Cities everywhere are setting themselves up to become the next Detroit

Reuters/Rebecca Cook

In the NIRP-heavy world I foresee, a portfolio balanced between major equity and fixed-income will be lucky to break even. Poor returns will be a thorny problem for anyone who is contractually obligated to use portfolio returns to pay certain amounts on certain dates but hasn’t set aside funds to do it.

Defined-benefit pension plans are the primary example. Today these exist mainly for public-sector employees. Private industry has shifted to 401(k) and other defined-contribution plans.  

Public pension plans are rarely fully funded. They assume that future investment returns will make up the difference.

But, what if they don’t?

Property taxes go up to pay for pension promises

In Chicago, retirees went back to the taxpayers whose representatives made the promises and demanded they pay up. And after years of argument and litigation, authorities raised property taxes to meet pension obligations.

Cook County taxpayers recently received their bills and were not amused:

Outside the assessor’s office, city homeowners told one property tax horror story after another.

“Our taxes increased fivefold,” said William Phillips of Rogers Park. “I was expecting it to go up maybe twice as much but not four to five times as much.”

“My tax bill increased almost $1,200 dollars,” said Cornes King of Chatham.

“More than tripled. The city’s piece more than tripled,” said Logan Square resident Janelle Squire.

The bills that arrived over the weekend reflect rising Cook County real estate values and, in Chicago, the city’s $588 million levy increase. Most of it is to restore police and firefighter pensions that Mayor Rahm Emanuel says his predecessors underfunded.

“A number of people across the spectrum politically denied, deferred, and delayed the day of judgment,” said Mayor Emanuel.

“I don’t think that I’m getting the services what I’m paying for,” said King.

Unfortunately for taxpayers, that’s not how the system works. Paying your taxes is not a commercial transaction. You don’t give the government money in exchange for goods and services. You must pay taxes, but the government need not give you anything in return.

Of course, if we’re unhappy with the way the city, county, or state is administering our taxes, we can vote for different politicians who will spend our money more in line with what the majority of us think. So, in general, we do get roads, police and fire departments, parks, and other services that are paid for by our taxes.

The problem is that, in all too many cases, politicians make promises to various government employees that include future retirement benefits. Then, they don’t actually spend the money to fund those promises. And those unpaid balances keep adding up until the future becomes today. This is what’s happening in Illinois and other states around the country.

Reuters/Rebecca Cook

When the current political powers in Illinois decided that they couldn’t afford to pay for the promises made by past politicians, the unions and retirees (not unjustifiably) asked the courts to force the various government agencies involved to keep those promises.

And the courts determined that, under state law, retirement benefits cannot be reduced after the fact.

Thus Illinois courts have determined that retired public employees have more rights than taxpayers do. Retirees are entitled to what their elected officials promised them, no matter how impossible it may be to keep those promises. So elected officials are forced to either reduce current services (such as police and fire and parks and roads) or raise taxes. Paying already contracted retirement benefits is at the top of the list of city expenditures.

Now, let’s go back to that Cook County news story:

[T]he Chicago Public Schools Board is expected to approve a $250 million property tax hike to pay for teacher pensions. The new levy was enabled last week by the Illinois General Assembly and Governor Bruce Rauner. The additional charges, hundreds of dollars more for an average city house, will appear on tax bills a year from now.

“We might have to consider selling. I don’t know if we’ll be able to afford it,” said Phillips of his Rogers Park home.

Mr. Phillips is free to sell his home, but to whom? And at what price?

Here’s the real problem with an increase in property taxes

A home’s market value is a function of supply and demand. Prospective buyers want to know more than the building and land costs before they buy—current and future tax liabilities are part of the equation, too. Mr. Phillips will have to set a selling price that reflects the known and unknown liabilities associated with his house.

In the US today, most people who are buying homes look not so much at the total mortgage but at whether they can afford the monthly payments.

For instance, I have a mortgage on my apartment. But a prospective buyer of my home would be interested not only in how much my monthly mortgage costs but also in my tax and insurance bills as well as my homeowners association dues and payments for utilities and other services.

It turns out that my HOA dues and taxes are significantly higher than my mortgage payments. The total of those costs affects the price I could get for my home if I wanted to sell.

So when Mr. Phillips says he may have to sell his home, those higher taxes are going to reduce its value. He’s going to pay the higher taxes one way or another. He either stays where he is and pays them, or he sells the property at a lower price because of the taxes. Those are his choices.

This isn’t just a Chicago problem or an Illinois problem. A significant number of public-sector pensions everywhere are in the same fix, to varying degrees. They all assume their portfolios will deliver returns well above the 2% to 4% or so that they may actually be able to get in the next decade.

They can try to extract more from taxpayers, but at some point taxpayers will simply leave. That’s what happened in Detroit.

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