Despite laws requiring balanced budgets, state and local governments have long concealed the true costs of government through misleading budgeting and accounting practices. This lack of transparency has led to a dangerous cycle: when crises like the COVID-19 pandemic or the 2008 housing collapse occur, the federal government is compelled to bail out state and local governments with billions of taxpayer dollars.
The Case for Balanced Budgets and Transparent Accounting
State and local governments are required by law to balance their budgets to avoid unsustainable debt and promote fiscal accountability. In his book, The Truth About the National Debt, former U.S. Treasury official Frank Cavanaugh asserted, “Politicians should not have the pleasure of spending (getting votes) without the pain of taxing (losing votes).” However, political math and misleading accounting practices often undermine these requirements. State and local governments rely on tricks and gimmicks to create the illusion of balanced budgets or surpluses. These include the selling of assets, borrowing, and cash accounting methods that obscure the true costs of government, such as unfunded pension and retiree healthcare liabilities.
The Hidden Truth of State Finances
For decades, misleading financial reporting has allowed state and local governments to conceal the true scope of their obligations, particularly pension liabilities. The Governmental Accounting Standards Board (GASB) required governments to underreport pension debt, thus masking the full financial burden from taxpayers. As a result, elected officials have been able to delay addressing these liabilities by relying on budget tricks and questionable accounting practices.
Before 1974, corporate officials, like government officials, could make their finances appear better by overpromising pension benefits without disclosing the true liabilities and underfunding them. This practice led to several corporations facing bankruptcy. In response to the public outcry over employees losing their pension benefits, Congress passed the Employee Retirement Income Security Act (ERISA). This landmark legislation aimed to protect employees in private sector retirement and health benefit plans by requiring corporations to fully disclose their unfunded pension liabilities and provide adequate funding for these obligations.
As a result, many private companies moved away from traditional pension plans, adopting 401(k) plans to avoid future pension funding issues. However, a significant flaw in ERISA is that it has exempted state and local governments from its requirements, allowing their pension problems to continue unchecked and grow to unsustainable levels.
The Case of Misleading “Balanced Budgets” and Even “Surpluses”
Most state and local governments use cash-basis accounting for their budgets, a method that the IRS considers so unreliable that it prohibits large corporations from using it. This practice distorts governments' real financial health, enabling officials to claim balanced budgets while accumulating debt. In May 2022, California Governor Gavin Newsom announced a $97.5 billion budget surplus. However, a closer look at the state's financial report, issued in February 2022, revealed an alarming $252 billion in unfunded liabilities, primarily due to pension and healthcare obligations.
California is not alone. The most recent report by Truth in Accounting found that 27 states had a $811 billion shortfall in 2023, despite their net pension debt appearing lower than usual due to the inflated market value of pension investments, driven by strong market conditions. Estimates of unfunded pension liabilities can vary significantly due to the unpredictable assumptions used in their calculation. Some estimates place the pension debt at over $1.59 trillion, highlighting the risks of defined benefit pension plans and exposing taxpayers to the uncertainty of potential tax increases and spending cuts in other areas.
During his re-election campaign, Illinois Governor J.B. Pritzker touted four “balanced budgets,” but in each of those years, the state relied on its notorious budget gimmicks. For example, in 2021, Illinois contributed $4.1 billion less than necessary to meet pension obligations. Between June 2020 and December 2020, the state borrowed $3.2 billion from the Federal Reserve, and the budget accounted for these borrowed funds as revenue, violating common sense and basic accounting principles. Illinois was the only state to use the Federal Reserve’s Municipal Liquidity Facility, as its financial situation was so dire that the municipal bond market imposed prohibitively high interest rates on its bonds.
The Problem with GASB Accounting Standards
Financial reporting should expose the mismanagement in state and local budgets, but instead, it frequently reinforces deceptive practices. GASB requires governments to maintain two sets of financial records. One record is the government-wide financial statements, which use an accrual basis, similar to corporate accounting. However, the second record is the budgeted funds' financial statements. They are prepared using the “modified accrual accounting basis,” despite GASB’s own admission that this method lacks a conceptual foundation. This approach, which resembles cash accounting more than proper accrual accounting, aligns closely with the political math behind budgeting by inflating fund balances, hiding the true costs of government, and omitting massive unfunded pension and retiree healthcare liabilities.
A 2020 SEC staff legal bulletin confirmed that state and local governments are subject to anti-fraud provisions, which require financial disclosures to be accurate and complete. These provisions apply not only to bond offerings but also to financial reports and other public statements, including press releases, interviews, press conferences, and public announcements. However, misleading financial reports and claims of balanced budgets continue to obscure the real financial picture.
The Need for Reform
To break the cycle of mismanagement, we must do the following:
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Encourage the SEC to urge the GASB to eliminate modified accrual accounting and require more transparent financial reporting from state and local governments.
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Investigate whether state and local governments violate anti-fraud provisions in their financial reports and claims of balanced budgets or surpluses.
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Urge Congress to amend ERISA, eliminating the one line that exempts state and local governments.
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Encourage the federal government to provide incentives to state and local governments to refrain from using one-time revenue sources or borrowing to balance their budgets and instead adopt accrual budgeting and accounting practices that reflect only earned revenue and all of the costs incurred, including pension and retiree health care benefits earned, and obligations incurred.
Conclusion
By implementing these reforms, we can ensure that state and local governments manage their finances responsibly and that taxpayers, especially federal taxpayers, are no longer left to shoulder the burden of state and local fiscal mismanagement. Citizens, advocacy groups, and local organizations must hold their elected officials accountable to ensure lasting reform. Public pressure is powerful in demanding greater transparency, fiscal responsibility, and honest financial reporting. Federal taxpayers should not be responsible for bailing out bad actors in state and local governments, especially when those governments have consistently misled the public and mismanaged their financial obligations. It's time to break the cycle of budget gimmicks and end the deceptive practices that endanger our nation's fiscal stability.