What Can Be Done to Fix N.J., Pa. Budget Woes?

It's no secret that New Jersey is in a dangerous fiscal position, due largely to rising pension and health-benefit costs in deeply underfunded plans.

In a new study based on states' audited financial reports, I rank New Jersey 49th out of 50 states for its fiscal health. Recently, I testified before the state Senate in Harrisburg on Pennsylvania's ranking, which is on a similar path at 41st. Fortunately, it may have time to change course by executing some of the same reforms that would help pull New Jersey out of its tailspin.

Most of New Jersey's spending is determined by legislative, constitutional, and federal mandates, leading to a Gordian knot of a budget. Gov. Christie presented a $34 billion balanced budget in June only after reducing the annual pension contribution from $3.1 billion to $1.3 billion and vetoing some streams of education aid. The Legislature proposed to fill the gap with increases in the corporate tax and income tax. Will this be enough, or is New Jersey limping into another fiscal year?

Ask the New Jersey Office of Legislative Services (OLS). It has sobering news to deliver:

If the state fully accounted for what is needed this year to pay for pensions, school funding, transportation, and property tax rebates (that is, all of its statutory obligations), its structural deficit would be $10.2 billion. In other words, if we count up the cost for fully funding this year's bills, New Jersey's deficit is nearly one-third the size of its current budget.

OLS notes that this is an "academic estimate," and one with which "reasonable people can disagree," but it brings home an important lesson: Balancing budgets by downplaying debts and deferring payments isn't the same thing as having healthy finances.

New Jersey is short on cash, struggling to balance its yearly budget, and relying on pay-as-you-go financing to cover mounting Other Post Employment Benefits (OPEB). Public-sector pensions are large and underfunded.

Pennsylvania is under similar short-term strain. At a budgetary impasse, the commonwealth faces a $2.3 billion budget deficit in 2015. Like New Jersey, Pennsylvania's fiscal troubles are largely driven by pension and health-benefit costs for public-sector workers. And with cash reserves insufficient to cover short-term expenses in the event of a recession, Pennsylvania's credit rating has also tumbled.

Gov. Wolf's budget task force also points to the tenuous place the state finds itself with only $231,000 in the rainy-day fund. The legislature proposes structural pension reform and the governor prefers to keep the existing system open and cover the gap with pension obligation bonds. The former will stop pensions from growing, while the latter runs the risk of adding debt to the pension tab.

Both states have shown a tendency to promise everything today while letting the next generation worry about the bill. That explains how we got here - but what can be done to fix it?

There are few basic principles Pennsylvania and New Jersey must follow going forward:

First, don't overlook rainy-day funds. Generally states save too little cash to cushion against recessions. Contributions to the fund should be a priority and should match the revenue loss in an average recession.

Second, both states need to reset their retirement systems. This means moving new workers to defined-contribution systems. And it means discipline in funding existing defined-benefit plans, a promise that the state has made to its workers. Skipping on contributions may buy relief today, but it guarantees greater budgetary pressure tomorrow.

Third, stop using short-term solutions to fix long-term problems. Avoid the temptation to address debt with more debt, the policy equivalent of using one credit card to pay for another. Pension obligation bonds have been used by many states to cover a contribution shortfall, with mixed results. Should pension investments underperform (as they did after 2007), the system has simply added to its pension bills.

In both Pennsylvania and New Jersey, structural deficits can be solved only with structural reforms. Unstoppable spending that overwhelms revenue growth can usually be traced back to promises that were made, or risks that were taken, without fully accounting for the costs. It's going to take a new way of thinking to solve years' worth of problems.