Cutting without Hurting the economy

I had a long conversation with a friend this morning about the effect that the cutting of state and local budgets could have on the economy. My friend maintains that cuts will greatly hamper any recovery by the economy. this is not necessarily true; indeed, there are many ways for state and local governments to cut that will do no harm at all.

First, let's start with some key facts: in 2011, state governments will spend more than they did in 2010. The same is true of local governments. The state and local governments will spend just under 200 billion dollars on pension costs in 2011. This is about 8% of total spending. Nearly all state and local pensions are defined benefit plans, while the pensions granted in private industry are nearly all defined contribution plans.

Let's analyze these facts: First, there is no reason why government workers should get better benefits than the standard in private industry. government ought to switch to defined contribution plans. For those of you not familiar with the lingo, a defined contribution plan is like your 401K, a plan in which the employer contributes a fixed percentage of the worker's income (like 3%) each year. Defined benefits work like social security in the sense that no matter what got paid into the plan, the worker gets a fixed amount paid each month once he or she retires.

Second, there is no current benefit to the state or local government or to the economy as a result of funding the pension plan. If the state of Connecticut puts half a billion dollars into the pension plan, that money comes out of the tax revenues received by the state. It then goes into investments like bank deposits or corporate bonds. It does not work to increase demand in the economy. Indeed, if the pension contribution is not made, the money left in the hands of the people is more likely to be spent or invested in a way that will expand the economy. This means that a cut to pension contributions will not harm the growth of the economy; quite the contrary, it may well help growth.

Third, by removing the need for ever larger future pension contributions by the states, a change in state pension plans to defined contribution ones will take away huge future liabilities that are now sitting on the state balance sheets. By removing these liabilities, the fiscal health of the states will be improved, and this may reduce the borrowing costs for the state.

In other words, here is an area that can be cut by the state and local government without doing any harm to the economy. In fact, these cuts could help the economy. Further, these cuts will make no difference to the state employees in the short term. Only those who stay long enough to retire will be affected. These folks will have years to plan for a different form of pension plan, just like everyone who works in the private sector.