THE NEW TAX ACT restricts federal deductions for state and local taxes to $10,000 — including local property, sales, and income taxes. These restrictions will put pressure on most states and cities to cap their taxes, thus reducing the revenues available to local governments. As a result, the new Tax Act will present major challenges to cities with large unfunded liabilities for pension benefits and retiree health care.
Unless these cities can figure out ways to circumvent the new restriction on deducting local taxes, they will face much higher political barriers to meeting their unfunded benefit obligations through increased tax revenues. But Boston is in relatively good shape, as compared to other US cities with populations of similar size, according to data prepared by the investment strategy team at JP Morgan Asset Management.
A city has three key obligations in making current contributions: (1) for interest on its outstanding bonds, (2) for unfunded pension liabilities, and (3) for other post-retirement benefits (called OPEB, consisting mainly of retiree health care). In Boston’s case, 13 percent of its revenues in fiscal year 2015 were needed to meet these three current obligations, based on the city’s actuarial and investment assumptions. Although 13 percent is substantial, it is lower than the percentage of annual revenues needed to meet these three current obligations by cities of similar size: Seattle (14 percent), Las Vegas (17 percent), Baltimore (20 percent), and Memphis (23 percent).
JP Morgan then calculates what it calls the “full accrual obligations ratio” — the percentage of a city’s revenues that would have been required to fulfill these three obligations if the city were reducing them at a normalized pace. This ratio was calculated on the basis of two reasonable assumptions — first, that a city should pay down its unfunded pension and retiree health care liabilities over 30 years and, second, that the annual investment returns of each city would average 6 percent over this period.
The most critical number is the gap between the percentage of city revenues devoted to current contributions and what it should be paying under the “full accrual obligations ratio.” For Boston, this gap is 4 percent, significantly lower than the gap for the other four cities – Seattle (8 percent), Las Vegas (11 percent), Baltimore (5 percent), and Memphis (11 percent).
In theory, this gap could be filled by increases in tax revenues. However, the new federal restrictions on state and local taxes deductions will ring the death knell for this strategy of raising local taxes to meet unfunded benefit obligations.
Cities could also deal with unfunded benefit obligations by making substantial cuts in direct spending (not servicing current obligations). But local voters will vociferously object to substantial municipal cuts in areas such as education, transportation, or police protection.
That leaves one more avenue for cities to pursue: enacting employee benefit reforms. According to JP Morgan, if the funding gap were closed entirely by higher worker contributions to benefit plans, that increase would have to be very large — 221 percent for Boston. Such an increase would definitely not be acceptable to public unions, and may not be legally permissible in Boston for various categories of public employees.
Yet there is another possible employee benefit reform that could offer a light at the end of this tunnel. The US Supreme Court has opined that health care benefits of retirees may be legally modified at the expiration of the collective bargaining agreement — unless expressly guaranteed for life. So the scope of health care benefits and premium sharing by public retirees will become a matter of political negotiations — in Boston, around 2019 or 2020.
Reform of public pensions will be more difficult. Although cities may establish a different retirement system for their newly hired employees, this will take years to have much impact. Already accrued benefits are sacrosanct in Massachusetts and in most jurisdictions — with the notable exception of reduced adjustments for costs of living, which have been allowed by many courts.
The big question is: Will courts allow modifications of pension benefits with respect to future accruals of current public employees? Historically, California has led the way in blocking such forward-looking pension changes. However, two California courts have recently allowed such changes as long as public employees still receive a “substantial” and “reasonable” pension. Whether Massachusetts will follow these California courts remains to be seen.
The new federal restriction on SALT deductions will create new challenges to reforming city benefit plans with large unfunded liabilities. As Boston voters absorb the financial implications of the new restriction, they are likely to oppose tax increases and service cuts to deal with these liabilities. Instead, Boston voters may end up supporting the gradual introduction of forward-looking changes in employee benefit plans to the extent legally permissible.
Robert C. Pozen is a senior lecturer at the MIT Sloan School of Management.