State and local governments have to get health and pension costs under control, Federal Reserve Board Chairman Ben Bernanke said at a Citizens Budget Commission event.

The commission was holding a dinner in a New York at a time when the New York state government is raising taxes and slashing budgets to cope with shortfalls.

Bernanke told attendees that the recession cut state government tax revenue Bernankeabout 12% between 2008 and 2009, and that tax revenue was up only 3% during the first 9 months of 2010.

Local government tax revenue held up better, but local governments could see their revenue drop, too, as a result of the effects of the real estate slump on property tax revenue, Bernanke said.

Meanwhile, as revenue has fallen, the recession has increased the demand for many government programs, such as Medicaid, Bernanke said. He pointed out that Medicaid caseloads rose to about 50 million in June 2010, from 43 million in December 2007.

State and local governments have responded by laying off or furloughing workers, freezing salaries, and raising taxes, and “continued evidence that states and localities are addressing fiscal shortfalls should help calm the municipal bond market,” Bernanke said.

Despite some turmoil at the beginning of the year, “generally, that market seems to be functioning reasonably well,” Bernanke said.

IN THE LONG RUN

Bernanke warned against the temptation to try to improve state and local government finances by cutting spending on education.

“Research increasingly has shown the benefits of early childhood education

and efforts to promote the lifelong acquisition of skills for both individuals and the economy as a whole,” Bernanke said. “The payoffs of early childhood programs can be especially high. For instance, preschool programs for disadvantaged children have been shown to increase high school graduation rates. Because high school graduates have higher earnings, pay more taxes, and are less likely to use public health programs, investing in such programs can pay.”

State and local governments should work harder at building adequate rainy day funds, and they should avoid becoming too dependent on taxes on capital income, which can fall sharply when the economy cools, Bernanke said.

State and local governments also have to deal with pension and retiree health care obligations, Bernanke said.

Some researchers say state and local governments may have more than $2 trillion in unfunded pension liabilities, and some have suggested that they may have $600 billion in retiree health benefit obligations.

“Some governments are beginning to take difficult steps to address [the pension] problem, although their ability to change plan provisions is limited by the strong legal protection (including, in some states, constitutional protection) accorded to accrued pension benefits of public employees in many jurisdictions,” Bernanke said.