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New Haven mayor John DeStefano has had a good relationship with his city’s municipal unions through most of his 17 years in office. But lately, those ties have frayed, thanks to the Democratic mayor’s claim that city workers’ wages and benefits—many granted by DeStefano himself in plusher years—have become dangerously unaffordable. DeStefano describes New Haven’s rising worker costs as “the Pac-Man of our budget, consuming everything in sight,” and he is laying off employees and exploring outsourcing to reduce expenses. The mayor’s actions brought angry police into the streets, blocking traffic and blaring sirens in protest. Members of a custodians’ union stormed out of a recent arbitration meeting, outraged by a mayoral proposal to save money. City unions even imported celebrity demagogue Al Sharpton to agitate for their cause.

DeStefano’s plight will be familiar to mayors, city managers, city councils, and boards of education across America. The national media (as well as many policy experts) have focused on state budget battles, like the one in Wisconsin between Governor Scott Walker and public-employee unions. But the truth is that America’s problem with government-worker costs is disproportionately a local issue. Compensation, including wages and benefits, accounts for just 30 percent of state general-fund expenditures, the National Governors Association reports—which makes sense, since states also spend money on programs in which worker pay isn’t the main expense, such as Medicaid. In the typical city, town, or school district, by contrast, compensation costs generally range from 70 to 80 percent of the budget.

Those compensation costs have soared over the years, as politicians made overgenerous promises to local government workers—not just pay but also the right to retire on full pensions at age 50 or 55, annual cost-of-living increases to those pensions, and full health care for life. These concessions haven’t merely resulted in big deficits; they have pushed many localities to the edge of fiscal ruin. Without substantial reform—soon—local taxpayers are likely to face a lethal combination of major tax increases and crumbling services.

Pensions are an enormous part of the problem. New Haven’s $475 million budget, for instance, is projected to grow by just $4 million this fiscal year, but the city’s pension and health-care costs will rise $12 million, forcing cuts elsewhere. In San Francisco, pensions consume about 14 percent of the budget, and rising retirement bills for city workers accounted for one-third of this year’s $306 million deficit. Pension and health benefits account for 20 percent of the $500 billion that the nation’s nearly 14,000 public school districts spend annually. In a recent National League of Cities survey, nearly 80 percent of municipal finance officers listed rising pension payments as one of their most significant budgetary problems.

Here again, the problem is disproportionately local. Yes, state-sponsored pension funds have accumulated anywhere from $750 billion to $3 trillion in unfunded pension and retiree health-care liabilities, depending on how the calculations are made. A huge portion of those liabilities, however, is actually owed by cities, towns, and school districts. States employ just 5.2 million of the 13 million active workers participating in state-sponsored pension funds; the rest are local employees, often teachers, who work for districts too small to manage their own pensions. Experts agree that pension costs for both states and localities are going to skyrocket. But states currently spend just 4 percent of their budgets on pensions, while many municipalities already spend 15 to 20 percent.

Pensions are certainly at the heart of the budget crisis in Costa Mesa, California, a city of 110,000 residents that made news earlier this year when it decided to contract out more than a dozen city services and send pink slips to 43 percent of its employees. Costa Mesa’s workers, like those in many California municipalities, participate in the statewide CalPERS (California Public Employees’ Retirement System). Ten years ago, the city’s annual pension bill from CalPERS was $5 million. Since then, it has tripled to $15 million—16 percent of the city’s $93 million budget—and Mayor Jim Righeimer has warned that it could reach a staggering $25 million by 2015. Since these bills are for services already delivered, there’s no clear way to cut them; even the radical steps that Costa Mesa has taken will limit only future costs.

What’s happening to Costa Mesa is no exception in the Golden State. Earlier this year, California’s Little Hoover Commission, a government oversight agency, observed: “Barring a miraculous market advance and sustained economic expansion, no government entity—especially at the local level—will be able to absorb the blow [from rising pensions] without severe cuts to services.” Los Angeles’s retiree costs currently make up an already troubling 18 percent of its budget, for instance, but the commission estimated that the percentage would swell to 37 percent by 2015. Retiree costs just for L.A.’s public-safety workers could double to $700 million annually, “enough . . . to fund a second police department in a major city.”

The pension situation is even graver elsewhere in California. Anaheim is already spending 22 percent of its $252 million budget on pensions, and its mayor estimates that pension contributions could increase by 50 percent, or about $27 million, in four years. San Francisco’s comptroller has estimated that his city’s pension bill will rise from $357 million this year to $422 million next year and then to $800 million in just a few years. San Jose’s pension costs for police and firefighters have already quadrupled over the past decade. Without reform, the city estimates that its yearly pension costs, $63 million in 2000, will swell to $650 million in 2015.

On the other coast, New York City has seen its annual pension contributions explode from $1.5 billion (6 percent of city funds) in 2002 to an estimated $8.5 billion (18 percent of city funds) in 2012. Pension expenditures have taken more than one-third of the entire increase in Gotham tax collections over that period. And the time bomb is ticking throughout the state—for example, in school districts, which (apart from those in New York City) fund teachers’ pensions through the New York State Teachers’ Retirement System. In a recent analysis, the Manhattan Institute’s Josh Barro and E. J. McMahon estimated that school districts’ total contributions to the fund will have to rise over the next five years from $900 million to $4.5 billion. New York schools are largely financed by property taxes, which would need to increase an average of 3.5 percent a year for the next half-decade to keep pace.

Years of fattening retirement privileges while blithely ignoring affordability have left some cities’ pension systems teetering on bankruptcy. The Chicago Tribune reported last November that Chicago’s public-pension funds were “racing toward insolvency,” with unfunded liabilities estimated by Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester at $44 billion—nearly eight times annual city revenues. Late last year, Illinois passed a law requiring municipalities to move toward properly funding their pension systems—which in Chicago’s case, city officials estimate, would require doubling its property taxes within the next five years. (“From today on, you won’t be able to sell your house,” outgoing mayor Richard Daley told Chicagoans.) The burden is so heavy that Rauh and Novy-Marx believe that a state bailout of Chicago is likelier than gigantic local tax hikes.

A state takeover is already an imminent possibility in Pittsburgh, whose pension system is only 33 percent funded. If Pittsburgh doesn’t pump some $200 million into its pension funds by the end of the year, it must cede control of them to Pennsylvania—a situation that the city is desperate to avoid, fearing that the state would require massive increases in annual contributions, pushing them from $56 million annually to as much as $120 million within a few years. So Pittsburgh, whose entire budget is just $450 million, has approved a plan to raise the necessary money by devoting millions of dollars in parking-meter revenues to the pensions. But that has made it harder to balance the city’s operating budget.

Pensions are only one part of the compensation squeeze choking municipalities. Local governments also helped bring on their current budget nightmares by carelessly expanding hiring and wages in recent boom years. In the decade leading up to the 2008 financial crash, the number of workers for cities, towns, and schools increased 16 percent, even though the country’s overall population grew just 12.5 percent. Wages also increased, and, of course, the hiring frenzy made those pension obligations even worse. The result: over the same decade, the total in wages and benefits that public schools paid to teachers and noninstructional staff (to take one category of public-sector worker) jumped an amazing 72 percent, despite moderate increases in student enrollment.

California’s local governments padded their employee count by 15 percent from 1999 to 2008, with average annual pay rising 60 percent, to $61,185, not counting the cost of benefits, according to the Little Hoover Commission. Average pay for cops and firefighters climbed 69 percent, to $89,056, again excluding benefits. According to the Rhode Island Public Expenditure Council, enrollment in that state’s public schools fell 10 percent between 2004 and 2010—yet the schools employed as many people in 2010 as they did in 2004, and local school boards actually inflated spending 20 percent, to $1.8 billion annually. In New Jersey, where enrollment increased by just 69,000 students from 2000 through 2009, public schools hired 33,000 new full-time staffers—that is, nearly one worker for every two new students.

Some cities face crises because, as their populations shrank, their officials failed to downsize the government workforce. Detroit, a city of 1.9 million in the 1950s, registered only 713,777 residents in the 2010 census. But the city and its school system eliminated jobs only slowly over the decades of population implosion, leaving Detroit with crippling legacy expenditures. The city currently has nearly 13,000 employees but is providing pension benefits to 22,000 retirees, a jaw-dropping ratio of retirees to current workers. The annual pension bill for the city’s retired police officers and firefighters alone is $150 million—as much as it costs to pay the salaries of 65 percent of the police and fire departments’ active workers.

Shrinking cities often banked on state and federal aid to prop up their payrolls as tax collections stalled. As recently as 2008, for instance, Newark’s government and school system received as much as three-quarters of a billion dollars annually from New Jersey; meanwhile, city hall continued to dispense jobs and political patronage, as it long had. Mayor Cory Booker, elected in 2005, vowed to change Newark’s corrupt culture, but he was late to rightsize local government until Governor Chris Christie slashed aid to Jersey municipalities in 2010. In a city where personnel costs made up four-fifths of the budget and had swollen 60 percent over five years, Booker scrambled to close an $80 million 2011 budget gap by putting nonunion staff on a four-day workweek and laying off hundreds.

The budget pain that thousands of cities and smaller governments are experiencing is likely to worsen. For one thing, states have balanced their own budgets by reducing the financial aid that they send to municipalities and school districts. The federal stimulus money that started to flow in 2009, sending nearly $300 billion in aid to states and localities, is now largely used up, too.

Worse, though property taxes—the main source of revenue for many municipalities—actually kept rising during much of the 2008 and 2009 downturn, reflecting multiyear assessments that still included robust economic years, collections are starting to plummet. That drop could continue for a while, if the past is any guide: the previous recession reached its low point in November 2001, but the low point of municipal tax collections didn’t occur until 2003, a National League of Cities survey found. Local governments could conceivably face declining revenues for another 18 months or so.

Cities are also running out of fiscal alternatives to deal with their deficits. Like states (see “State Budget Bunk,” Winter 2011), many cities have used one-shot revenue deals, hidden borrowing, and other gimmicks to bolster their finances. The weak economy has lasted so long, though, that these techniques have been exhausted. To balance its 2010 budget, for example, Providence, Rhode Island, borrowed some $48 million (using its fire stations and headquarters as collateral); it also drained most of its reserve fund, which shrank from $17 million to $2 million in just one year. Moody’s Investors Service and Fitch Ratings subsequently downgraded the city’s bond ratings by two notches, essentially ending its ability to use fiscal gimmicks. But Providence still faces a budget squeeze because its retiree costs amount to 50 percent of tax collections. Newark is up against the same wall. Last year, to close half of its budget deficit, it raised a quick $40 million by selling and then leasing back city-owned buildings—at a cost of $125 million in principal and interest over the next 20 years. Almost immediately after the deal, Mayor Booker admitted that Newark had used up its one-shots, and now a new $40 million hole looms in next year’s budget. Richard Daley balanced Chicago’s budget by raiding funds raised in 2009 when the city sold the rights to its parking-meter revenues to a private company for 75 years, bringing in $1.15 billion. The giant pot of money was supposed to last for decades, but less than 7 percent now remains; Chicago won’t have parking-meter revenues available to it for 73 years.

Local politicians are desperate to find other ways to reduce employee costs. One strategy rapidly winning adherents is to outsource or privatize whole departments or functions, on the assumption that the private sector can deliver many services that government performs, but without the inflated benefits. Mayor DeStefano of New Haven wants to jettison 200 school-custodian jobs in his city and outsource the work to a private firm for an estimated $7 million in annual savings. Chicago’s new mayor, Rahm Emanuel, is touting “managed competition,” in which the city bids out certain services previously performed by municipal workers. Emanuel estimates that by consolidating the city’s sanitation services, now broken up into dozens of smaller systems, and subjecting the work to competitive bidding, Chicago could save $65 million annually. Detroit mayor Dave Bing is also proposing privatizing sanitation for his city, for $14 million in savings. Outsourcing doesn’t always mean privatizing, however: Costa Mesa’s proposed outsourced services include firefighting, which the Orange County Fire Authority would now handle, at a savings of anywhere from 15 percent to 40 percent of employee costs.

Needless to say, unions and their allies relentlessly oppose these money-saving strategies, forcing some local politicians to try to negotiate concessions from unions or, failing that, simply to slash government jobs, at the risk of gutting critical services and harming cities’ quality of life. A National League of Cities survey last fall found that 35 percent of cities had already used layoffs to reduce payroll costs, while 75 percent had hiring freezes in place. After negotiations between Booker and Newark’s police union broke down earlier this year, he laid off 167 cops, about 10 percent of the force. After several years of crime declines that have been a hallmark of Booker’s tenure, Newark’s crime rate has begun rising again. San Jose is getting rid of 500 positions, or 10 percent of its workforce, this year—slashing library hours, shrinking the police and fire departments, and eliminating some city inspectors. Reno, Nevada, has cut about 570 employees, or one-third of its workforce, since the housing bubble there burst three years ago. Even with the layoffs, cost-of-living increases in contracts drove up the average compensation of a Reno city worker 8 percent last year, from $76,914 to $83,540.

Another way to reduce the burden of local compensation involves reforming various things that states require localities to do. These requirements, which can govern everything from how cities negotiate contracts to how school districts can spend money, often hamper local officials’ efforts to balance budgets. More than half of the states, for instance, have laws limiting class size, a 2008 survey by the National Council on Teacher Quality reported. Such laws often amount to unfunded mandates because the state dictates what localities must do without providing the funds to do it.

In response, New Jersey governor Christie has developed a promising “tool kit” of reforms, including giving municipalities the flexibility to furlough workers and to negotiate better contracts with unions. The state has also modified its binding arbitration system: when a police or firefighters’ union and local government officials can’t agree on a new contract, the salary increases awarded by arbitrators are now limited to an average of 2 percent annually. Other states have followed suit, notably Ohio, where new governor John Kasich signed legislation in April replacing arbitration, in the case of a negotiating impasse, with a mediation process that places the final vote on a new contract in the hands of a local school board or city council.

Potentially of even greater consequence are new restrictions on the collective bargaining rights of public-sector workers. Wisconsin’s controversial new legislation gives workers and unions the right to bargain only for wages. In arguing for the bill, Governor Walker explained that back when he served as Milwaukee County’s executive, the state’s collective bargaining law hamstrung his ability to reduce costs and restructure his workforce to avoid layoffs and service cuts. Michigan has followed Wisconsin with a narrower law that allows state-appointed monitors overseeing municipalities in fiscal distress to suspend collective bargaining rights for local workers. Indiana voted to restrict teachers’ collective bargaining to wages, which Governor Mitch Daniels said would “free our school leaders from all the handcuffs” that restrain reform efforts.

Perhaps the most far-reaching budget reform for many states would be to fix their pension systems. In June, the New Jersey state legislature, responding to complaints from local officials about high pension costs, finally enacted reforms that cut them. In Detroit recently, an arbitrator working under the state’s new fiscal-emergency legislation took the unprecedented step of ruling that the city could reduce future pension benefits for some current workers. Without the reduction, Mayor Bing estimated, pension and health benefits would consume half of the city’s general fund by 2015. But other cities still need change. In New York, Mayor Michael Bloomberg has urged the state legislature to raise the retirement age for government employees to 65, from 55 for most workers, and to calculate retirement pay according to an employee’s base pay only, excluding overtime.

Images of angry government workers occupying state capitols or facing off against Tea Party protesters have made for compelling television. Headlines portraying newly elected governors like Scott Walker as union busters are provocative. But the compensation monster is threatening local budgets, too, and it has officials desperately fighting back. If they lose, cities, towns, and school districts across America face a much darker future.

Steven Malanga is the senior editor of City Journal and a senior fellow at the Manhattan Institute. He is the author of Shakedown: The Continuing Conspiracy Against the American Taxpayer.