from last year’s high to a low of losing 18.1 percent in the 2009 fiscal year.

A study published by the Goldwater Institute in 2010 recalculated the reported unfunded obligations of the state’s four pension funds using the rate of return realized on treasury bills. At the time, the pension funds were reporting unfunded liabilities of about $10 billion using the normal rate of investment return of 8 percent annually or more. Applying the U.S. Treasury bond rate increased that unfunded debt to more than $50 billion.

The Governmental Accounting Standards Board (GASB), a private organization partly funded by government which sets financial accounting standards for state and local governments, has proposed new guidelines aimed at forcing a more realistic assessment of unfunded pension liabilities.

Fund shortfalls would be calculated in part by using the yields of high-quality, tax-exempt municipal bonds rather than only the more arbitrary 8 to 9 percent figure used now.

The GASB board is currently reviewing public comments. New rules could be issued in July.

Burden on Taxpayers

In the end, it doesn’t matter whether government debt comes through bonds, certificates of participation, lease-purchase, unfunded pension obligations or accounting tricks. It doesn’t matter whether it is issued directly through a city or county, a municipal property corporation or some other type of special district.

Taxpayers have to pay it back one way or another.

“It is recognized that all debt, regardless of the source of revenue pledged for repayment, represents some sort of cost to taxpayers and ratepayers,” a recent debt management plan published by Glendale reads. “While lease-secured and certificates of participation obligations may not be debt under strict legal definitions, future appropriations are still required if the underlying transaction is to continue.”

For people like George Lee, who lost his buildings in Prescott Valley, the level of government that issued the debt is not what was important. What mattered was that when the economy soured, the taxes he was paying did not leave him flexibility to save his business, and he ended up losing everything he’d worked a lifetime to build.

“The problem is the jurisdiction for those districts, the president of the United States couldn’t change it,” Lee said. “They are unto their own. They are their own law and nobody can touch them.”

>> Read Debt and Taxes: Recommendations for Reform

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