Should States be Allowed to Declare Bankruptcy?

No Quick Fix

For many states, the budget crisis is deep and immediate and solutions must be found quickly. In Illinois, Gov. Pat Quinn won permission from the legislature to plug the $13-billion hole in the budget by increasing the state income tax by 67% (to 5.3%), and hike the corporate tax 45% (to 10.9%). And the tax hike still isn’t enough; Quinn reportedly is looking to borrow billions more to fill the gap.

Governor Jerry Brown proposes getting rid of California’s $17.2-billion deficit with a combination of tax increases and spending cuts on services including assistance to children in low-income families, education and health care for the poor. According to CNN, he recently announced a state government-wide hiring freeze, he said, “until agencies and departments prove that they can achieve these savings.”

“California faces a crisis that is real and unprecedented,” Brown said in his state of the state speech. “Kicking the can down the road . . . is simply out of the question.”

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In this act-now environment, giving states the right to declare bankruptcy would be no quick fix. First there’s a constitutional question to answer: Since states are co-sovereigns with the federal government, could they cede control of their budgets to a federal court? Whatever the answer, deciding it would require a long court battle which in all likelihood would ultimately land in the U.S. Supreme Court.

“The idea that [state bankruptcy] will help states solve their short-term budget crisis is silly,” says Max Neiman, a professor of government relations at the University of California, Berkeley. “But it plays to the crowd, and the crowd is angry about the Great Recession.”

Even if state bankruptcy were legal today, the process itself would be slow, bankruptcy experts say. Big corporate bankruptcies sometimes take years to wend their way through court. Compared to a state bankruptcy, that would be a cakewalk.

“In a corporate reorganization you can shed shareholders and creditors,” says James Spiotto, lead bankruptcy attorney at Chapman and Cutler, a Chicago law firm. In a government bankruptcy, however, “you have the same taxpayers, the same shareholders. And you usually have to pay off the same creditors. It’s a far more time-intensive and expensive process.”

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David Skeel, a law professor at University of Pennsylvania, started the whole debate over state bankruptcy by writing an editorial for the conservative Weekly Standard calling for states to be given the right to declare bankruptcy. In it, Skeel drew on the experience of cities and other local municipalities winning the same right in the 1930s to argue that the case for state bankruptcy is relatively simple.

“The constitutionality of bankruptcy-for-states is beyond serious dispute,” wrote Skeel, who did not return phone calls seeking comment.

Bankruptcy experts aren’t so sure. Cities “took four years and a couple Supreme Court decisions” in the middle of the Great Depression to win the right to declare bankruptcy, Spiotto says. “That process would be significantly more complex for states.”

Would it Help or Hurt State Finances? »