While central governments’ fiscal problems plague manyeconomies, a parallel crisis is enveloping many subnational governments around theworld. From Spain to Chinato the United Statesto Italy,these governments – regions, states, provinces, cities, and towns – faceimmense fiscal challenges. Higher levels of government are “on the hook” to bail out local insolventgovernments, and may even suffer bond downgradesas a result; in Spain, Italy, and China, that role falls to thenational government, and for US cities and towns, to their states.
There are many similarities within and among countries in terms of thenature and causes of these local fiscal calamities.Local officials used growing revenues during the boom to fund pet projects or boost pay and benefits, withlittle regard to future costs. In the downturn,revenues and subsidies from the central government collapsed and the bills came due. Creative accounting gimmicks masked the full extent of the problem.Now comes the reckoning.
To finance local businesses, Chinese local governments use local-governmentfinancing vehicles (LGFVs) to circumventbans on direct borrowing. In Spain,housing and employment collapses have hammeredrevenue. Rumors of an imminent default swirl around Sicily,whose governor has resigned as borrowing soaredafter cutbacks from Rome. A new report from a task forceco-chaired by former Federal Reserve Chairman PaulVolcker indicates that unfunded pensionand health-care costs make many American states’ medium- and longer-run fiscalprospects bleak.
California’s fiscal crises may also provide lessons for subnationalgovernments around the world. Three Californiacities have recently declared bankruptcy: Stockton,the largest American city ever to do so; San Bernardino,the second-largest bankrupt city; and Mammoth Lakes.Comptonis rumored to be next; most observers expect more to follow.
The state faces another large budget deficit, yet Governor Jerry Brown’sbudget this year includes a substantial spending increase. Brown’s ballot initiative this November would raise California’s toppersonal income-tax rate to 13.3%, the nation’s highest. According to Brown,the tax hike would be temporary, yet it would last seven years.Meanwhile, he claims to be tough on California’snotoriously well-paid and powerful public-employee unions by negotiating a 5%pay cut. But the details reveal a net 1.6% pay cut in exchange for a 5%reduction in work hours.
Cities are declaring bankruptcy to escape the pressure of exponentiallyrising pension and health costs. In contrast to the state, cities have even cutback essential services, including 20% reductions in police and fire personnel.
Bankruptcy should allow local governments to renegotiate their bond debtand, perhaps, their retired employees’ pension and health-care costs (that’s upto a bankruptcy judge). The state would be expected to take over essentialpublic services from bankrupt local governments. But the state itself is in dire financial straits;one of the cities’ problems is the sharp curtailmentof state funds to localities.
Despite these problems, Brown has committed Californiato a San Francisco-to-Los Angeles high-speed rail boondoggle. To get the cost projections down to$68 billion from a $100 billion estimate, some existing low-speed rail will beused, likely doubling the time it takes to travel from Los Angeles to San Franciscoto 5-6 hours. California will most likely beunable to pay for the entire project, leaving little use for the first segmentin the sparsely populated Central Valley. And, if the project somehow is completed, it will be anot-so-high-speed rail that will drain badlyneeded resources from other essential government services for many decades.
These sorry episodes reveal someimportant lessons. One-party government weakens accountability and breeds hubris. The Californialegislature has been controlled by the Democratic Party for decades, and ittakes its cue from its party’s most powerfulspecial interests: public-employee unions, environmentalists, trial lawyers, and teachers’ unions.
They have concocted an extremelyprogressive social experiment: with 12% of the USpopulation, Californiahas more than 30% of its welfare dependents. From the mid-1980’s to 2005, California's population grewby 10 million, while Medicaid recipients soared by seven million; tax filers paying income taxes rose by just 150,000;and the prison population swelled by115,000.
The state income tax is not only uncompetitivelyhigh, but the revenues are volatile. In theeconomic and stock-market upswing, revenuesroll in far more rapidly than incomes rise, owing to the extremely progressiveincome tax (in good years, the top 1% pays about half the state’s incometaxes).
The legislature spends it as if the elevated revenues will continueforever. Then the inevitable recession and stock-market collapse plunges the state into crisis. The progressivesocial experiment has gone so severely off-track that the state cannot evendependably provide essential services, from courtsto education, for the most needy.
Not surprisingly, California’s economy,which used to outperform the rest of the US, now substantiallyunderperforms. The unemployment rate, at 10.8%, is almost one-third higher thanthe national average, and higher than every other state except Nevada and Rhode Island.
California still has great strengths in technology, entertainment,and agriculture. But citizens and politicians alike must agree to targetservices far more carefully; reform the tax system with lower rates on abroader base of economic activity and people (almost half pay no state incometax); and modernize inefficient stateprograms to spend less and produce far better outcomes. Not coincidentally, that’s a perfect prescription for bloated, debt-riddencentral and subnational governments worldwide.