American cities have to pay for a lot of things: police and other safety services, roads, infrastructure and public buildings. But they are also responsible for the pensions of former city employees. In new research, Evgenia Gorina finds that when cities have less stable revenues and a greater reliance on payments from their home state, their pension liabilities are more likely to go unfunded. She suggests that cities that rely more closely on less stable revenue sources like sales taxes and user fees are more likely to have unfunded pension liabilities as they prioritize more day-to-day operational expenditures.

In the American system of fiscal federalism, city operations are typically funded by residential and commercial property taxes, local sales taxes, and a variety of local user fees and charges. Many cities also rely on funding from the state (so-called intergovernmental revenues). Using these revenue sources, a typical American city provides a wide array of local public goods and services from safety and transportation to community art exhibits.

In addition to these common items of operational spending, cities allocate funds to spending categories that can be less visible to local voters. One of those is annual contributions to employee retirement plans. A relatively small share of these accumulated contributions is paid out annually to retirees as benefits. Most of these contributions are accumulated over time and invested to generate interest revenue.

Since spending on common operating needs is more visible and more immediate in its impacts on local communities than spending on pensions, cities may have an incentive to prioritize it. Do they? My new research suggests that they may, particularly in uncertain fiscal environments.

Using a sample of US cities with over 50,000 residents, I show that cities with less stable revenues and higher reliance on intergovernmental aid tend to have higher unfunded pension liabilities. So how exactly might local revenue stability influence pension funding?

Traditionally, property taxes have been the most stable source of revenue in the local revenue mix. While sales tax collections and user fee revenues drop in recessions as residents reduce their spending, property tax collections do not decline because they depend on assessed property values rather than on direct consumption. As a result, cities with a heavier reliance on property taxes are shielded from the negative effects of the economic cycle on their revenues.

“City Hall” by Neon Tommy is licensed under CC BY SA 2.0

City administrators are well aware of their revenue mix and know that compared to property taxes, sales taxes and user fee collections are more likely to decline in recessions. Reliance on less stable revenue sources may affect managers’ ability and willingness to allocate funds to pension contributions in two ways. Higher revenue uncertainty may encourage higher savings for an uncertain future and make cities less willing to contribute to pension plans. Also, revenue uncertainty may render cities more concerned and more focused on meeting operating needs with direct and immediate benefits to the community than on funding longer-term obligations, particularly in times of fiscal stress.

Interestingly, intergovernmental fiscal support to localities that is designed to boost local fiscal capacity may have unintended consequences. According to my study, cities with a higher reliance on intergovernmental revenues tend to underfund pensions. Given the uncertainty of state aid distribution, cities may view it as unstable revenue and, as a result, be less willing to allocate funds to pensions. Or, state support may be perceived as ‘centrally provided insurance’ and a promise of a bail-out in dire fiscal straits, which can make cities less disciplined in funding longer-term obligations.

The empirical analysis in my paper also shows that when pension plans are administered by cities rather than managed at the state level, unfunded pension liabilities grow suggesting a negative effect of local discretion over pension management. The conversation about local fiscal autonomy has recently gained momentum in US domestic policy and led to tensions between state legislatures and local leaders who feel they are under attack. Though many leaders concur that the needs of local communities are better met when fiscal decision-making is local, many realize that state oversight holds promise for preventing local race to the bottom. Given complex incentives and competing funding priorities, state institutional constraints and more prescriptive fiscal policies over pension funding may benefit cities and brighten their retiree fiscal futures.

• This article is based on the paper ‘City Revenue Structure and Unfunded Pension Liabilities’ in State and Local Government Review.

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Note:  This article gives the views of the author, and not the position of USAPP – American Politics and Policy, nor the London School of Economics.

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About the author

Evgenia Gorina – University of Texas at Dallas
Evgenia Gorina is an assistant professor at the School of Economic, Political and Policy Sciences at the University of Texas at Dallas. Her research in applied government finance focuses on state and local retirement systems, pension reform, and analysis of local financial condition with a focus on sustainable management of operating budgets, long-term debt, and retirement obligations. More details on her research are available at www.evgorina.com.