Government Workers vs. Self-Employed: A Financial Comparison

When discussing what level of compensation is appropriate and affordable for government workers, it is helpful to make apples-to-apples comparisons between public and private sector workers. In this analysis, the ultimate private sector taxpayer, the self-employed worker, is compared to the typical state or local government employee in California. In both cases, the annual compensation used for comparison is $70,000, which is the average base salary paid to state and local government employees in California (ref. U.S. Census data for California: State, and Local). But the impact of benefits paid by the government employer, combined with the impact of mandatory employee contributions (taxes, retirement set-asides, and healthcare costs), yield dramatically different end results in terms of total net compensation. Both the self-employed worker and the government worker make $70,000 per year. But to say they make the same amount of money is grossly misleading.

The table below, “Total Compensation – Gov’t vs. Self-Employed Worker,” begins to illustrate this disparity. The difference between total compensation and gross earnings in the case of the self-employed worker is zero. There is nobody paying for benefits beyond what the self-employed person earns. Whatever amenities they need to purchase, they have to pay for out of their gross earnings.

In the case of the government worker, there are a host of employer funded benefits; only the basic ones are covered here, using conservative assumptions. If it is assumed the average household health insurance coverage is $500 per month, and the employer pays 50% of that, this adds $3,000 per year to the total compensation of a government worker. In reality, factoring in employer coverages of medical, dental and vision plans, it is very unlikely the average government worker doesn’t get well in excess of $3,000 per year in employer health care benefits.

Current expenses for health care, however, are not the only health expenses that governments pay for their workers. Typically there are provisions for retirement health care coverage that are taken on as obligations by the government for their workers. For example, there are “medigap” plans, with all or part of the premiums paid for by the government. In some cases, such as with most safety employees and management employees, the government pays 100% of the premiums for lifetime premium health insurance plans. These future obligations must be funded during current employment. To estimate another $2,000 per year for this cost, or, more generally, to estimate $5,000 per year per employee for the average government contribution to current and retirement health care, is definitely conservative.

In addition to healthcare costs, state and local government employers cover pension benefits for which much of the costs – and in many cases 100% of the costs – are paid by the government, not the employee. If one assumes a contribution by the government employer of only 12% of gross salary per year – clearly lower than reality – this adds another $8,400 to the total compensation of a government worker.

A simmering question regarding pensions for government workers – how much can these pension funds really earn each year in interest – generates the next estimate. In our analysis “The Taxpayer Cost to Bailout California’s Pensions,” along with “What Percent of Payroll Will Keep Pensions Solvent,” we have explored the underlying calculations in depth. The reader is invited to review those calculations and assumptions. But the bottom line is this: If pension funds have to lower their long-term expected rate of return by 2.0%, and they will, this will add at least $11,200 per year to the cost of funding the average pension. These obligations may be scaled back, but until they are, this amount must be included when adding up the total compensation of the average government employee in California.

Taking all of this into account, a self-employed person making $70,000 per year makes $70,000 per year. A government worker making $70,000 per year in base pay is actually making $94,600 per year in total compensation, 35% more. But it doesn’t end there.

The next table, below, examines the impact of what might best be described as “mandatory employee contributions,” taking the form of the employee share of health insurance coverage, retirement pensions and social security, along with state and local taxes. Once these mandatory contributions are deducted from the income (before tax in the case of health care and retirement contributions) of both the self-employed and the government worker, and the employer provided benefits – which are tax-free – are added back to the income of the government worker, the disparity between their actual net total compensation becomes even more dramatic.

If one assumes that the self-employed person is going to purchase health insurance for their household, they will pay 100% of the premium. Using the same assumptions, this means they will spend $6,000 per year for these benefits, whereas the government worker, paying 50% of the premium, will only spend $3,000 per year.

By participating in social security and medicare as a self-employed person, they are obligated to pay both the employee and the employer share of those assessments, which at a gross annual income of $70,000 will cost them $10,500 per year. By contrast, even if the government worker pays 10% of their salary into their pension – a level that is still fairly unusual to see among government workers – this will only cost them $7,000 per year.

In the above table, “Net Total Compensation – Gov’t vs. Self-Employed Worker,” these before tax deductions are subtracted from their base annual salary to arrive at their taxable annual salary. This taxable amount then has deducted from it what a California household in 2011 would have to pay in state and federal taxes. Finally, the non-taxable employer contributions are added back to the actual take-home pay to yield the net total compensation after mandatory contributions.

This is the apples-to-apples result: A self-employed person making $70,000 per year, once they’ve paid their taxes. social security and insurance premiums, will enjoy compensation of $45,021 per year. A government worker making $70,000 per year, once they’ve paid their taxes, pension contribution and insurance premiums, with the value of their current and deferred benefits added back, will enjoy compensation of $74,781 per year, 66% more.

It doesn’t end there. As shown on the next table, “Retirement Security – Gov’t vs. Self-Employed Worker,” the self-employed worker, who must pay $10,500 per year for social security and medicare, can expect to retire at the age of 66 with a social security benefit of $20,144 per year. The government worker, who must pay $7,000 per year for their pension, can expect to retire at the age of 60 with a pension of $46,666 per year. The total value of these respective retirement benefits, based on a life-span of 80, is $282,016 for the self-employed worker, and $933,324 for the government worker.

It is important to emphasize how conservative these numbers are. While the average pay of a government worker in California is only about $70,000 per year, the average pension for state and local government workers in California is not $46K per year, but nearly $70K per year. For state and local government workers who retire at age 66 and spend their careers in government service, the average pension is nearly $100K per year (ref. CalPERS Annual Report FYE 6-30-11, page 153, and CalSTRS Annual Report FYE 6-30-11, page 149). This means the assumptions used to calculate pension contributions at various rates of return, which assumed pensions equivalent to 66% of average salary, are obviously inadequate. This is because pensions aren’t calculated on average salary, they’re calculated on final salary. The assumptions underlying our pension contribution estimates also don’t take into account the current state of underfunding for pensions.

For a self-employed person to enjoy a net total compensation equivalent to the average government employee who makes “only” $70,000 per year, they would have to earn well in excess of $100,000 per year, particularly since as they climb in gross income, they encounter higher and higher tax brackets. A self employed person who makes less than $108,000 per year and more than $74,000 per year, because their income is still under the social security withholding ceiling, actually pays taxes at the margin of over 50%. But that is a topic for another post.

Pricing A Taxpayer Bailout of California’s Pensions

Last month both of California’s largest government employee pension funds, CalPERS and CalSTRS, released their portfolio earnings numbers for the most recent twelve months. In a statement released on January 24th, “CalSTRS Calendar Year-End Investment Returns Show Slight Gains,” CalSTRS disclosed “Investment returns for the California State Teachers’ Retirement System (CalSTRS) ended the 2011 calendar year posting a 2.3 percent gain.” CalPER’s statement released on January 23rd, was titled “[CalPERS} Pension Fund earns 1.1 percent return for 2011 calendar year.”

These funds, and the rest of California’s many local government employee pension funds, are still clinging to long-term rate of return assumptions of between 7.5% and 7.75% per year. So how much would taxpayers be on the hook for if rates of return stay this low?

The first step towards determining this would be to estimate the average pension paid out to a state or local worker in California, based on recent retirees who have worked a full 30 year career. Despite the claim that “The average CalPERS pension is $2,220 per month” (made yet again in the final paragraph of their above-referenced press release), for a more accurate figure, one must look at the average pension awarded recent retirees, based on a full 30+ year career. The problem with the low figure used by CalPERS and others is that it includes people who retired decades ago when salaries and pension benefit formulas were much lower, and it includes people who may have only worked a few years for the government. Since we will be multiplying this average pension by the number of full time state and local government workers in California, we have to assume a full career when calculating the average pension, since for every worker who only worked 10 years, for example, two additional retirees will also be in the system who have themselves also only worked 10 years. To calculate the cost of a full-career pension, you have to add all three of these part-career retirees together. Here is what these pensions really average, based on CalPERS Annual Report FYE 6-30-11 (page 153), and CalSTRS Annual Report FYE 6-30-11, (page 149):

CalPERS average final salary for 30 years work, retiring 2010: $82,884
CalPERS average pension for 30 years work, retiring 2010: $60,894  –
Pension equals 73% of final salary (average of 25-30 year and 30+ year stats)

CalSTRS average final salary for 30 years work, retiring 2010: $88,164
CalSTRS average pension for 30 years work, retiring 2010: $59,580  –
Pension equals 68% of final salary (average of 25-30 year and 30-35 year stats)

If one extrapolates the CalPERS and CalSTRS data to the many independent pension funds serving local agencies – many of these are quite large, such as the one for Los Angeles County employees – it is probably conservative to peg the average pension going forward for full-career government workers in California at at least $60,000 per year, and at least 70% of final salary.

The next step in figuring out how much state and local government worker pensions could cost California’s taxpayers in the future is to establish the sensitivity of pension contribution rates to changes in the rate of return of pension funds. CIV FI has explored this question repeatedly, with a good summary in the July 2011 post entitled “What Percent of Payroll Will Keep Pensions Solvent?” Using the same financial assumptions as were used in that analysis, here is how the required pension contribution rates – expressed as a percent of payroll – change in response to lower earning rates for the pension funds. This is based on pensions averaging 70% of final salary, and assumes 30 years working, 25 years retired, and salary (in real dollars) eventually doubling between hire date and retirement date:

If the pension fund’s return is 7.75%, the contribution rate is 22% of payroll.
If the pension fund’s return is 6.75%, the contribution rate is 28% of payroll.
If the pension fund’s return is 5.75%, the contribution rate is 37% of payroll.
If the pension fund’s return is 4.75%, the contribution rate is 48% of payroll.
If the pension fund’s return is 3.75%, the contribution rate is 63% of payroll.

What the above figures quickly indicate is not only that the required payroll contributions go up sharply when projected rates of investment return come down, but that the lower the rate of return goes, the more sharply the required contribution rises.

To complete this analysis, one only needs to multiply the number of full time state and local government employees in California by the average payroll for these employees, and multiply that result by the various required contribution rates. Using 2010 U.S. Census data for California’s State Employees and for California’s Local Government Employees, one can quickly determine that there are 339,430 state workers earning on average $68,880 in base annual salary, and there are 1,185,935 local government workers earning on average $69,399 in base annual salary.

To sum this up, there are currently 1,525,365 full time (not “full-time equivalent,” which would be an even higher number, but those part-time employees may or may not have pension benefits) state and local government employees in California. They earn, on average, $69,284 per year in base pay. Here is how much pensions will cost for these workers each year based on various rates of return:

If the pension fund’s return is 7.75%, the state pays $23 billion to pension funds each year.
If the pension fund’s return is 6.75%, the state pays $29 billion to pension funds each year.
If the pension fund’s return is 5.75%, the state pays $39 billion to pension funds each year.
If the pension fund’s return is 4.75%, the state pays $51 billion to pension funds each year.
If the pension fund’s return is 3.75%, the state pays $66 billion to pension funds each year.

It is interesting to note that both CalPERS and CalSTRS failed to even achieve a 3.75% return in calendar year 2011, the lowest amount used in these examples and the lowest amount that can even keep pace with inflation.

When one takes into account the fact that only about five million households in California pay net taxes, the impact of the pension con job Wall Street brokerages have enlisted the support of public sector unions to foist onto taxpayers is even more dramatic. Because if, during the great deleveraging that likely will consume this economy for at least another decade, California’s pension funds only deliver 3.75% per year, instead of 7.75% per year, that will translate into $8,600 per year in new taxes for each and every taxpaying California household.

Preserving America’s Middle Class

To say America’s middle class is threatened is a common refrain. But there is no malevolent force operating to shrink America’s middle class. America’s middle class is challenged by the momentum of history. Technology automates jobs at the same time as the capacity of foreign manufacturers continuously improves. At the same time, American taxpayers confront the challenges of providing for an aging population as well as choosing what is affordable from an expanding array of social welfare and safety-net choices. In some respects, America’s middle class is a victim of its own success – we live longer, we have better medical technology, our productivity is continuously improving, and American military power – expensively purchased – enables competitive global commerce. Here then, relieved of ideological cant, are the reasons for America’s shrinking middle class:

(1) More money is needed to take care of retirees, and investment returns will no longer cover most of the costs. America’s aging population creates higher demand for liquidity, because retired people need to sell assets to generate cash to pay bills. As an ever higher percentage of America’s population are retirees, there will be more sellers in the investment market, dampening prices and price appreciation. This will lower rates of return on retirement investments and, in turn, all assets.

(2) Advancing technologies have automated millions of jobs. From office information systems to robotic manufacturing, innovation has eliminated the need for millions of highly educated, highly skilled workers. Despite rising productivity, workers have been relentlessly displaced. Entire industries have experienced steady growth at the same time as they have reduced their workforces.

(3) International competition to export products has never been more challenging. Nations create jobs more easily if they are net exporters. During the half-century beginning around 1950, America went from being the only industrialized nation left standing in the wake of WWII to being reduced to 25% of global GDP. Still the world’s largest economy by far, the U.S. has not been a net exporter for nearly twenty years – instead the U.S. relies on foreign purchases of U.S. assets to offset chronic trade deficits.

(4) The ability of the U.S. economy to sustain a trade deficit via debt accumulation is not unlimited. The sheer size and diversity of the U.S. economy buys time, but Americans already carry an unusually high debt load. To the extent that interest payments are remitted to offshore creditors or offshore corporations, American borrowing to finance imports is sending cash and jobs overseas.

(5) Failure to regulate speculative lending, combined with the internationalization and automation of trading in stocks and other assets has enabled America’s debt bubble to reach unprecedented levels. The last time the total market debt in the U.S. exceeded 300% of GDP, America’s economy experienced the great depression. Total market debt in the U.S., not including derivatives, approaches 400% of GDP.

The way to preserve America’s middle class requires embracing disruptive innovation and competition.

In a age where the U.S. no longer owns virtually all the productive assets in the world, the ebb and flow of trade balances between nations requires them to take turns either relying on debt accumulation and asset inflation to finance their trade deficits, or being nations that eliminate debt and have positive cash flows through being net exporters. Because innovations deliver increasing productivity, this ebb and flow can yield aggregate net asset values of all nations combined continuously increasing. As long as these asset values increase, debt accumulation does not have to stop completely. If collective global asset formation has sufficient momentum, even nations who are net importers and are accumulating debt can still improve their debt to asset ratios, rendering them economically healthier.

The key to economic growth, however, is not just to increase productivity through supporting technological innovation, which is difficult enough by itself. Nations also must support policies that lower the costs for basic resources, energy, water, land, materials. This requires competitive resource development, something that is resisted by powerful special interests, corporate, labor, environmentalist and government, who all benefit from high prices and high profits for basic necessities. But if competitive resource development enabled these commodities to be consumed at lower prices, this would release capital for investment in, as well as consumption of, entirely new classes of assets that technological innovation is delivering at an accelerating rate. Increasing productivity through technology is creative destruction, and, crucially, results in asset deflation and lower profit margins in the monopolistic sectors being disrupted, but this is nonetheless desirable because it is the only way sufficient capital can flow instead into investments in entirely new classes of valuable, previously nonexistent assets. Only by creating new assets in new industries can technological innovation ensure a continuous increase in global economic wealth, and hence more collateral to improve debt / asset ratios. These new areas for investment and asset formation will issue from ongoing and dramatic technological innovations in the fields of health care and life-extension, entertainment and transportation, expansion of settlements and industry into outer space and the deep ocean, and myriad other compelling products and services we can’t yet imagine.

This is one of the unheralded tragedies of a malthusian “setting limits” mentality common to environmentalists and coopted by corporate and union cartels. Despite daunting challenges that span every continent and culture, human civilization is experiencing a golden age of technological advancement – steady improvements to the collective global per-capita standard of living – and that golden age may be denied fruition by misguided policies designed to curtail development of energy and other basic resources. By encouraging competition to provide these commodities at lower prices, capital becomes available to eliminate debt and invest in new industries. This allows for more rapid increases in per capita wealth and lower birth rates. Ultimately, tomorrow’s global energy consumption and resource depletion will be less if rapid energy development occurs today.

America’s middle class faces new rules, but these new rules are actually the historical norm for peoples in the world. The aftermath of WWII, which bestowed on the U.S. a pent-up ability for consumer product innovation, a uniquely intact industrial base, and an explosion of births that, for a while, kept pace with advances in life-span, was an aberration without precedent in human history. The good news is that the absolute median standard of living for Americans continues to improve. From the poorest person to the richest in America, as well as throughout the polarizing middle, the available amenities consistently exceed, year after year, what has come before.

America’s middle class is indeed threatened, insofar as the economic distance between those at the top and those at the bottom is widening, and the percentage of people in the middle is declining. But by embracing competition and innovation of all types, Americans, who remain at all strata better off than they have ever been, can climb out of their debt quagmire and usher in the next phase of the digital renaissance.

The Faces of the Forgotten 33%

Last month a post entitled “America’s Forgotten 33% ” described those Americans who are not members of the elite 1% super-rich, nor part of the privileged 20% who work for the government, nor among the nearly 50% of America’s population who are, apparently, poor enough to avoid taxes altogether.

Who are these forgotten 33%? Who is this one-third of America, people who, compared to the other two-thirds, pay far more in taxes than they receive in return? Who are the faces of the forgotten 33%?

  • They are small business owners who can’t compete with the crony capitalist captains of big business, who use their financial influence with legislators to enact regulations that small businesses can’t possibly afford to comply with.
  • They are independent contractors who work multiple jobs to earn a mid-five-figure annual gross income, yet pay nearly 50% in taxes on every extra dollar they make (25% federal, 9% state, 13% social security and medicare).
  • They are small investors whose retirement savings lose value at the same time as government employee pension funds beat the market using high-frequency trading and other manipulative tactics that individual value investors can’t hope to emulate (and hold taxpayers accountable to cover the difference when they don’t beat the market).
  • They are parents who can’t get a decent education for their children in public schools, because the teacher’s union makes it impossible to fire bad teachers, and creates a self-serving bureaucracy where administrators outnumber teachers. Parents who have no chance to influence local or state education policy because the teacher’s union will spend literally millions to elect their puppets on school boards.
  • They are elected public officials at the state and local level – especially in the large urban centers – city councilmen and county supervisors – who have to close parks and libraries, and defer maintenance of roads and other infrastructure, because they are bound to pay local government employees wages and benefits that are often more than twice what people might earn for similar work in the private sector.

And the forgotten 33% have friends among the rest of the American people.

  • There are the millions of government workers who deliver an honest day’s work and do their jobs well, yet watch people who merely show up get the same compensation and enjoy the same job security as they do, thanks to union work rules and collective bargaining. And there are additional millions of government workers who are tired of seeing their union dues used to promote politicians and causes they don’t support.
  • There are activists, entrepreneurs, educators, and many others within the disadvantaged communities who have seen for themselves the destructive impacts of government welfare and other social programs.
  • There are members of the elite 1%, the super rich, who want to invest in America but face record high taxes, and industry after industry controlled by special interests who have created regulations designed to protect their turf and deter genuine competition.

How long can the alliance of the big – big government, big finance, big labor, and big business – continue to render more and more citizens dependent on entitlements, buy off the unionized government workers with pay and benefits that greatly exceed market norms, and pursue fiscal and monetary policies that channel more and more wealth to the elite 1% (ref. “The Extremists of the Status Quo“)?

How long can the alliance of the big continue to rely on taxing the forgotten 33% to fund the entitlements, the pensions, and the Wall Street bailouts?

What combination of the forgotten 33% along with their friends among the other two-thirds of America’s electorate might form a new alliance – the alliance of the accountable? How might such an alliance strike an optimal balance between preserving individual incentives and providing ALL workers a reasonable taxpayer-funded safety net for health and retirement security (ref. “Merge Social Security and Public Pensions”)? A critical first step towards forming a political coalition powerful enough to take on the alliance of the big is for voters to recognize that public sector unions are just as much of a barrier to achieving those goals as the monopolistic corporate and financial interests.