Will America’s Private Sector Continue to Shrink? A Look at Government Compensation

In my previous blog looking at America’s Private Sector for October, 2010, I stated that I thought over the long-term the private sector share of personal income would continue to fall.  This post will begin to explore why I think that is the case.  Be warned that this journey involves delving into the intricacies of national accounting (which is why it took me awhile to amass this blog) so I’m going to try to keep it a high level.  Links to mind-numbing details will be provided.

So, let’s refresh our memory on how the private sector is measured.  The equation is: Private Sector = Total personal income – (government transfer receipts [Social Security, Medicare, Medicaid, etc.] + government compensation [Federal Civilian and Military, State and Local]).  Today we will look at government compensation.

Government compensation consists of wages and salaries and benefits and are accounted for on a cash-basis.  This is no big deal for wages and salaries since they are paid in cash in the current period; however, benefits are another story.  A large part of benefits for government workers is their defined-benefit (DB) retirement plans–this is where it gets tricky becomes the timing of payments makes a big difference.

Under cash accounting, only the payments being made into the DB plans are counted in compensation.  However, the final value of the DB plan to the employee is worth more than the actual contributions because the return earned on the trust fund will also be used to pay their benefits.  So, ideally, an accrual-based accounting would be better a better system because it would make estimates of the total value of DB plan including the future returns on the trust fund.  However, due to a lack of data and disagreement on the assumptions needed to make it work, accrual accounting is not yet possible.

As such, cash accounting is the de facto measure of government compensation.  This is a serious problem for two reasons:  First, payments to state DB plans rarely equal the annual required contribution (ARC) based on requirements from the Government Accounting Standards Board (GASB) and, second, as economist Novy-Marx and Rauh point out the GASB mandates dramatically underestimate the ARC payments.  In the future, this means ARC payments will dramatically increase dragging government compensation with it.  In Maine, for example, where stronger Constitutional constraints trump GASB; official pension payments are expected to more than double in just four short years from $300 million to over $700 million.

To illustrate how cash accounting affects the timing of DB payments consider the effects of Pension Obligation Bonds (POBs).  States have resorted to risky schemes such as POBs to try and undo the damage of short-changing their DB plans.  Let’s look at the case of Illinois which in 2003 issued one of the largest POBs ever worth approximately $10 billion.  Chart 1 below shows how the POB issuance in 2003 caused state compensation to significantly jump in 2003 under cash accounting .  This one-time infusion created an overestimate of compensation in that one year, but an underestimate in the years (most years) that Illinois neglected to pay its ARC.

Illinois State Compensation 2000 to 2009

More disturbing, states that issue POB’s not only face the escalating cost of their ARC payments due to year’s of underpayment, but they also saddle their taxpayers with the payback schedule of the POB.  Chart 2 below shows the payback schedule of Illinois’s 2003 POB which more than doubles over the 30 year schedule.  Adding insult to injury, note that the first few  years were interest-only payments!  But wait, there’s more, a new study by the Center for Retirement Research at Boston College (pdf), found that:

“while POBs may seem like a way to alleviate fiscal distress or reduce pension costs, they pose considerable risks.  After the recent financial crisis, most POBs issued since 1992 are in the red.”

Illinois Pension Obligation Bond Payment Schedule Issued in 2003

To wrap this up, the point of this is that under the current cash accounting system contributions to state DB plans will soar in the future because of past underfunding, unsustainable assumptions about the future and the use of risky schemes such as POBs.  This means that government compensation will be growing at rates that the private sector will find hard to keep up with, especially if taxes on capital are raised to pay for the growing DB costs.  As a result, government compensation will continue to crowd-out the private sector.

The only way this doesn’t come to pass is if the DB pension burden becomes too much to bear and they are dramatically reformed.  In the case of California or Illinois, that decision may be forced on them because their DB system has effectively bankrupted the state government.  If these DB systems are reformed, willingly or not, then perhaps we will one day see the private sector grow again.  I’m still not optimistic, because we still need to look at the other part of the equation, government transfer receipts, which is also an ugly picture . . . stay tuned.

For mind-number details on how the Bureau of Economic Analysis treats DB plans in their statistics, see: