Businesses Should Fear States' Big Pension Debts

In late June the ratings agency Moody's issued a report recalculating states' pension debts using more conservative metrics than the states themselves apply. Whereas states claim they've funded about 74 percent of the promises they've made to workers, Moody's found that the median pension funding of states was just 48 percent of the money needed to pay off those promises. Moreover, 10 states had pension debt equal to 100 percent or more of their current annual revenues.

Moody's is concerned primarily with the impact of growing debt on state and local creditworthiness, and therefore on the investors who buy municipal debt. But it is taxpayers, not bondholders, who are in the crosshairs of government when it comes to paying off these debts. Businesses, especially, are a convenient target for politicians looking to stem the rise in taxes on individuals, and also moderate the cuts to basic services prompted by rising retirement costs.

Smart businesses are starting to figure out that their decisions on where to expand, relocate or otherwise invest their resources have to take into account the staggering debts that some states and cities have accumulated, especially since the retirement debt burden is not dispersed equally across the country. Some states are in far worse shape than others. As the Chicago Tribune, writing about Illinois' formidable pension debt, astutely observed last year, "Companies don't want to buy shares in a phenomenal tax burden that will unfold over the decades."

Businesses in Illinois already know what this means. In January of 2011 the state, facing incredible pressure to pay its bills, instituted $7 billion in new corporate and income taxes. But the legislature did nothing to reform spending. Raising taxes, it seems, is easier in Illinois than reforming employee pensions. Absent reform, about half of the Illinois tax increase simply went into the state's pension system to keep it afloat. Meanwhile, state debt continues to mount.

California businesses are learning the same lesson. Earlier this year, the giant state pension fund Calpers moved to grab its share of state tax increases instituted last November. The pension fund boosted rates that governments must pay annually (using taxpayer dollars of course) by a whopping 50 percent in order to begin cutting the system's enormous liabilities.

Meanwhile, the state legislature has yet to pass any meaningful pension reform. As pension and health care costs have soared in the state's budget, spending on education, transportation and social services have all declined. California already boasts the second worst business tax climate in the nation, according to the Tax Foundation.

Some places win business thanks to their talent pool, local amenities, and even good weather. But the state and local pension crisis adds a troubling new element to the consideration of where to locate: uncertainty. Governments are now in unprecedented territory with the pension mess, and it's not clear how it will all play out. As the Moody's report suggests, there's not even a consensus on how much states owes.

One troubling component of the uncertainty is that some state laws give government pensions unusual protections. Whereas in the private sector employers are free to alter solvent retirement plans as long as they don't eliminate benefits already earned, government workers argue that once they become vested in a public pension plan, they have the right to continue earning benefits at the same level for as long as they work. Courts have sometimes sided with workers.

To take one startling example: A California court recently struck down a voter initiative requiring workers in Pacific Grove to contribute more to their pensions. Under the court's reasoning, "What is vested in the employee is the right to earn a pension on the terms promised to him or her upon employment." As a result, "no subsequent legislation...can take these rights away once given."

In places like bankrupt Stockton, Ca., politicians granted benefits years ago without bothering to calculate their true cost. Now, some courts say, those pensions are unchangeable for the entire current workforce. That's a prescription for higher taxes, fewer services and eventual insolvency.

Large businesses that operate in multiple locations see this playing out as a new aggressiveness on the part of states. Every few years Chief Financial Officer magazine asks executives at large companies to rate the states in terms of how aggressively they pursue higher tax collections. In the last study, completed in 2011, executives told the magazine that, as one finance exec wrote: "The states are in a pure money-grab mode and don't care about policy, the law, or fairness." Not surprisingly, four of the five worst-rated states in that study-California, New York, Illinois and New Jersey-all have mountains of debt of one form or another.

Some state governments have switched from merely trying to collect taxes on in-state business to extending their tax arm as far as possible. That means firms with a single telecommuter in a state are being dunned for corporate income tax claims, as are firms with no physical presence in a state other than a website hosted on local server.

"We are seriously going to consider whether we allow employees to travel to or participate in events" in New York, one CEO recently told Chief Executive magazine. New York has the second highest per capita debt load among the states, according to a report by its comptroller, as well as one of the highest tax burdens in the nation. So it's not surprising that the CEO explained his strategy by noting, "We can't afford for NY to become a tax nexus for us just because our employees participate in a conference in NY or the like."

Indebted states must eventually become money-grabbing states, if they aren't already. Businesses that haven't learned that lesson yet will learn it the hard way.