Underfunded Pensions: The Expanding and Escalating Challenge

A bailout would create what economists call moral hazard by letting states know that if they accrue more debt than they can pay back, the federal government will simply increase transfer payments to allow them to continue meeting their obligations. Bond markets provide a check on the amount of debt that states can accrue, but if bondholders expect the federal government to prevent defaults, they may continue to buy municipal bonds that states cannot pay back. A larger or more prolonged backdoor bailout would further reduce state policymakers’ incentives for fiscal discipline. The American system of competitive federalism relies on state governments providing services to their residents out of the tax revenue that they raise locally. Backdoor bailouts for state pensions would further erode the incentive for states to manage their finances well because the federal government would be further subsidizing all state services. The federal government already faces an enormous fiscal gap, and increasing transfers to state governments would only exacerbate serious fiscal consequences at every level of government.

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