The Supreme Court of the United States (SCOTUS) on June 27th ruled in a 5–4 vote that government workers who choose not to join unions may not be required to help pay for collective bargaining and other union endeavors. Bloomberg estimates that this ruling will affect 5 million workers. Many feel that governments have been at a disadvantage, noting the conflict of interest that may arise when politicians must negotiate with the constituents that elect them. Fewer dollars flowing into the political operations of organized labor may give governments a better negotiating position regarding municipal employee salaries and the pension and other post-employment benefits that are becoming outsized burdens on governments and taxpayers. Later in this commentary, we compare right-to-work states (where employees cannot be required to pay agency fees to a union) and their pension funding status with the 22 non-right-to-work states. The upshot: 76.1% funded compared with 59.3% funded, respectively.

On June 21, 2018, the SCOTUS also ruled 5–4 to allow taxation of internet-based sales by ruling against the physical presence rule in the case of South Dakota vs. Wayfair. This ruling overturned past rulings that were predicated on an economy that did not depend on internet commerce; the historic Quill case was based on catalog sales. We think this ruling will benefit states and localities that have sales tax as a major revenue component and increase debt-service coverage on bonds that are secured by sales taxes. The change in sales tax collection may encourage more businesses to have a local presence because they would no longer be at such a competitive disadvantage with online retailers. Such a trend would further local employment and grow the local tax base.

We think these SCOTUS rulings are favorable for municipal credit, as discussed in further detail in our comments below and as mentioned in John Mousseau’s recent commentary “Tax-Free Munis Continue to Perform”.

Pension Negotiations and Agency Fees

The SCOTUS ruling for the plaintiff in Janus vs. American Federation of State, County, and Municipal Employees Council 31 eliminates the requirement that non-union public sector employees pay agency fees to contribute to the cost of collective bargaining and other activities through fair-share agreements. The court determined that requiring employees to pay the fees violates their First Amendment rights. The new ruling reverses a 40-year-old ruling that allowed the practice.

The Illinois Economic Policy Institute estimates the decision could decrease public sector unionization in California, New York, and Illinois by 189,000, 136,000, and 49,000, respectively. Vikram Rai and his team at Citibank think the drop could be even greater, citing the experience of Wisconsin. That state instituted union reforms in 2011 and became a right-to-work state in 2015. Since 2011, union membership in the state fell from 13% in 2011 to 8.3% in 2018.

An article in The Atlantic on June 27th, quotes from the court’s majority opinion, written by Justice Alito: “We recognize that the loss of payments from non-members may cause unions to experience unpleasant transition costs in the short term, and may require unions to make adjustments in order to attract and retain members.” The Atlantic further reports that some unions without fair-share agreements have stepped up to provide important services and more communication with their constituents in an effort to increase union enrollment.

The ruling is expected to bring more power to states when they are negotiating compensation and benefits with unions. Some states have already been able to gain concessions from unions regarding, for example, cost-of-living adjustments (COLA), which can have the biggest bang for the buck in reducing pension liability growth. States may have been making strides ahead of the ruling, possibly because unions are realizing the growing burden. Loop Capital Markets notes in a recent study that the gap between pension assets and liabilities shows no sign of narrowing, despite pension reforms, and that among states reporting 2017 data, the net pension liability has increased from $284 billion to $379 billion from 2014 to 2017, a period of generally favorable investment returns.

Moody’s recently maintained its stable outlook on Kentucky’s Aa3 with a stable outlook in part because of the credit benefits of recently enacted pension reforms that maintain employer contributions, reduce employee benefits, and create a new mandatory hybrid plan for teachers. Colorado’s outlook was revised on June 7th to stable from negative by S&P, following the state’s adoption of pension reform that should stem the decline in the funded level and lead to full funding in 30 years. In May, the Rhode Island Supreme Court reaffirmed a 2015 pension overhaul settlement that eliminated COLA adjustments, increased retirement ages, and formed hybrid pensions.

Fitch Ratings notes that regardless of the legal framework of a state, state and local governments remain limited in their ability to control labor spending and points to the mass demonstrations by public school teachers in several states. We commented on this phenomenon in our Q1 muni credit piece. Fitch does note that any changes arising from the ruling are likely to be incremental. We think that while some municipalities with large unfunded liabilities need immediate changes, pensions are a long-term issue, and incremental change can help.

The ruling will, it is hoped, reduce the politics of union negotiations and focus on the well-being of retirees, current employees, and taxpayers to arrive at sustainable solutions. This trend would bode well for municipal credit quality.

Right to Work and Pension Funded Level

A right-to-work state has laws that guarantee that no person can be compelled, as a condition of employment, to join (or not to join) or to pay dues to a labor union. The ruling essentially eliminates the right-to-work distinction going forward. However, comparing the pension funding level of the 27 right-to-work states with the others shows that right-to-work states enjoy better pension funding levels. The average funded levels for all states, according to Pew Trust, is 65.9%, while the funded status for right-to-work states is 76.1%, compared with 59.3% for the other states. The chart below shows the funded levels for all states. Not that there aren’t outliers, such as New York, which has a very well-funded pension and is not a right-to-work state, and Kentucky, which is a right-to-work state and has the second lowest funded status.

Pension Funded Ratios: 28 Right-to-Work States Compared with the 22 Non- Right-to-Work States

Sources:*National Conference of State Legislatures ** Pew Charitable Trusts

Sales Tax Ruling

As I noted earlier, the South Dakota vs. Wayfair Inc. ruling decided on June 21st found that a business did not need to have a physical presence in a state in order for the state to levy a sales tax. The decision also recognized improvements in technology that have changed the interpretation of previous rulings. We think this ruling will benefit states and localities that have sales tax as a major revenue component, improve debt-service coverage of sales tax-secured bonds, and may encourage more local businesses to have a physical presence, which would add to tax-base growth.

The effect could be muted in some areas, as some states had workarounds to address the issue, and major providers such as Amazon were already charging and remitting sales taxes. Amazon accounts for over 40% of online retail sales and already remits sales taxes to all states imposing them. However, Amazon does not currently collect sales tax for most third-party sales, which represent about half of its total sales. The court noted in its decision that states should refrain from placing undue burdens on sellers to comply. Improvements in programs and services for smaller online sales companies will help to reduce the burden on the smaller firms to comply with the new law. There are already 20 states that participate in the Streamlined Sales and Use Tax Agreement, which establishes that out-of-state sellers can use tax administration software paid for by the state and are not liable for any mistakes made by the software.

According to a June 21st S&P release, the ruling will help stem state tax erosion in a changing economic environment. In 2017, e-commerce grew 15.9%, while retail sales without e-commerce grew only 3.4%, continuing a long-term trend. We expect most states that impose a retail sales tax to enact new legislation that requires at least large out-of-state online retailers to collect sales tax at the time of sale. This legislation should provide a welcome incremental addition to state coffers. S&P also notes that this process may take some time.

All in all, the sales tax ruling creates a more level playing field and is positive for municipal credit quality.