Bankruptcy for States? It's a Better Idea than You Think. | Opinion

Look out, America: Illinois, New Jersey and New York are coming for your wallet.

These states' government-imposed shutdowns in response to the Wuhan coronavirus have cratered their expected tax revenue. Having failed for decades to deal with their irresponsible and excessive pension obligations, they are now floating the idea of a federal bailout to help them through the rough water ahead.

Rather than simply writing a check to state spendthrifts, we should be looking at the idea voiced by Senate Majority Leader Mitch McConnell to allow states to seek protection under federal bankruptcy laws.

This is hardly the first time in recent memory that America has faced the looming specter of state defaults. After the financial crisis, California prepared to pay bills with IOUs, as did Illinois in 2015. In 2011, former Florida Governor Jeb Bush penned a piecesupporting the return of state bankruptcy protections. And in 2016, President Barack Obama actually authorized a form of bankruptcy protection and reorganization for Puerto Rico.

State bankruptcy wouldn't be unique in American history, either. In the 1830s, states borrowed heavily against expected property tax revenue to finance road, railroad and canal construction. The Panic of 1837 swept away much of that tax revenue, and many states ended up defaulting on those debts.

Most of those debts were rescheduled and repaid, as in bankruptcy, but both the depression and the defaults cast a long shadow over the country's memory—as deep and long as the Great Depression. Accordingly, states tightened up their fiscal management, placing limits on debt issuance and requiring balanced budgets.

By contrast, states have let these unfunded pensions build up over decades. Funded at over 100% in 2001, the New York City Employees' Retirement System fund fell to only 64% funded by 2010. Despite strong market returns, the fund had only recovered only to 72% funded by 2018. The State Retirement System' of Illinois' fund has languished at less than 40% funding since 2010.

New Jersey is a case study in the dangers of a bailout. Governor Phil Murphy has been among those in the greatest fiscal anguish. But he has actively opposed measures to help fix a pension system ever more mired in debt, even as those pensions threaten the state's ability to build and repair infrastructure.

It's hard to see the creation of long-term unfunded pension obligations as anything other than a dodge to get around those fiscal stringencies. No debt is issued, and only the current year's payment needs to be covered by the current year's revenues, but the taxpayers are still on the hook for potentially massive long-term obligations.

Contrary to pension apologists, bankruptcy wouldn't necessarily mean the end of defined benefit pensions. Current pensioners would and should collect what was promised to them. While terminating those plans in favor of defined contribution plans might be desirable, it might also be possible to require that new defined benefits be fully funded from day one.

Most important, we can bring the market enforcement of fiscal discipline to state finances. By making the risk explicit, rather than allowing for hidden, soft defaults, it would help to bring borrowing costs in line with actual risks. After the 1840s, U.S. states faced as much as a full percentage point borrowing premium compared to Canadian provinces. That's how it should be.

New Jersey Governor Phil Murphy
New Jersey Governor Phil Murphy Kevin Mazur/Getty Images for iStar

Fiscally irresponsible states won't go without a fight. New York Governor Andrew Cuomo claims his state is entitled to compensation because it sends more to the federal government than it gets back. Such special pleading ignores the decades' worth of state and local tax deductability that subsidized his state and other high-tax states, enabling their profligacy. Rather than chasing their tax base out of the state with additional tax hikes, perhaps they should have spent the last three years getting their house in order.

The two other non-bankruptcy options often floated, either bailing out the states or doing nothing at all, are worse. So far, none of the governors asking for help has offered a plan to make sure they won't be back soon, clamoring for even more. Bailing out the states would continue to enable corrupt behavior, while forcing people who never had a hand in making those deals to make good on them. The risk of moral hazard is real.

Doing nothing at least has the benefit of forcing a reckoning, but it could be a very messy, drawn-out reckoning that fails to address the destructive underlying behavior that landed those states in this mess in the first place.

Allowing profligate states to declare bankruptcy would force more honest accounting of liabilities, align borrowing costs to risk, and close loopholes that states have been using to avoid fiscal discipline. It's the best of the painful choices that some states have left themselves.

Joshua Sharf is a Senior Fellow for Fiscal Policy at the Independence Institute, a free-market think tank based in Denver, Colorado. He currently serves as a State House Republican appointee on the Pension Review Subcommittee for the Colorado legislature.

The views expressed in this article are the writer's own.