Why the state must set a new course for fiscal responsibility

By Bill DeRosa

In the summer of 2009, as Connecticut struggled to see its way out of the recession and lawmakers wrangled with the Rell administration over how to erase $8 billion in red ink from the state budget, CBIA called for comprehensive reforms to state government to prevent future fiscal turmoil and spur economic growth. We argued in CBIA News that decisive action is critical, because a turnaround in the economy alone would not be enough to avoid budget crises down the road.

We said that even if our economic recovery is faster and more robust than economists predict (it hasn't been), and income, business, and sales tax revenues rebound (they haven't), massive unfunded liabilities for state employee pensions and retiree health benefits would put enormous pressure on future budgets.

Fast-forward to 2011. In the absence of systemic changes to make state government more efficient and less expensive, Governor Malloy inherited a $3.2 billion budget deficit, which the administration and legislature addressed with the largest tax increase in Connecticut history, an agreement with the state employee unions that fell short of delivering a promised $1.6 billion in cost savings, and modest spending cuts and government reforms.

Although Governor Malloy and lawmakers deserve credit for beginning to reduce our unfunded liabilities, streamline the bureaucracy, and cut costs in some of our highest-spending areas, progress in reforming state government has been slow: too slow, in fact, to head off another fiscal crisis as the 2013 General Assembly prepares to convene on Jan. 9 and craft a new two-year budget.

At press time, the state faced a $415 million deficit for the current fiscal year and, as a result, had begun seeking lines of credit for as much as $550 million to prepare for the possibility that short-term borrowing would be necessary to pay for the daily operations of government.

Looking out to the next biennium (Fiscal Years 2014-2015), the picture gets even worse. In November, the state Office of Policy and Management (the governor's budget office) projected a $1.16 billion shortfall for FY 2014 and a nearly $1 billion gap for FY 2015.

Spending on a Steep, Upward Arc

Although state officials correctly attribute Connecticut's current budget woes to higher-than-expected demand for Medicaid and lagging tax revenue, that doesn't tell the whole story. At the bottom of it all is the fact that state spending has surpassed taxpayers' ability to support it.

The state's response to budget deficits over the years has often been to add and/or increase taxes or fees, while any budget "cuts" have typically just slowed the rate of spending growth. According to a report published by CBIA this month, state spending has grown 184% since 1990, easily outpacing growth in inflation, the state population, and median household income. The most dramatic spending growth over the last two decades has occurred in five main areas:

  • State employee retiree health benefits: 1,395%
  • Medicaid: 405%
  • Debt service (paying off state borrowing): 391%
  • The corrections system: 253%
  • State employee pensions: 187%

Of course, much of the rise in spending is a response to increased need for vital social services, which have been stretched by the poor economy, as well as rising healthcare costs for the Connecticut's at-risk and aging population.

"Costs have also risen, however, because of agreements made over time to guarantee generous retirement benefits for state employees," says CBIA's report. (For example, retired state employees and their spouses receive free lifetime health benefits after 10 years of service.) "These guaranteed benefits have created significant and perhaps unsustainable long-term obligations for state taxpayers."

Long-Term Liabilities

According to state estimates, Connecticut has $57.3 billion in long-term obligations comprising bonded debt, unfunded liabilities for teacher and state employee pensions and post-retirement health and life insurance benefits, and the cumulative GAAP deficit. That figure represents an improvement over last year's total of $70.2 billion, based on an actuarial valuation of Connecticut's post-employment benefits plan released in May 2012.

Part of the savings came from changes in the state employee retiree benefits structure negotiated with state employee unions. Some of it, however, came from what are likely unrealistic assumptions about the rate of return on the state's invested pension fund.

A report published in September by the Connecticut Policy Institute (CPI) puts the state's total long-term debt at more than $80 billion, the third-highest debt per capita in the country, and argues that the state underestimates the amount of its long-term obligations because it uses an unrealistically high assumed discount rate (the return on invested funds): 8.25% or higher: which allows for a lower valuation of unfunded liabilities.

"The higher the assumed discount rate, the lower the liabilities, since less money would be needed on-hand now to cover benefits owed in the future," CPI explains, adding that most economists believe that the "riskless" rate of 2.5%-3% should be used.

The discount rate notwithstanding, it's difficult to get around the fact that Connecticut's failure to rein in the cost of government and more significantly reduce its long-term obligations has put the state in a precarious fiscal position, increasing the threat of future tax increases, drastic cuts in essential services, and further economic uncertainty.

The situation is not unlike what the federal government is facing, says CBIA President and CEO John Rathgeber.

"Much of the 'fiscal cliff' discussion has focused on the importance of fiscal responsibility to our economic goals: encouraging more business investment, job creation, and higher levels of GDP growth. The same holds true in Connecticut. If we approach our fiscal challenges realistically: in a way that addresses short-term deficits without additional tax or fee increases and puts us on a path toward a more sustainable future with regard to our long-term liabilities: then we'll encourage business confidence."

When that happens, says Rathgeber, economic growth will accelerate, which in turn will help keep the state on a sound fiscal footing going forward.

"Economic growth must be the focus of the administration and the legislature, because if we achieve it, we'll put people back to work and end up with higher tax revenues and fewer people relying on state assistance programs."

In with the Old, Out with the Young

Two demographic trends in Connecticut make controlling future state spending all the more urgent: the aging of the population and the outmigration of young people.

"Connecticut's population has been aging as more baby boomers head toward retirement and out of the workforce," says Joe Brennan, CBIA's senior vice president of public policy. "What's more, we're losing young people faster than almost any other state."

U.S. Census data shows that Connecticut's 25-to-34-year-old population dropped by 28% between 1990 and 2010, a decline eclipsed only by Maine and New Hampshire (29.5% each).

"From a fiscal perspective, those trends don't bode well for Connecticut, because demand for public services like Medicaid will increase at the same time fewer people are available to pay for them," says Brennan. "In addition, if we keep piling up debt on young people, it will be difficult to attract them to the state."

Former U.S. Comptroller General (1998-2008) David Walker agrees. A Bridgeport resident, Walker is the founder and CEO of the Comeback America Initiative, a nonprofit organization dedicated to promoting fiscal responsibility and sustainability. He argues that if the state fails to reduce its long-term obligations and improve in other areas, it will be unable to compete for new businesses and skilled workers, and existing companies and residents "will eventually flee the state."

"We are rapidly approaching a tipping point and cannot delay acting any longer," he says. "Connecticut faces serious fiscal and other key sustainability challenges"_It needs major transformational changes that must be led by the governor with the support of key groups, including the business community. I am willing to do my part to help achieve needed transformational changes. However, if I do not see real progress within the next three to five years, I: along with many other Connecticut residents: will leave."

Competitiveness in the Balance

Loss of economic competitiveness is a real risk for states that continually struggle to make ends meet and manage long-term debt, because a state's fiscal condition is a major consideration when businesses decide where to invest. In a fiscally stable state, businesses can operate with confidence knowing that tax increases or unfavorable changes to the tax structure aren't a perpetual threat. That's not the case in states where fiscal mismanagement leads to repeated budget deficits and pressure to increase revenues.

In fact, CBIA's 2012 Annual Membership Survey found that Connecticut's fiscal problems and their potential impact on taxes are a major worry for business owners here. When asked to identify their greatest concern related to their ability to operate a successful business in Connecticut, 40% of respondents cited fiscal issues: taxes, potential state budget deficits, and the state's unfunded liabilities.

Similarly, a CBIA survey of businesses in northwestern Connecticut in November found that 90% of respondents are concerned or extremely concerned about the state's fiscal situation, and 65% say that it has affected their long-range business decisions.

Rathgeber is quick to point out that enabling Connecticut to compete in the global economy does not translate into companies producing cheaper goods while offering lower wages and fewer employee benefits.

"Actually, it's just the opposite," he says, citing a 2012 study, Prosperity at Risk, by noted Harvard Business School professors Michael Porter and Jan Rivkin.

Porter and Rivkin define competitiveness as "the extent to which firms operating in the U.S. are able to compete successfully in the global economy while supporting high and rising living standards for Americans." They argue that competitiveness depends on improving productivity, "creating a high value of goods and services per unit of human, capital, and natural resources deployed."

"That's exactly what we're talking about when we advocate for a more economically competitive Connecticut," says Rathgeber. "It's not that we want to find the lowest common denominator; Connecticut is known for its innovative companies that provide high-value-added products and services with a highly skilled, well-paid workforce. We want to build on that so that we can sustain a high quality of life, not only for ourselves but also for future generations. It won't happen, however, if rising state spending and inefficient use of taxpayer dollars continue to take money out of the economy and discourage business investment."

On the other hand, he says, if Connecticut can move to the forefront nationally in terms of leaning state government and handling its fiscal challenges in a responsible way, the state's reputation locally and nationally would improve, "making us more attractive to the investments needed to fuel economic growth."

Disinvesting in Our Future

Without a bold strategy to address its major cost drivers and long-term liabilities, Connecticut risks reaching its own fiscal cliff, a point at which residents and employers will not only face a heavier tax burden but also potentially drastic budget cuts in areas critical to the state's economic future and quality of life: areas such as transportation, technology, energy infrastructure, and education.

An October 2012 report, Shifting Priorities: Trends in State Appropriations, 1992-2012, by advocacy group Connecticut Voices for Children, documents how state investments in education and other key areas have already been crowded out by rising spending in two main budget categories: Non-Functional and Corrections. The Non-Functional category comprises many of the state's long-term fiscal liabilities, including current and retired state employee health benefits and General Fund debt service.

The report shows that spending in FY 2012 decreased significantly in Education (20.9%), Health & Hospitals (10.7%), and Human Services (7.4%) relative to their proportion of the FY 1992 budget. At the same time, spending in the Non-Functional category increased by nearly 40% and in Corrections by nearly 29%.

'A Big Flashing Yellow Light'

Connecticut's fiscal troubles are also leading to questions about the state's credit quality. A year ago, Moody's downgraded the state's general obligation bonds to an Aa3 rating from Aa2, citing, among other things, "Connecticut's high combined fixed costs for debt service and post-employment benefits relative to the state's budget."

Prior to the Moody's action, Fitch Ratings and Standard & Poor's also downgraded Connecticut's bond rating. Nevertheless, it's worth noting that Connecticut's credit ratings remain solid, if not stellar, and all four rating agencies have given the state a "stable" credit outlook.

Will that last? Some experts aren't optimistic.

In November, Hartford asset management firm Conning Inc. released its biannual State of the States report ranking all 50 states on their credit quality. Based on several credit and macroeconomic indicators, Conning put Connecticut last among the 50 states, down sharply from its June position at 37th.

"Connecticut is not on most lists of states in fiscal stress," said Paul Mansour, managing director of Conning's municipal credit research group and lead author of the report. "However, the reality is quite alarming. The state is among the worst in job creation and tax revenue growth and has not yet seen a recovery in home prices. It has very high debt and retirement obligations, little budget flexibility, and no rainy day fund balance."

In a strongly worded response, State Treasurer Denise Nappier took issue with Conning's results, saying that the survey's "simplistic methodology" doesn't take into account the way the state issues bonds for school construction and other projects. She pointed out that Connecticut's debt issuance is centralized at the state level, a departure from other states that have county forms of government and often issue bonds at the local level.

"Indeed," said Nappier, "were Conning to make this more pragmatic comparison, state and local debt combined and compared to GDP puts Connecticut squarely in the middle of the pack, not at the bottom."

Nappier admitted, however, that Connecticut is feeling the effects of "past shortsightedness" in the funding of state employee retirement benefits, but she believes that new Malloy administration initiatives "will set the state on a more fiscally prudent path when it comes to the long-term funding policy of its retirement system."

CBIA economist Pete Gioia views the Conning report as a "big flashing yellow light," a warning to Connecticut that we need to "formulate a plan to defease our long-term debt and set the stage to improve our credit rating. If we ignore the warning," says Gioia, "although we are not in peril now, we could put ourselves in peril."

Hope for the Best, Budget for the Worst

So, what do state leaders need to do to turn a flashing yellow light to green?

First of all, says Gioia, they need to adopt a more realistic, disciplined approach to budgeting so that the state isn't struggling to pay down huge deficits every time the economy falters.

He cites rapidly rising Medicaid costs: one cause of the state's current budget deficit: as a case in point, noting that in 15 of the last 20 years, Connecticut has seen overspending in Medicaid. That, he says, reflects the state's unwillingness to recognize the highly variable nature of Medicaid costs, which tend to grow dramatically.

"You can't budget for it based on a rosiest-case scenario or even a median-case scenario," says Gioia. "You've got to have an expectation of something closer to a worst-case scenario and put that much money into the budget."

Gioia also points out that changes to Connecticut's income tax have contributed to recent state budget deficits. The tax relies heavily on revenue from capital gains, financial-sector bonus payments, dividends, and interest: politically popular but historically unreliable sources of revenue, because they fluctuate with the highs and lows of the financial markets. The result, says Gioia, is extreme volatility in the tax structure.

"In good times, such a tax structure swells state coffers, but in bad times, it really shrinks the amount of revenue you're going to get. So the state ends up facing these massive deficits after overspending in the good times."

Consequently, he says, the state must maintain an adequate rainy day fund and be much more vigilant when it comes to spending.

"It's really a matter of underspending in the good times and building reserves so that you can ride out the storm in the bad times. Connecticut hasn't shown that kind of discipline, and when history repeats itself, we're always surprised. But we shouldn't be; it's totally predictable."

Target: 2016

When it comes to addressing the highest-cost parts of the state budget and expanding efforts already undertaken by the Malloy administration to lean government operations, CBIA urges policymakers to have major reforms completed by the end of 2016.

"We're making that recommendation in our 2013 Government Affairs Program," says Gioia, "and we believe the task should be approached with a SWAT-team kind of effort. Ordinary levels of effort and change are no longer acceptable, given how weakly the state is performing economically and that the last biennial budget included a huge tax increase."

The good news, he says, is that state policymakers don't have to reinvent the wheel. He points out that the Connecticut Institute for the 21st Century has released a series of reports outlining ways the state can save billions of dollars. In addition, Connecticut can emulate other states' best practices, something we haven't done enough, says Gioia.

"One of the things that is continually frustrating to me as an observer of the Connecticut fiscal situation is our unwillingness to use the other 49 states as a laboratory for good ideas and different ways of approaching our problems. Our stubbornness to adopt things because they are not invented here does our citizens a great disservice. We have to be a lot more open to shamelessly copying things from other states that work."

Operational Reforms

Since 2011, the Malloy administration has reduced the number of state agencies, through consolidations and eliminations, from 81 to 60 and trimmed the executive branch's permanent workforce by approximately 2,500. In addition, the departments of Energy and Environmental Protection, Labor, and Revenue Services are in various stages of implementing lean practices, with positive results in several aspects of their operations.

To complete the process by 2016, CBIA encourages the state to:

  • Adopt lean and other efficiency strategies in every major aspect of state government
  • Require every major state program and agency to adopt performance-based systems: such as results-based accountability and zero-based budgeting: that measure and compel effectiveness as a prerequisite for funding
  • Upgrade the state's information technology system to create real-time sharing of information across agencies and better coordination of state services

Patients, Prisons, and Pensions

To achieve meaningful results on the programmatic side by 2016, the state needs to accelerate and expand reforms in three high-cost areas: long-term care, corrections, and state employee retirement benefits.

Long-term care. The goals of reforming Connecticut's long-term care system are to ensure that patients receive the care they need in the settings they prefer while reducing skyrocketing Medicaid costs. That can be done by speeding up the transition from a system reliant on institutional care to one that depends more on home- and community-based care. The state has already made some headway through its "Money Follows the Person" initiative, but progress has been too slow.

Currently, close to 50% of long-term care patients in Connecticut are placed in institutional settings, such as nursing homes, where costs can be twice that of home-based care. Rebalancing the system so that 75% of patients are placed in home-based care and 25% in institutional settings will result in significant savings, says CBIA board member Jim Torgerson, president and CEO of UIL Holdings Corporation and chair of the Connecticut Institute's Steering Committee.

"Medicaid is a large expense in Connecticut: More than $4.7 billion in FY 2012," says Torgerson. (Fifty percent of that cost is reimbursed by the federal government.) "Rebalancing our system in the way many other states have already done to expand community- and home-based care will avoid more than $900 million in annual costs by 2025."

Part of the challenge in getting there is the number of state agencies and amount of red tape involved in arranging for Medicaid-funded home care.* "A lot of it is getting all the agencies out of the way," says Torgerson.

Corrections. According to the state Department of Correction's annual report, 17,631 offenders were incarcerated in FY 2011 at a per-inmate cost of $93.29 per day and $34,051 per year.

"The state's correction, parole, and probation systems are also one of the largest segments of the state budget," says Torgerson. "Not surprisingly, costs in these areas are directly tied to the size of the prison population. The key to getting costs under control is making sure recidivism improves dramatically."

Reducing recidivism requires using evidence-based programs to strengthen the corrections system in such areas as substance abuse rehab, education and job training, and collaboration with businesses and community-based organizations to place ex-offenders in good jobs, provide them with support, and monitor their status.

CBIA and its members are working with the Connecticut Institute to promote innovative alternative programs for reducing recidivism, such as the Malta Prison Volunteers of Connecticut, which helps find jobs for qualified ex-offenders.

"We would like to see enough changes to get to a 33% recidivism rate over three years starting at the end of 2016, not 67%, which is about where it is now," says Gioia.

State employee retirement benefits. Connecticut faces a wide gap between the retirement promises made to state employees and the money put aside to keep those promises. There are, however, steps policymakers can take to close the gap and bring pension and retiree health benefit costs more in line with what the state can afford.

Measures stemming from previous negotiations with state employee unions have already been implemented. These include an increased penalty for early retirement, an increase in the years of service to be eligible for regular retirement, mandatory contributions to the retirement healthcare trust fund, and a decrease in the minimum cost-of-living adjustment from 2.5% to 2%.

However, CBIA believes that much more can be done to cut costs while safeguarding pensions and health benefits for those state employees closest to retirement. Among other things, CBIA strongly recommends that the state:

  • Increase the normal retirement age from 62 to 65 and index future normal retirement based upon changes in life expectancy
  • Cap maximum annual pension payouts at $100,000
  • Convert the existing defined benefits pension plan to a federal-type hybrid plan: part defined benefits, part defined contribution, such as a 401(k): for employees more than five years from normal retirement
  • Switch to a defined contribution plan and eliminate post-retirement medical coverage for all new hires
  • Increase medical copays for all existing retirees beginning in five years and all future retirees now

Of course, says Gioia, instituting such changes means further negotiations with state employee unions, something the state should not shy away from.

"We have to have the political courage to approach the unions, looking toward 2015 when the no-layoffs provision from the 2011 negotiations expires, and explain that avoiding layoffs means making some major adjustments to the rules governing the state's retirement program."

Setting the Tone

During the legislative session that begins this month, the governor and lawmakers have an opportunity to set the tone for a new era of fiscal responsibility in Connecticut by reaching agreement on a biennial budget that:

  • Reduces the size and cost of state government while improving its effectiveness
  • Stays in balance without any new tax increases that would hinder economic recovery and hiring
  • Adheres to the state's Constitutional spending cap
  • Advances the phase-in of GAAP: Generally Accepted Accounting Principles

It's also essential, says David Walker, that the budget reflect recommendations from both sides of the political aisle, despite the fact that Democrats control the executive branch and both houses of the state legislature.

"Sustainable success requires bipartisan agreements," says Walker. "In addition, the people will not view a budget agreement as being credible and fair unless it has significant bipartisan support."

A budget that reflects meaningful steps toward long-term fiscal stability would send an important message to the private sector that Connecticut can be counted on as a good place to invest and create jobs, says Rathgeber.

"We have tremendous potential for future growth and prosperity in Connecticut if we get things right. We can solve our educational problems, attract young people to the state, and sustain our quality of life by getting reinvestment by our existing world-class, highly diverse economic base. If we get things right, we can be a global leader in creating 21st century jobs."

Bill DeRosa is editor of CBIA News and can be reached at bill.derosa@cbia.com.

* When the national Medicaid system was created in 1965, institutions were the only real long-term care option, so Medicaid funds paid only for institutional services. Today, in recognition of the growth and desirability of home-based care, the federal government allows states to apply for Medicaid "waivers," which waive the requirement to get long-term care services in an institution, such as a nursing home. Connecticut administers a complicated system of waiver programs, each providing various kinds of services or addressing different types of health conditions. The programs are administered and implemented separately and have strict eligibility requirements, limits on the number of participants, and often, long waiting lists: all factors that make acquiring home- and community-based services extremely challenging.