October 26, 2011

President Obama has proposed that the federal government provide $35 billion to assist state budgets. It’s a fine idea — provided there’s a carrot.

Many states have been hit hard by fast-rising retirement costs for public-sector employees, forcing those states to divert money from services such as education and public safety. Vice President Biden has rightly called these reductions in essential services “an emergency.”

In California, for example, this year the state will divert more than $5 billion from its general fund to cover pension and other retirement costs, and in so doing will reduce spending on vital public services. Worse, as large as that $5 billion is, it covers only 40 percent of those retirement obligations, the balance accruing interest and kicked down the road — a portent of even larger retirement costs, and even greater diversions from public services, in the future.

Because of this compounding, younger generations will find that our unfunded pension liabilities will crowd out virtually all of their spending on public safety, health, higher education, environmental protection and more.

As a result, pension reform is desperately needed. Handing funding to the states without demanding such reform would just allow them to continue hiding and deferring the pension problem. Consider the case of Illinois, which last year enacted a large tax increase but didn’t tie that tax increase to any pension reforms. This year that tax increase yielded nearly $7 billion, but according to the Chicago Tribune, virtually all of that additional revenue went to cover pension-related costs. Because no reform was required, the problem will just grow.

The pension situation provides an opportunity for Obama to leverage his clever approach to improving K-12 education. In 2009, he enacted the Race to the Top Fund, a competitive grant program designed to encourage and reward states for creating the conditions for education innovation and reform. Grants were awarded based upon how states met the selection criteria. Some states won and some lost.

Similarly, Congress and the president could establish a Race to Reform Public-Sector Pensions. States would compete for the $35 billion, and selection criteria would focus on three ingredients: 1) honest measurement of liabilities; 2) proper and contemporaneous funding that doesn’t kick costs to future generations; and 3) reforms that reduce liabilities.

Given the deleterious impact of deferred pension costs on innocent parties in the future, pension reform is a moral issue, as well as a financial one. Congress and Obama could take a big step toward addressing both problems by igniting a Race to Reform Pensions.

The writer, a Democrat, was an economic adviser to former California governor Arnold Schwarzenegger (R). He is president of Govern for California, an organization that aims to get independent-minded leaders elected to the state legislature, and a director of the Volcker-Ravitch Task Force on the State Budget Crisis.