By Rob Arnott and Lisa Meulbroek
Most cities, countries and states have committed taxpayers to significant future unfunded spending. This mostly takes the form of pensions and post-retirement health-care obligations. For public employees, a burden that averages $75k per household in some states. Many states protect public pensions in their constitutions, meaning they cannot be renegotiated. Future pension obligations simply must be paid, either through higher taxes or cuts to public services.
Is there a way out for taxpayers in states that are deep in the red? Milton Friedman famously observed that the only thing more mobile than they wealthy is their capital. Some residents may hope that they can avoid the pension crash by decamping to a more fiscally sound state.
But this escape may be illusory. State taxes are collected on four economic activities: consumption (sales tax), labor and investment (income tax) and real estate ownership (property tax). The affluent can escape sales and income taxes by moving to a new state – but real estate stays behind. Property values must ultimately support the obligations that the politicians have promised, even if those obligations aren’t properly funded, because real estate is the only source of state and local revenue that can’t pick up and move elsewhere. Whether or not unfunded obligations are paid with property taxes, it’s the property that backs the obligations in the end.
When property owners choose to sell and become tax refugees, they pass along the burden to the next owner. And buyers of properties in troubled states will demand lower prices if they expect property taxes to increase.
It doesn’t matter if we own or rent; landlords pass higher taxes on tenants. Nor does it matter if properties are mortgaged to the hilt or owner outright. In time, unfunded pension obligations will be reflected in real-estate prices, if they aren’t already. A state’s unfunded liabilities are effectively a stealth mortgage on private property. Think you can pass your property on to your heirs? Only net of the unfunded pension obligations.
We calculated the ratio of unfunded pension obligations relative to property values in each state. We used 3% bond market yields as our discount rate to measure unfunded obligations, because while other assets ostensibly earn a risk premium above the bond yield, these assets can also underperform.
Unfunded pension obligations range from a low of $30k per household of four in Tennessee to a high of $180k per household in Alaska. They amount to less than 11% of the average home values in Florida, Tennessee and Utah and more than %50 in Alaska, Mississippi and Ohio.
There are a few surprises. California, Hawaii and New York have large unfunded obligations, but because property in these states is so expensive, the average household burden is less than 15% of the average home price. Meanwhile, West Virginia and Iowa have relatively low pension debts – but the average household obligation is more than 30% of the average home price because property is far less expensive in these states.
On average nationwide, unfunded state and local pension burdens represent 20% of real estate values. This ratio can rival or exceed an owner’s home equity, depending on the size of his mortgage. If real-estate prices adjust to reflect unfunded pension obligations, many homeowners’ equity could be at risk. As we’ve seen in Detroit, the public pension stealth mortgage can ultimately devastate the housing market.
Mr. Arnott is founding chairman of Research Affiliates LLC. Ms. Meulbroek is a professor of finance at Claremont McKenna College. Article originally posted on WallStreetJournal.com
