Last year in these pages, we explained how Oklahoma’s public pension crisis is significantly larger than the official estimates.1 In a series of path-breaking new analyses, economists Robert Novy-Marx and Joshua Rauh found that the actuarial analysis of how to determine pension liabilities used a discount rate that is unrealistically high. Using a lower, more realistic discount rate, they found that Oklahoma’s official $13 billion unfunded pension liability (in FY-2008) is actually somewhere in the range of $23.6 billion to a whopping $47 billion.2 More ominously, their calculations estimate that Oklahoma’s pension system will run out of money in 2020—only nine years from now.3

As a result of the significantly larger unfunded pension liabilities, the state contribution to the pension system will also have to be much larger than it is today. In 2010 the state government was required to pay $1.1 billion into the pension system for state workers and teachers (though the state actually paid less). To accommodate even larger required pension payments, the state will either have to (a) reduce other spending, (b) reduce pension benefits, or (c) raise taxes.

Raising taxes to cover the unfunded pension liability would have negative economic effects. The first, and most obvious, effect would be paying the higher tax bill. Recently, Rauh and Novy-Marx released a new study that estimates how much taxes would have to be raised in order to meet the higher annual pension payments discussed above.4

As shown in Chart 1, they found that, for FY-2009, taxes in Oklahoma would have to be $1.2 billion higher—or $850 per household. To put this in perspective, in order to raise $1.2 billion the state sales tax would have to be increased by 56 percent (based on FY-2009 tax collections) or the individual income tax would have to be increased by 48 percent. Keep in mind that this would be a permanent tax increase with all additional revenue going exclusively to the pension system. This would not include any spending increases for education, roads, health care, or anything else.

This then leads us to the second effect of a higher tax bill: a smaller overall economy. Economists call this the “deadweight losses” of taxation. Deadweight loss describes the economic inefficiencies created by taxation, such as when taxpayers reduce work and/or consumption or shift income to avoid taxation. In other words, the very process of transferring resources from the private to the public sector results in a permanent loss of potential economic output.

For simplicity, let’s assume the $1.2 billion in new revenue would be raised through the individual income tax. As a result, in FY-2009, the top marginal income tax rate would need to increase by 48 percent—to 8.13 percent from 5.5 percent.5 The deadweight loss would be $88.8 million per year every year. In present-value terms, the total deadweight loss to Oklahoma’s economy is $2.96 billion—or more than twice as large as the tax increase itself.6 This amounts to $2,069 per household.

Overall, then, the current public pension system would cost Oklahomans $2,919 in higher taxes and lost economic output if policymakers pursue higher taxes as the route to resolving the pension crisis. Clearly, this price is too high, especially with Oklahoma and the rest of the country mired in a “jobless recovery.”

Fortunately, state legislators chose wisely in 2011, deciding that reforming the public pension system was in fact the better choice for Oklahoma’s taxpayers. The enactment of HB 2132 will shave more than $5 billion from Oklahoma’s unfunded pension liability. (Since this legislation was enacted only a few months ago, it was not factored into the analysis discussed above.)

But even with this year’s reform, keep in mind that Rauh and Novy-Marx estimate that Oklahoma’s true unfunded pension liability is as high as $47 billion. If that’s the case, HB 2132 reduces that by a mere 9.4 percent. Further pension reforms are needed to put the pension system on a sustainable path.

Legislators should consider pension reforms such as replacing the current defined-benefit system with a defined-contribution system for new employees and right-sizing the state government workforce to further reduce the unfunded pension liability.7

Economists J. Scott Moody (M.A., George Mason University) and Wendy P. Warcholik (Ph.D., George Mason University) are OCPA research fellows.

Endnotes

1 Moody, J. Scott, and Warcholik, Wendy P., “Oklahoma’s Public Pension Crisis: It’s Worse Than You Think,” Oklahoma Council of Public Affairs, Perspective, September 2010. http://ocpathink.org/articles/1016

2 Novy-Marx, Robert, and Rauh, Joshua D., “Public Pension Promises: How Big are They and What are they Worth?” July 10, 2009. http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1645454_code345896.pdf?abstractid=1352608&mirid=1

3 Rauh, Joshua D., “Are State Public Pensions Sustainable? Why the Federal Government Should Worry about State Pension Plans,” prepared for the Urban-Brookings Tax Policy Center/USC-Caltech Center for the Study of Law and Politics conference “Train Wreck: A Conference on America’s Looming Fiscal Crisis,” January 2010. http://www.taxpolicycenter.org/events/upload/Rauh-ASPSS-USC-20091231.pdf

4 Novy-Marx, Robert, and Rauh, Joshua D., “The Revenue Demands of Public Employee Pension Promises,” June 2011. http://kellogg.northwestern.edu/faculty/rauh/research/RDPEPP.pdf

5 The top rate is currently 5.5 percent. It drops to 5.25 percent on January 1, 2012.

6 Based on a 3 percent discount rate.

7 “Oklahoma’s Bureaucratic Overhead Problem Persists,” May 3, 2011. http://www.ocpathink.org/articles/1148