Tuesday, August 16, 2022

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5. Fiscal Evasion

Park in Trenton with a view of the capitol dome

New Jersey’s budgetary rules have proven ineffectual in limiting the growth of public spending and debt. Legislative spending caps are weak and only apply to a fraction of spending, allowing the state to continue unsustainable fiscal practices. In addition, the state Supreme Court has allowed the state to evade constitutional limits on the issuance of debt. Ineffectual budget rules and weak enforcement of other well-designed rules were supplemented by poor accounting practices and budget gimmicks, such as granting pension contribution deferrals to state and local governments, relying on one-shot revenue sources to balance the budget, and failing to report debt in the state’s budget.

5.A. The Treatment of Debt

While the New Jersey Constitution’s debt limitation clause restricts borrowing by requiring voter approval, the New Jersey Supreme Court has permitted broad exceptions to this rule, allowing the state to issue debt through independent authorities and to use debt to balance the state’s operating budget.

In at least 33 states, independent authority debt has become more common in recent years as a source of financing capital projects, emerging as a “particularly blatant evasion” of debt limitation clauses contained in state constitutions.[36]

The New Jersey Supreme Court has ruled that independent authority debt (also known as contract debt since it represents a contract between the treasury and the authority) is backed by the state’s promise to make an annual appropriation to repay the debt. This “subject-to-appropriation” debt, the court has contended, is unlike other forms of state-issued debt, which are backed by the state’s guarantee to use its taxing powers to repay it. In other words, the state is not legally obligated to pay subject-to-appropriation debt.

The issuance of debt by independent authorities increased rapidly in the 1990s. Today, total state debt amounts to $45 billion, or 11.25 percent of state GDP. New Jersey’s annual debt service is $3,478 per capita, compared to a state median of $700 per capita,[37] making New Jersey the sixth-most indebted state. Of this total, voters have only approved $2.8 billion in general obligation debt. The largest piece of New Jersey’s total debt is $27.3 billion in subject-to-appropriation debt, most of it issued through the Economic Development Authority (EDA) and the Transportation Trust Fund Authority.[38] In November 2008, voters approved a referendum to limit this practice via a constitutional amendment requiring voter approval for the issuance of independent authority bonds.

Several bond issues have prompted criticism not only due to the absence of voter approval, but also for their purpose. Debt has been issued to balance the state’s budget. And, in spite of the amount of state and local tax revenues dedicated to school districts, debt has been issued to finance school construction projects.

In 2000, the Whitman administration issued $8.6 billion in School Facilities Construction Bonds to meet the court’s 1997 mandate to upgrade school buildings in Abbott districts.[39] This bond issuance, the largest in the state’s history, became the basis for a court case brought by former Bogota, NJ mayor Steve Lonegan.

Lonegan v. New Jersey argued that the issuance of debt without voter approval violated the constitution’s debt limitation clause.[40] The court split the case. In Lonegan v. New Jersey I, the court only considered the issuance of school construction bonds. They ruled 6-to-1 that this debt was sui generis, or one of a kind, with constitutional underpinnings in both the educational provision, and the school fund provision of the constitution. The court reasoned that since the debt is subject to appropriation by the legislature, it is not binding; thus, the state doesn’t have to pay it. Further, as a practical matter, the state cannot default on its debt without a substantial negative impact on its credit rating and access to financial markets.

In Lonegan II the court considered the general practice of issuing public authority debt without voter approval, excluding for school construction. The court nearly reversed its vote in a 4-to-3 decision, expressing reservations about public authority debt, but found the practice did not violate the state’s constitution, since the debt is not “legally enforceable against the State.”[41]

In 2004, the McGreevey administration borrowed $1 billion against New Jersey’s share of the national tobacco settlement, and issued $900,000 in bonds against the motor vehicles surcharge. The proceeds were used to balance the FY 2004 and FY 2005 budgets. These bond issues were challenged in court by State Senator Leonard Lance and Assemblyman Alex de Croce,[42] who argued that issuing bonds to pay for general operating expenses violated the state constitution’s revenue clause.[43]

The court agreed, acknowledging that relying on bond proceeds as revenue “belies the common sense notion of a balanced budget and is contrary to the framer’s original intent in the Appropriations Clause… bond proceeds scarcely resemble revenue.”[44] However, it permitted the governor a “one time pass” reasoning that renegotiation of the budget in July 2004 would disrupt the operation of state government.[45]

With the new debt limitation provision in place, subject-to-appropriation debt is likely to decline. However, shortly before the legislature voted in June to place the debt limitation referendum on the November ballot, Governor Corzine issued $3.9 billion in school construction debt. The $8.6 billion in Education Facilities Bonds had largely been wasted. Two-thirds of the planned new school buildings were not built. In spite of accusations of corruption surrounding the initial bond proceeds, the governor and legislature voted to issue the additional bonds in order to meet the court’s requirements under the Abbott decisions.[46]

The treatment and expansion of debt in New Jersey highlights the importance of the courts in setting the fiscal climate. In spite of a constitutional limitation, the courts have given the state wide latitude to use debt for a variety of purposes. Such over-reliance on debt enabled the state to ignore its perennial fiscal instability, borrowing to hide shortfalls in the general fund. In addition to producing structural instabilities, bond issuances added the expense of debt service to the budget and caused New Jersey’s creditworthiness to decline.[47]

5.B. The Pension System

New Jersey has also relied on accounting tactics to mask increasing state obligations and provide local governments with property tax relief. The most dramatic example of this is found in how the state has managed its public pension system in the last two decades.

New Jersey’s pension fund faces a potential $34 billion unfunded liability (up from $18 billion in 2006), which rises to $130 billion when post-retirement medical and prescription drug benefits and stock market losses are factored in.  Until recently,m New Jersey’s pension system was considered sound. In 2000 the plan was funded at 111.4 percent (the ratio of valuation assets to accrued liabilities) with a market value of $85.8 billion. Today it is funded at 50 percent.

Like many states, New Jersey expanded its pension system during the 1990s when the stock market was booming. In addition to benefit expansions, New Jersey’s pension system was weakened by changes in the methodology used to value the fund, and the granting of “pension holidays” to state and local governments.[48] Pension holidays allowed state and local government employers to defer contributions to the pension system between 1997 and 2003.

The Pension Revaluation Act of 1992 changed the valuation methodology from book value to actual market value. This change allowed the state to report a higher rate of return on the fund (from 7 to 8.75 percent) while letting localities reduce their pension contributions in FY 1992 and FY 1993 by a total of $1.5 billion. In 1994 the Pension Reform Act replaced the entry age normal method with the projected unit credit method. Employer pension contributions fell by $1.49 billion.

Until 1997, full annual employer contributions were made to the plan. As the state itself recognized, “offsetting normal employer contributions with surplus pension assets is not a prudent practice.”[49] Federal rules permit states to defer payments to public pension funds when the funds contain excess assets. However, once the fund’s assets were exhausted, the pension plan was under-funded, and employer pension contributions became much higher than they otherwise would have been.[50]

Pension deferrals, while providing short-term budget relief to state and local governments, also create fiscal illusion. In the short-term, governments adjust their behavior, dedicating revenues meant for the pension system to other areas.  When scheduled contributions resume, governments find they are unable to pay the full amount because they have treated temporary payment reductions as permanent, necessitating a “phase-in” of contributions. Phased-in contributions allow local governments to gradually adjust to paying the full contribution. In 2003, local governments gradually began to increase their contributions in increments of 20 percent a year, until they reached 100 percent in 2008. Phase-ins, by continuing to delay full contributions to the system, increase the amount needed to fully fund the pension system.

Deferred contributions and methodology changes were coupled with a series of pension enhancements. In 1999 benefits were extended to surviving spouses, increasing liabilities by $500 million. In 2001 legislation increased the size of the Public Employees Retirement System and the Teachers Pension and Annuity Fund by 90.9 percent, with liabilities growing to $4.2 billion. Other legislation included increased benefits for prosecutors and workers compensation judges.

The state is attempting to curb bad practices. In 2007, Governor Corzine promised “serious restructuring” of the pension system.[51] A few minor changes were made. The Public Employee Pension and Benefits Reform Act of 2008 raised the retirement age from 60 to 62; Lincoln’s birthday was eliminated as a state holiday; and income eligibility requirements for a teacher’s pension were increased to $7,500, saving the state $6.4 billion by 2022. Yet, the recession is leading to a repeat of past mistakes. In March 2009, the legislature approved the governor’s proposal to allow municipalities to defer, for the next year, half of their payments into the pension system to prevent an increase in property taxes.

[36] Briffault, “State and Local Finance,” in State Constitutions for the Twenty-First Century, 221.

[37] State of New Jersey Debt Report and Addendum, November 2008,  http://www.state.nj.us/treasury/public_finance/pdf/2008%20Debt%20Report.pdf.

[38] Other authorities include the Building Authority, the Educational Facilities Authority, the Garden State Preservation Trust Fund, Health Care Facilities Financing Authority, and the Sports and Exposition Authority.

[39] Of this amount, $6 billion was to be used for Abbott districts and $2.6 billion for other New Jersey school districts.

[40] The constitution’s debt limitation clause states, “The Legislature shall not, in any manner, create in any fiscal year a debt or debts, liability or liabilities of the State, which together with any previous debts or liabilities shall exceed at any time one per centum of the total amount appropriated by the general appropriation law for that fiscal year, unless the same shall be authorized by a law for some single object or work distinctly specified therein. Regardless of any limitation relating to taxation in this Constitution, such law shall provide the ways and means, exclusive of loans, to pay the interest of such debt or liability as it falls due, and also to pay and discharge the principal thereof within thirty-five years from the time it is contracted; and the law shall not be repealed until such debt or liability and the interest thereon are fully paid and discharged. Except as hereinafter provided, no such law shall take effect until it shall have been submitted to the people at a general election and approved by a majority of the legally qualified voters of the State voting thereon. New Jersey. Constitution, art. 8, sec. 2, para. a, http://www.njleg.state.nj.us/lawsconstitution/constitution.asp.

[41] Stop the Debt.Com LLC v. State of New Jersey, et al., 176 N.J. 2, 819 A.2d 395.

[42] Steve Lonegan and Stop the Debt.com LLC joined in the lawsuit.

[43] New Jersey Constitution, art. 8, sec. 2, para. 2.

[44] http://iplaw.rutgers.edu/ols/ols08022005.pdf.

[45] As a consequence, the State Superior Court extended the Supreme Court’s ruling to prevent the state from using the net proceeds of bonds to refinance or pay off existing bonds.

[46] Dunstan McNichol and Chandra M. Hayslett, “State funds $4 billion in new school,” The New Jersey Star Ledger, July 9, 2008.

[47] In July 2004, in response to the New Jersey Supreme Court’s ruling to permit the state to borrow $1.9 billion to balance the budget, Standard & Poors Ratings Service and Fitch Ratings lowered New Jersey’s general obligation bond rating from AA to AA-, and their rating on state appropriations-backed debt from AA- to A+.

[48] In 1997, the Pension Security Plan allowed the state to issue $2.8 billion in pension bonds. The bonds were issued to eliminate a $4.25 billion unfunded liability that surfaced when the Whitman administration entered office. At the end of Governor Florio’s term, the state reported $9.6 billion in debt. However, an additional $1 billion in additional debt had been issued during Governor Florio’s term and not recorded, and a further $4.5 billion in unfunded liabilities was “footnoted” on the state’s balance sheet, bringing total state debt of $14.75 billion. The pension bond issue enabled the state to refinance its total debt by reducing the total amount and paying a lower rate of interest over a shorter period. The proceeds of the bond sale were deposited into the pension system.

[49] Report of the Benefits Review Task Force, December 2005, http://www.state.nj.us/benefitsreview/final_report.pdf.

[50] Ibid, Report of the Benefits Review Task Force, 17.

[51] David W. Chen, “Session Over, Corzine Vows to Keep up Fight on Benefits,” The New York Times, December 19, 2006, http://query.nytimes.com/gst/fullpage.html?res=9B01E3D71331F93AA25751C1A9609C8B63.