On May 7, 2008, the town of Vallejo, California, declared bankruptcy. This San Francisco Bay suburb of 120,000 residents could no longer afford to pay the huge salaries and retirement benefits of its public employees. These contracts are so exorbitant that some of the richest residents of Vallejo are the police and firemen. Ten firemen earned more than $200,000 last year with overtime--a salary nearly four times higher than what the average family in Vallejo earns. Incredibly, 80 percent of the city's budget is consumed by labor and pension costs. "No city or private person wants to declare bankruptcy," says Councilwoman Stephanie Gomes, "but if you're facing insolvency, you have no choice but to seek protection."

Welcome to the next great financial bubble in America--a fiscal time bomb that could cause your local and state tax bills to double or even triple in years to come. They're creating a nasty social problem as well. America, in case you hadn't noticed, is dividing into two nations. The 22.5-million-strong public sector (that includes retirees) is growing ever larger, and enjoying ever greater wages and benefits often guaranteed by state constitutions.

In private-sector America your job hangs on the fate of the economy. Has your employer ever offered you a pension for life? Those retirement accounts you’ve put money into all these years? Unless they are invested in Treasury Notes, they aren't doing too well. In private-sector America, most people are working longer and living poorer.

In public-sector America things just get better and better. The common presumption is that public servants forgo high wages in exchange for safe jobs and benefits. The reality is they get all three. State and local government workers get paid an average of $25.30 an hour, which is 33% higher than the private sector's $19, according to Bureau of Labor Statistics data. Throw in pensions and other benefits and the gap widens to 42%.

Constantly increasing public employee pension costs are crunching municipal budgets and causing service cuts or tax hikes in many states. In California’s Los Angeles County school system, health, pension, and workers compensation liabilities are so mountainous that an estimated one of every three dollars budgeted for the L.A. schools goes to teacher retirement costs. Accordiing to Keith Richman, a former state legislator and now president of the California Foundation for Fiscal Responsibility (CFFR), "The three Rs in the L.A. County school system are now reading, writing, and retirement," moans Richman.

There are other horror stories. The CFFR found that many cities have a 3 percent rule which allows a worker to accrue a pension benefit of 3 percent of his final salary for each year worked. So an employee who started on the job at age 22 can retire at age 52 with a lifetime pension benefit of 90 percent of the final salary. Most California towns also allow city employees to "spike" their pensions. This is a popular scam that allows workers to pad their final salary--and so their pension--by as much as 50 percent through bonuses, overtime, accrued vacation, and other add-ons. These pensions also come with an annual cost of living adjustment and lifetime health care.

So how did the taxpayer get into this jam? There lies the real scandal. For years, even decades, the only people who've cared much about public employee salaries are the public employee unions. The politicians who sit across the table and negotiate with the union bosses have little if any incentive to drive a tough bargain. The costs won't be visible until the politicians who negotiated them are long gone.

In California, taxpayer watchdog groups like the Howard Jarvis Foundation are starting to fight back against the public employee unions. These groups are mobilizing to put an initiative on the ballot called "Proposition 13 for Pensions." It would simply require public employees to work until the age of 65 before they can receive retirement benefits. That's standard fare in the private sector, and the reform would save the state of California and its localities an estimated $500 billion through 2030. No surprise that the unions have pledged to spend millions of dollars to defeat the measure.

The more sensible long-term solution is for cities to immediately abolish these anachronistic guaranteed "defined benefit" pension systems and convert public employees to portable and cost-constrained 401(k)-type pensions. "In the private sector, defined benefit pension structures are rapidly becoming extinct," says financial analyst Dan Clifton of Strategas, a Wall Street advisory firm. "Pretty much only the government still offers them."

But the unions have plenty of political firepower to preserve their pension empire. This year public employee unions are expected to spend $50 to $100 million on political campaigns--as they've been doing for years. No wonder that many politicians behave like fully owned subsidiaries of the unions. So the luxurious benefits of public employees grow more unaffordable each year while the states and cities keep edging closer to the fiscal cliff. Bankruptcy may be their only recourse. Just ask the folks in Vallejo, California.