January 17, 2011

Is Bankruptcy A Viable Way Out for State Governments?

There has been recent discussion on whether Congress should authorize states to use bankruptcy laws as a way to shed pension funding obligations for public employees.  There has been chatter on conservative talk radio, debates among law professors and, apparently, a position paper from a well-respected think tank..  The LA Times recently ran an article describing the negative effects on the tax exempt bond market should the State of California file for bankruptcy.  

So, what gives?  The idea that public employee unions – who have consistently made exorbitant demands for increased pay, job security and “comfortable” retirements – should face a day of reckoning is appealing.  During the recession, state employees were paid better than private sector employees and benefitted from a federal bailout to prevent or soften layoffs.  By and large, public employees at all levels were less vulnerable to the wrenching job losses that hit the private sector. 

But now state governments are running short on cash for essential services and something has to give.  Clearly, funding public employee pensions in the current environment places a heavy burden on state governments and threatens the solvencyof many states.   This naturally leads to “creative” thinking about how to put states on more balanced financial footing.  It also presents the traditional critics of public employee unions (conservatives, Republicans, Libertarians, moderates, anyone with a private sector job) a chance to undermine their power and influence.  Hence, talk of a bankruptcy option which states can use to reject onerous commitments such as pension funding.

Whatever the motivation of its proponents, the bankruptcy option for states is not the right answer.  It would involve a host of troubling questions.  

Filing for bankruptcy puts the bankrupt under the full and complete control of a federal court.  Can this really be consistent with the limited government and states’ rights ideals cherished by conservatives and libertarians?  Federal courts should never, ever be given total control over a state.  Could a bankruptcy judge, for instance, order that state inmates be set free to save the state money?  At a minimum, that’s a policy that should be debated and decided in a democratic process.

Filing for bankruptcy typically creates a separate legal entity that succeeds to the rights and obligations of the bankrupt known as the “bankruptcy estate.”  So, what is the relationship between the estate and the governor, or the state legislature, or its U.S.  Senators (who theoretically represent a state, rather than the inhabitants of a state)?   One could easily imagine a nightmare scenario wherein the filing of bankruptcy by a state fundamentally marginalizes the power of its elected political leaders.  That’s not democracy.

There’s more.  Could the bankruptcy judge order the state (or, technically, the estate) to raise taxes to fund government obligations, including public employee pensions?  This is where the bankruptcy option falls apart.  A state that files for bankruptcy will be required to propose a plan of reorganization.  This plan could just as easily propose revenue increases (read: tax increases) as spending reductions (such as rejecting pension funding obligations).  Given the demonstrated power of public employee unions, there is every reason to believe that states will try to use bankruptcy to raise taxes to satisfy important interest groups.  Thus the bankruptcy option could, perversely, strengthen the hand of public employees. 

A much wiser, and less risky, policy option would be to  place meaningful restrictions on any future aid to state governments.  If California wants more federal money, California must first renegotiate its public pension obligations.  If California fails to do so, no federal assistance.  This avoids the thorny issues of excessive federal control over states and limits the ability of public employee unions to force tax hikes in the midst of a recession.