ESSAYS ON ISSUES THE FEDERAL RESERVE BANK JANUARY 2014 OF CHICAGO NUMBER 318a

Chicag­o Fed Letter

What happens after Detroit’s bankruptcy? Lessons in reform by Richard H. Mattoon, senior economist and economic advisor

Detroit recently filed for bankruptcy, becoming the largest municipality to seek protection under the U.S. Bankruptcy Code’s Chapter 9. In the wake of Detroit’s filing, the Federal Reserve Bank of Chicago and the Citizens Research Council of Michigan convened a conference on November 7–8, 2013, to identify strategies to prevent municipalities’ fiscal decline, as well as mechanisms to restore struggling cities’ financial sustainability and economic growth.

Detroit’s bankruptcy filing on July 18, to emerge from the recession in strong 2013,1 is historic for its size and symbol- fiscal shape. Turning to the NLC survey ism: The largest municipal bankruptcy results, Pagano stated that 72% of the in U.S. history represents a low point for respondents are expecting modestly im- the once-dominant American industrial proved fiscal conditions for their cities icon. However, Detroit is certainly not in 2013 relative to 2012. In terms of tax the first U.S. city to face profound fiscal revenues, those from property taxes problems. To examine what lessons might declined in 2012 and are projected to be learned from other episodes of mu- decline again in 2013; yet this decrease nicipal fiscal stress, experts from govern- is expected to be offset by continued ment, academia, nonprofits, and business growth in sales and local income tax Some materials presented at gathered at the conference held at the revenues. That said, not all local govern- the conference are available Chicago Fed’s Detroit Branch. Confer- ments are permitted to levy sales and at www.chicagofed.org/ ence participants discussed models of income taxes by their state governments. local governance reform and state inter- Pagano said that according to the NLC webpages/events/2013/ vention to identify the common strategies survey, the sources of fiscal stress for cities bankruptcy_government_ and tools that cities have relied on to include infrastructure and public safety emerge from their fiscal troubles and reform.cfm. costs, as well as employee-related costs then maintain financial stability and for health care and pensions. Another boost economic growth. source of fiscal stress is declining federal Fiscal positions of cities today and state aid. Cities experiencing such stress have tended to reduce employee- Michael Pagano, University of Illinois at related costs (which make up 70% of a Chicago, provided an overview of cities’ typical budget) to balance their budgets. fiscal conditions today and focused much of his presentation on the findings from Focusing on the fiscal health of local the National League of Cities’ (NLC) governments in Michigan, Debra Horner, annual survey of city finance officers.2 University of Michigan, discussed the The recent recession had a profound results from the spring 2013 wave of the impact on the finances of cities across Michigan Public Policy Survey.3 She noted the nation; however, differences among that local governments in Michigan their fiscal structures due to a number have faced about a decade of strained of factors (such as the available types revenues. State aid was reduced cumu- of taxes and amounts of reserve funds) latively by $4.2 billion from fiscal year led to significant variation in their ability (FY) 2000–01 through FY2011–12. Moreover, local property tax revenues (e.g., not reforming inefficient and ex- distinctions while addressing this ques- are down 20% from their 2007 level pensive labor policies, underfunding tion. First, there are “excludable” services, and are not expected to fully rebound pensions, rolling over debt, and not main- such as education and water. It may be until sometime between 2023 and taining nor improving infrastructure). possible to determine specific prices for 2027, she said. These decreases have these services based on who benefits from The second step has a short-run com- led to a series of expenditure actions, them. In these cases, an average variable ponent to address the immediate fiscal including drawing down general fund cost for a service might be determined problem and a long-run component to reserves, reducing staff levels, shifting and then paid for through a user fee. steer the city’s institutions on the right health care costs to employees, and in- Second, there are “nonexcludable” ser- path toward fiscal sustainability, said creasing intergovernmental coopera- vices, such as public safety, roads, and Inman. In the short run, a fiscal control tion to share costs. (For the most part, courts, for which broad-based taxation board should be set up to oversee city local governments have tried to avoid is the preferred method for funding, finances, achieve a balanced budget, increases in debt loads and reductions in because determining a user fee would be and draw up a five-year fiscal plan. This service levels.) These local government impractical. Third, there is the special case of services for low-income house- holds; Inman argued that it is appro- The goal of state intervention in a fiscally distressed locality priate and efficient to provide these should be to create a sustainable community, not just to services at the city level, although financ- ing for them should occur at the state, solve the near-term budget problem. regional, or federal level. Efforts to fund these services at the city level put undue actions have resulted in a downward board—composed of state, regional, stress on the local tax base, and city fund- trend in municipal fiscal stress across and city representatives—should be an ing for them may crowd out funding for Michigan since 2009–10. independent and credible organization other vital services. In addition, Inman with appropriate powers to enforce its contended that taxes should be focused To conclude, Horner explained survey recommended changes; one of its chief on where people live (not where people respondents’ views and concerns about aims is to signal to outside parties that work): Residential income taxes, land the future of local government funding the necessary steps are being taken to value taxes, and property taxes whose in Michigan. First, respondents recog- restore the city’s fiscal stability. revenues are largely retained by the nized that the funds needed to build new neighborhoods that generate them (as infrastructure and to improve service In the long run, the local governmental opposed to generally distributed across levels will be difficult to obtain. Second, institutions have to ensure that the mar- the city) should be emphasized. Residents there is broad-based support (58% of the ginal benefits of government services are should pay for residential services, while respondents) for significantly reforming greater than or equal to the marginal businesses should pay for business ser- the current funding structure for local costs, said Inman. To achieve this goal, vices. The final question is how to decide governments in order to improve their local government officials must address what to do. Inman argued that to effec- fiscal performance. This support for re- the following questions: tively carry out the policies he outlined, form applies to all major revenue sources, • What should cities do? the best form of governance would be including gas and sales taxes; there is one with a mayor who has broader au- even support for revisiting state consti- • How should cities pay for what thority than the city’s legislative body tutional amendments that set particular they do? (e.g., veto powers requiring a two-thirds requirements on how certain taxes and • And how should cities decide what majority of the city council to be over- governmental expenditures (e.g., for to do? ridden). Also, contracts to provide ser- school funding) are to be handled. vices should be granted through a bidding In answer to the first question, Inman process where government providers How to emerge from fiscal crisis said that city governments should pro- compete with private sector firms. Finally, Robert Inman, Wharton School, vide two primary types of public services Inman said that both neighborhood University of Pennsylvania, presented a (and goods): residential services (e.g., and business improvement districts three-step plan for cities to emerge from education, public safety, sanitation, water should be set up. These special districts fiscal crisis. The first step is to recognize and sewer, neighborhood and parks are areas where property and/or busi- the components of a fiscal crisis. These infrastructure, libraries, and courts and ness owners agree to pay for expanded components are weak demographics prisons, as well as services for low-income public services (beyond those already (e.g., 38% of Detroit’s population is poor households) and business services, which provided by the city)—such as more and 12% is elderly); a weak economy are similar but somewhat narrower (e.g., police patrols and street cleaning—or (e.g., Detroit experienced a 30% drop commuting infrastructure). The next more capital improvements—such as in the number of jobs over the period question is how to pay for these services. upgrading roadways—which may raise 2000–12); and weak government policies Inman discussed some important property values (and in turn enhance property tax revenues). Their success or municipal bondholders a first lien on special assessments are usually necessary failure could help city leaders decide property tax revenues. When Central to regain fiscal stability. on future governmental investments. Falls, Rhode Island, entered into bank- ruptcy in 2011, this law effectively meant Investor and business views The third and final step of Inman’s plan that the brunt of bankruptcy adjustments Lisa Washburn, Municipal Market is about getting the fiscal culture right, would have to be borne by its local gov- Advisors, discussed the impact of which for him involves gaining more ernment work force and retirees (e.g., Detroit’s bankruptcy filing on the mu- stakeholders in the city’s progress and retiree benefits were reduced 55%). A nicipal bond market and strategies for empowering them. The establishment more successful example of state inter- improving market access for fiscally dis- of neighborhood and business improve- vention in fiscally distressed local govern- tressed communities. She noted that ment districts should yield more prop- ments has been in Maryland, Shafroth Detroit’s filing did not surprise the mar- erty and business owners with a stake noted. Even though Baltimore has un- ket. The city’s declining fiscal position in the success of the city and improve favorable demographics, it has done was well known, and the city’s debt had long-run outcomes, Inman contended. fairly well in dealing with fiscal stress, been rated below investment grade since For renters to gain a similar stake, they largely because the state funds the city’s 2009. What did surprise the market was could be sold shares in the city (e.g., local social services. Michigan’s response. Historically, the tax increment financing bonds, whose state had been praised for having a sys- proceeds are normally used to subsidize The main issues facing virtually all cities tem in place for intervening in fiscally the redevelopment of blighted areas), are shifting demographics and pension distressed localities. However, when it he said. funding, Shafroth said. As the population came to Detroit, the state’s lack of a grows older and lives longer, demands Responding to Inman’s presentation, direct pledge of financial support was for services for seniors will rise. In addi- Anthony Minghine, Michigan Municipal viewed by some as a signal to the city to tion, as city workers reach retirement, League, said that a crisis facing a city like file for bankruptcy and default on its ob- they may face underfunded pensions. Detroit is caused by people leaving the ligations. Moreover, the state-appointed In states such as California, Michigan, city as the costs for services accumulate. EM suggested in a restructuring proposal and Illinois, where various types of con- This exodus leads to a failure of the city’s (made shortly before the bankruptcy stitutional protections are in place to financial model as service demands esca- filing) that the full faith and credit pledge preserve public pension benefits, a grow- late and those best able to pay for services behind general obligation bonds did not ing legal struggle is likely to determine if move outside the city’s boundaries. The necessarily ensure that these debts would public pension payments can be reduced service crisis is precipitated at the same be paid off before other debts, such as in order to support fiscal sustainability. time as property values are falling, further pension and health care promises. In eroding the tax revenue base. Minghine In response to Shafroth’s presentation, noted that the goal of state intervention Joyce Parker, The Municipal Group, Charles L. Evans, President ; Daniel G. Sullivan, in a fiscally distressed locality should be to stressed the need for outside interven- Executive Vice President and Director of Research; create a sustainable community, not just tion to restore fiscal balance in troubled Spencer Krane, Senior Vice President and Economic to solve the near-term budget problem. cities. Parker explained some strategies Advisor ; David Marshall, Senior Vice President, financial markets group ; Daniel Aaronson, Vice President, she employed as the state-appointed microeconomic policy research; Jonas D. M. Fisher, Communities currently in distress emergency manager (EM) of two for- Vice President, macroeconomic policy research; Richard Heckinger,Vice President, markets team; Anna L. Frank Shafroth, George Mason University, merly financially distressed Michigan Paulson, Vice President, finance team; William A. Testa, provided his perspective on these matters cities, Ecorse and Allen Park. The first Vice President, regional programs, and Economics Editor ; based on a MacArthur Foundation-funded one was to involve the community in Helen O’D. Koshy and Han Y. Choi, Editors ; Rita Molloy and Julia Baker, Production Editors ; study that examines the experiences of the process of restoring fiscal stability— Sheila A. Mangler, Editorial Assistant. 4 communities currently in fiscal distress. most notably by creating a transition ad- Chicago Fed Letter is published by the Economic Focusing on the role of the state, Shafroth visory board. Establishing such a board, Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ noted that in some cases, state actions may Parker emphasized, would make it easier and do not necessarily reflect the views of the precipitate a local government’s funding to implement difficult changes, such as Federal Reserve Bank of Chicago or the Federal crisis. For instance, in California, the state those to labor contracts that affect city Reserve System. government’s withdrawal of funds for employee and retiree health care and © 2014 Federal Reserve Bank of Chicago Chicago Fed Letter articles may be reproduced in local redevelopment agencies (following pensions. Another strategy is to consol- whole or in part, provided the articles are not the California Supreme Court’s decision idate certain government services (e.g., reproduced or distributed for commercial gain and provided the source is appropriately credited. to dissolve them in December 2011) water and sewer); it may be possible to Prior written permission must be obtained for created funding shortfalls in communi- create cost-sharing agreements for cer- any other reproduction, distribution, republica- ties across the state. In other cases, state tain services with other local governments. tion, or creation of derivative works of Chicago Fed Letter articles. To request permission, please contact actions can determine the flexibility a Finally, Parker said that based on her Helen Koshy, senior editor, at 312-322-5830 or community has in dealing with fiscal EM experience, simply reducing expen- email [email protected]. Chicago Fed Letter and other Bank publications are available stress. For instance, the Rhode Island ditures will not often restore a city’s fiscal at www.chicagofed.org. state government passed a law that gives health. More revenues in the form of ISSN 0895-0164 response to the EM’s proposal and the Assessing the state’s role Eric Lupher, Citizens Research Council of bankruptcy filing, yields on Detroit’s Stephen Fehr, Pew Charitable Trusts, Michigan, argued that in Michigan, state secured municipal bonds spiked, prompt- presented findings from his organiza- involvement comes too late for troubled ing the yields on other Michigan munici- tion’s study on the state’s role in re- localities. Detroit’s fiscal crisis did not stem pal bonds to also rise; thus, both factors sponding to local government financial from a single event but rather was years had a material effect on the borrowing distress.6 The key findings from the in the making. Additionally, Michigan has 5 costs of Michigan municipal issuers. study are as follows: several other cities with similar financial problems and population dynamics. Washburn next discussed some strategies • Nineteen states are allowed to inter- Lupher said that Michigan would be better for fiscally distressed cities to regain vene in a city, town, or county in fi- served by a state program with signifi- access to the credit markets. New York, nancial crisis. However, the level and cant oversight of local governments’ fi- Philadelphia, and the District of Columbia nature of intervention vary widely. nances that would allow the state to head relied on comprehensive strategies that off severe fiscal problems before broader involved improving financial oversight, • Some states (e.g., Michigan, North intervention is required. While Michigan’s setting up an independent authority to Carolina, Pennsylvania, and Rhode state intervention program has many of refinance debt, and creating new access Island) are more aggressive than the features of North Carolina’s Local to funding (through either new revenues others when they intervene. Government Commission, it is under- or borrowing). The State of New Jersey • It is rare for a local government to resourced and does not function as effec- was allowed to intercept revenues of seek bankruptcy protection. tively. Lupher also noted that pension fiscally distressed communities and set funding is often a source of fiscal prob- them aside to make certain payments. • Local governments tend to resist lems, and argued that the state should In all of these cases, municipal bond state intervention. consider creating a guaranteed pooled investor confidence was enhanced. In One state with a long history of state pension fund for all its localities (similar closing, Washburn said that investors will oversight and intervention is North to what the private sector does), which evaluate communities emerging from Carolina: The state created the Local could help support pension payments financial distress based on the leader- Government Commission in 1931 after in fiscally distressed communities. ship in place, the support that the a wave of local government defaults dur- state is providing, and the availability ing the Great Depression. The commis- Conclusion of financial resources. sion monitors local government budgets On balance, the conference presenters William Pulte, of Pulte Capital Partners and intervenes when a local government’s maintained that improved state govern- (a private equity firm focused on building reserves fall below 8% of expenditures. ment oversight of local budgets—coupled products), provided a business perspec- The commission provides technical ad- with institutions that are empowered to tive on what can be done to improve vice (such as financial management ad- complete fiscal restructurings with little economic development opportunities in vice) to the distressed community and can outside political pressure—may hold the Detroit. He said that one clear systemic take over day-to-day operations if war- key to preventing local financial distress problem facing Detroit is the estimated ranted. In addition, the commission pre- or mitigating its effects. 100,000 vacant structures in the city. vents cities from getting into trouble These structures place a large burden on through poor debt and/or pension fund- 1 For more details on the filing, see Gene Amromin and Ben Chabot, 2013, “Detroit’s the city’s police and firefighters, reduce ing practices. All local debt has to be issued through the commission and pen- bankruptcy: The uncharted waters of adjacent property values, and impair Chapter 9,” Chicago Fed Letter, Federal Reserve business investment. So, Pulte argued sion contributions are centralized at Bank of Chicago, No. 316, November. the commission. These requirements that blight removal is necessary to restore 2 For the full report (and related materials), Detroit’s neighborhoods and boost eco- provide oversight for two areas that of- see www.nlc.org/find-city-solutions/ nomic development. Thus far, $150 mil- ten fall victim to improper or inept local city-solutions-and-applied-research/ lion in federal money has been provided fiscal practices. 2013-city-fiscal-conditions. for blight removal, and some large areas— Finally, Fehr said that states should inter- 3 For survey results and other details, see including ten blocks near Eastern Market http://closup.umich.edu/ vene in local governments to maintain michigan-public-policy-survey/. and 14 blocks in the Brightmoor area— their financial safety and health, to avoid 4 For details on the study, see have already been cleared. But additional the stigma of poor fiscal management, funds will be needed to remove more http://publicservicecenters.gmu.edu/ and to prevent “fiscal contagion,” where state-and-local/local-fiscal-crisis. blight. The ultimate goal of this strategy one community’s poor fiscal performance 5 See also Amromin and Chabot (2013). is to complement the restoration of a impacts the ability of other communities 6 thriving downtown Detroit with neigh- in the state to attract investment and For the full report (and related materials), borhoods that are stable and can attract see www.pewstates.org/research/reports/ finance debt. the-state-role-in-local-government-financial- residential and commercial investment. distress-85899492075.