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"When the small, beleaguered city of Central Falls, RI, filed for bankruptcy this month, it sought to cut the pension checks it has been sending to its retired police officers, firefighters and other workers by as much as half," stated the New York Times on Aug. 13, 2011. But the state of Rhode Island requires its municipalities to have balanced budgets, and the Central Falls Code of Ordinances requires the city to have balanced budgets. With those requirements, how can Central Falls go bankrupt and default on its pension obligations? Easy. Read on.
The notion of the balanced budget is one of the most widely accepted aspects of public finance. Virtually every state claims to have some type of balanced budget requirement and most local governments are also required either by state statute or local ordinance to have one. The National Association of State Budget Officers (NASBO) reports that the constitution, a statute, or both explicitly require the governor to submit a balanced budget in 44 of the 50 states and that the legislature must pass a balanced budget in 41 of the states.1
An earlier study by Lewis found that 99 of the 100 most populous cities claimed to have some sort of balanced budget requirement.2 Although these numbers seem impressive, just how rigorous is the requirement for balanced budgets? Many state and local governments report unrestricted net asset deficiencies in their governmentwide financial statements - deficits that would be billions of dollars greater if their financial statements had to show the full unfunded obligation for retiree pension and health care benefits.
How can governments accumulate such deficits if they must balance their budgets annually? One reason they can is that balanced budget requirements are not rigorous at all. Balanced budget laws lack rigor primarily because of the way the laws are written: They use terms like "expenditures" or "appropriations" without describing the accounting measurements that affect them. As a result, these terms have been interpreted to permit countless budgetary gimmicks and, most seriously, the systematic under-financing of retiree pension benefits by some governments and extensive under-financing of retiree health care benefits by virtually all governments. Another reason balanced budget laws lack rigor is that some laws allow governments to issue long-term debt...