ESSAYS ON ISSUES THE FEDERAL RESERVE BANK JULY 2014 OF CHICAGO NUMBER 324a

Chicag­o Fed Letter

After Detroit: How will Illinois and its communities respond? by Richard H. Mattoon, senior economist and economic advisor, and Sarah Wetmore, vice president, Civic Federation

Detroit’s bankruptcy filing has highlighted fiscal pressures being experienced by communities across the nation, including Chicago. Problems such as flat or declining property tax revenues, underfunded public pensions, and reduced state support are straining local government operations. To investigate how municipalities are adjusting to fiscal stress, the Civic Federation and the Federal Reserve Bank of Chicago held a forum on April 23, 2014, that brought together over 140 participants.1

To kick off the event, Robert Inman, scope (e.g., commuter roads and park- professor, Wharton School of the ing garages). Inman argued that it is University of Pennsylvania, explained appropriate and efficient for cities to that city finances should be of concern deliver social services to local low-income to the entire nation because cities are households, but financing for social the drivers of economic growth. The key services should occur at the state, re- to a fiscally healthy city, he contended, gional, or federal level; efforts to fund is to gain more residential and com- these services at the city level would put mercial property owners, as well as busi- undue stress on the local tax base and nesses, with a stake in the city’s long-term likely drive out economic activity, and Some materials presented success; city policies that produce such city funding for them might crowd out at the forum are available at stakeholders ultimately lead to a strong funding for other vital services. (Inman www.chicagofed.org/ and sustainable level of financial perfor- also noted that keeping low-income webpages/events/2014/ mance for the local government. More- households out of poverty helps keep over, local policymakers must recognize local home values up: A 3% increase in after_detroit_chicago_fed_ that a city is an open economy, where the the poverty rate translates into a 25% civic_federation.cfm. failure to deliver services at competitive fall in home values.) prices will drive out economic activity. Cities should be attuned to how they pay Inman said that to achieve good fiscal for the services they provide, Inman health, cities should start by determining noted. User fees are the best option what services they should and should for services that can be easily priced not provide. According to Inman, cities per use—usually services considered should provide the following residential “excludable” (i.e., services that are not services (and goods): education through rendered if an individual does not pay the community college level, public for them). For services that are difficult safety (i.e., police and fire protection), to price per use—usually those deemed courts and prisons, sanitation, water and “nonexcludable” (such as public safety, sewer, and neighborhood roads, as well roads, and courts)—general, broad- as amenities such as open spaces for based taxes are needed. It is also impor- recreation, parks, and libraries. He said tant that taxes are not based on mobile that cities should also provide business factors but instead on where economic services that are similar to these resi- activity is located, Inman said. This cri- dential services but a little narrower in terion favors residential income taxes, land value taxes, and localized property Chicago: City at a turning point discipline in the public sector. Ciccarone taxes that benefit either a specific neigh- Lois Scott, chief financial officer, City said ratings have been based on the borhood or business district. Finally, to of Chicago, spoke about the central default history of the class of securities, the extent possible, residential and busi- importance of pension reform to im- combined with the strength of the city ness taxes should be separated and should prove Chicago’s fiscal future and ensure (or state) government’s underlying only be used to pay for the services that the long-term sustainability of the pen- economic base. This basis of evaluation residents and businesses consume, re- sion funds. She described how Chicago has led the three major rating agencies spectively, said Inman. got into such a difficult pension situa- (Moody’s, Standard & Poor’s, and Fitch Ratings) to give at least 79% of cities Inman concluded by outlining some steps tion over the past 20 years and explained top ratings of AA or AAA. Ciccarone that cities can take to attain a strong that new legislation that was then await- questioned how such a large percentage and sustainable fiscal performance. ing Illinois Governor Pat Quinn’s signa- of high ratings could create fiscal disci- First, he said, cities should adopt his ture would put two of Chicago’s four pline among local governments. He said preferred form of local governance: a pension funds (the municipal employees that instead of the current ratings meth- odology that focuses mostly on “here and now” fiscal conditions, a better approach Greater fiscal transparency would help localities avoid fiscal would add a consideration of a city’s stress or detect and address it early. long-term vulnerabilities earlier in the ratings process. mayor who has broader authority than and laborers pension funds, but not the Ciccarone compared the City of Chicago the city’s legislative body (e.g., veto police and firefighters pension funds) with other cities, using various measures powers requiring a two-thirds majority on the road to recovery at a more sus- of financial condition to see if the city’s of the city council to be overridden). tainable cost to taxpayers. debt rating was fair and consistent with This type of government concentrates Scott said the largest contributing factors its financial results. He explained that financial control (as well as account- to pension underfunding in Chicago Chicago is an outlier with regard to fund- ability to voters citywide) in a single were a state-imposed funding system ing its pension liabilities in comparison individual, rather than dispersing it that does not adjust the city’s contribu- with other cities with an A bond rating; among multiple parties with disparate tions to match the financial needs of the e.g., Chicago’s pension funding ratio aims. Additionally, Inman said that fund, a compounded automatic annual was 35.2% versus a median of 78.8% for cities should use competitive bidding annuity increase, and investment losses A-rated cities in fiscal year (FY) 2012. for the provision of services, which during the two economic downturns in Moreover, Chicago has low indicators of creates price transparency. Inman also the 2000s. Scott noted that in the low cash on hand and fund balance relative promoted strategies that decentralize inflationary environment of the past to other A-rated cities. However, Chicago a city’s fiscal structure. Specifically, he decade, the 3% compounded annual has a level of taxes per capita ($1,955 said that both neighborhood and busi- increase that annuitants receive has been in municipal and school district taxes ness improvement districts should be a major source of underfunding because combined for FY2012) that is only a little permitted so that locally instituted the annual increase has significantly higher than the median for big cities (with taxes could be used to pay for expanded outpaced inflation. The new legislation populations over 500,000); Ciccarone services (beyond those already provided therefore focuses on tying the automatic concluded that it might be possible for by the city)—e.g., more police patrols annuity increase to a measure of the Chicago to increase taxes to take care and street cleaning—and additional level of inflation.2 Additionally, Scott of its pension liabilities, which would capital improvements—e.g., further praised labor groups for being partners be more difficult for higher-rated big upgrades of roadways. These special in developing the reform package. She cities with larger per capita tax burdens districts would make certain that some said that Chicago Mayor Rahm Emanuel (e.g., New York) to do. tax payments are connected to locally will continue to call on Governor Quinn provided services. Finally, Inman rec- Looking at the national context in which to sign the legislation and then will urge ommended putting in place a fiscal pension reform litigation in Illinois will the Illinois General Assembly to move enforcer for the city. This could be a play out was Stuart Buck, vice president forward with equally important reforms strict balanced budget requirement from of research integrity, Laura and John to police and firefighters pension benefits. the state, with independent assessment Arnold Foundation. Buck described re- and penalties for noncompliance. It Richard Ciccarone, president and chief cent decisions by state supreme courts could also be a politically independent executive officer, Merritt Research and lower courts from around the coun- fiscal control board with credible enforce- Services, examined the rationale behind try on whether governments can modify ment measures, including the abilities how rating agencies assign their public public pension benefits for current to deny state aid and limit municipal debt ratings and took a look at the role employees and retirees. He highlighted bond issuance guarantees. these organizations play in creating fiscal the similarity between Arizona’s and Illinois’s constitutional protection of the intervener is granted the authority Civic Federation—presented the Civic pension benefits, which could mean to restructure debt and labor contracts, Federation’s proposal to create the that state supreme court justices in Illinois raise taxes and fees, offer state-backed Illinois Municipal Protection Authority will consider the Arizona Supreme loans and grants, provide technical (IMPA). IMPA would be a quasi-judicial Court’s decision to strike down pension assistance (such as financial manage- mediation and arbitration program for changes in their own rulings. However, ment advice), and even dissolve the local fiscally troubled municipalities seeking there will likely be a difference in how government. Fehr added that given the assistance on a voluntary basis—a key the cases are argued as the State of wide-ranging powers of the intervener, quality in that the authority’s recommen- Arizona did not use the fiscal emergency local governments tend to grudgingly dations would have a greater chance of framework that will be central to the accept state intervention. getting buy-ins from all parties in the State of Illinois’s argument for the con- community. Spiotto said IMPA would Fehr noted that a particularly good ex- stitutionality of pension reform. allow local governments facing fiscal ample of state oversight of localities’ turmoil to develop sustainable fiscal Buck emphasized that under constitu- financial standing is North Carolina’s structures that ensure that essential tional law, exceptions to even the most Local Government Commission—which government services (such as public absolute language are often found, was created in 1931 in response to several safety, sanitation, and education) can and he opined that state constitutional municipal bond defaults associated with continue to be provided. Through a fact- pension clauses would be no excep- the Great Depression. The commission finding process for the fiscally distressed tion. That said, Buck recommended oversees and regulates financial report- city, IMPA would establish what the costs that in order to be prepared for any ing by local governments and monitors are for local government services and eventuality, Chicago should look to the their fiscal health. If problems are severe what resources are available to pay for experience of San Jose, California, enough, local governments can be them. After that, it would help the mu- when drafting future pension legislation: taken over by the state. Additionally, nicipality develop a recovery plan that The Santa Clara County Superior Court local governments must seek approval prioritizes paying for essential services struck down pension reforms imple- from the commission to issue debt, and and then restructures legacy costs (such mented via referendum in San Jose but the commission is responsible for sell- as those associated with funding public held that wages can be reduced even if ing their bonds. To complement the pensions), which may have been one of pension benefits cannot. The City of Local Government Commission, North the chief sources of its fiscal troubles. Chicago might therefore include provi- Carolina uses a centralized pension As part its work, IMPA would deter- sions that reduce employee wages if a system to avoid underfunding pension mine whether a local government has pension reform bill is ruled as unconsti- funds. North Carolina’s efforts to moni- additional capacity to raise taxes and tutional under the Illinois Constitution. tor and manage local fiscal distress have resulted in its having a large percentage State intervention of AAA-rated local governments. Charles L. Evans, President ; Daniel G. Sullivan, Stephen Fehr, senior officer, Pew Executive Vice President and Director of Research; Fehr concluded with some recommen- Spencer Krane, Senior Vice President and Economic Charitable Trusts, presented findings from dations offered in the study: Advisor ; David Marshall, Senior Vice President, financial a study on the state’s role in addressing markets group ; Daniel Aaronson, Vice President, local government financial distress.3 The • States and cities should be more pro- microeconomic policy research; Jonas D. M. Fisher, Vice President, macroeconomic policy research; Richard study found that 19 states have laws that active in detecting local government Heckinger,Vice President, markets team; Anna L. allow the state government to intervene fiscal stress through strong oversight, Paulson, Vice President, finance team; William A. Testa, Vice President, regional programs, and Economics Editor ; in fiscally distressed localities; however, and states should address municipal Helen O’D. Koshy and Han Y. Choi, Editors ; the laws vary widely in regard to the financial problems early on with the Rita Molloy and Julia Baker, Production Editors ; powers given to the states. In practice, provision of technical assistance. Sheila A. Mangler, Editorial Assistant. only a handful of states intervene Chicago Fed Letter is published by the Economic • Multiyear budgeting for cities should Research Department of the Federal Reserve Bank aggressively when a municipality is in be adopted to better manage finances. of Chicago. The views expressed are the authors’ fiscal trouble. Fehr pointed out that the and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal most aggressive state assistance pro- • Intervention programs should involve Reserve System. grams are in Michigan, North Carolina, all stakeholders in discussions to find © 2014 Federal Reserve Bank of Chicago Pennsylvania, and Rhode Island. a solution and should explain upfront Chicago Fed Letter articles may be reproduced in that control will be returned to local whole or in part, provided the articles are not For states with active state assistance reproduced or distributed for commercial gain officials as quickly as possible in or- programs, Fehr said, the approach to and provided the source is appropriately credited. der to promote better cooperation Prior written permission must be obtained for helping cities in fiscal distress varies any other reproduction, distribution, republica- among all the interested parties. but usually starts by appointing an tion, or creation of derivative works of Chicago Fed Letter articles. To request permission, please contact intervener—e.g., a receiver, emergency Jim Spiotto—managing director, Helen Koshy, senior editor, at 312-322-5830 or manager, state agency head, or financial Chapman Strategic Advisors LLC, and email [email protected]. Chicago Fed Letter and other Bank publications are available control board. Depending on the state, co-chair, Pension Committee of the at www.chicagofed.org.

ISSN 0895-0164 examine whether service provision should Keynote address is extremely important for city and state be transferred to other governmental John Hill, chief financial officer, City leaders, as well as residents, to focus not bodies and if other remedies such as of Detroit, compared the fiscal crisis only on the exit from bankruptcy but privatization should be considered. In experienced by Washington, DC, in also on the formulation and execution closing, Spiotto said that IMPA could the 1990s with the one experienced by of a plan for recovery. Currently, there be established so that fiscally distressed Detroit over the past decade. Hill noted are several proposed recovery plans, but cities are required to seek its assistance: some similarities in the circumstances none of them have associated plans for In this alternative vision for IMPA, trigger that precipitated fiscal turmoil in both implementation. The emergency man- events (such as the failure to make stat- cities: falling population, declining rev- ager’s plan of adjustment could lead to utory or annual required contributions enues leading to budget deficits, lack of a recovery, but that would require the to public pension funds from existing financial controls, and high unfunded stabilization of the city’s revenue collec- operating revenues for two years in a row) pension obligations. In the case of tion and other systems, as well as broad would require a municipality to create Washington, the U.S. Congress stepped buy-in from the city’s elected officials. To a recovery plan with IMPA’s guidance. in to create a financial control board conclude, Hill said to improve Detroit’s fiscal performance in the future, the fol- Michael Pagano, dean, College of Urban with significant financial and lawmaking lowing would be needed: a commitment Planning & Public Affairs, University of authority. This board was to retain con- to restructure the city from the bottom Illinois at Chicago, described limitations trol over local finances until the city’s up, the provision of new services that that states have placed on local revenue- budget met certain financial criteria would make the city attractive to new raising options, as well as trends in fed- for a number of consecutive years. An residents (such as mass transit), a com- eral and state aid to localities. Pagano independent chief financial officer -po mitment from business leaders to sup- explained that municipal tax authority sition was created whose incumbent port the city’s restructuring process, and varies greatly from state to state. Some could not be removed except with the long-term financial monitoring after states allow local governments to levy a permission of the financial control board. exiting bankruptcy. broad range of taxes, such as property, After fiscal controls were imposed by both the board and chief financial officer sales, and income taxes. Others are more Conclusion restrictive, limiting not only their munic- and after Congress relieved Washington Greater fiscal transparency would help ipalities’ choice of tax bases but also the of certain expensive programs (such as localities avoid fiscal stress or detect and annual increase in a particular tax. This its court system and Medicaid), the city address it early. For communities already state-to-state variation in local govern- was able to perform well enough to have in fiscal trouble, the creation of a recovery ments’ ability to levy taxes has contributed the board be dissolved within six years. plan that ensures that there will not be to differences in their fiscal condition as Since then, Washington has maintained severe disruptions to essential services they recover from the Great Recession. budget surpluses every year and still has will be vital to restoring firm fiscal foot- Pagano proceeded to highlight trends an independent chief financial officer; ing. Finally, new institutions and rules in intergovernmental fiscal relationships. moreover, the threat of the imposition may be necessary to ensure that an in- First, he noted that federal aid as a per- of a new financial control board has dependent review of city fiscal plans centage of municipal general fund rev- given Washington an incentive to keep occurs regularly. enue had fallen from a high of 11.9% in its fiscal house in order. 1977 to 3.0% in 2011; over the period In addition to the types of problems 1 Some speakers at this forum also made 1992–2007, this measure of federal aid Washington faced during the 1990s, presentations at a 2013 Chicago Fed con- ference summarized in Richard H. Mattoon, ranged from 2.1% to 2.4%. Second, he Detroit must currently deal with other said that state aid as a percentage of 2014, “What happens after Detroit’s bank- difficulties, including a large geographic ruptcy? Lessons in reform,” Chicago Fed municipal general fund revenue stayed footprint relative to its population (which Letter, Federal Reserve Bank of Chicago, within a reasonable compact range of makes the delivery of services expensive No. 318a, January. 17.3% to 19.9% over the period 1982– and inefficient) and significantly dete- 2 The annuity increase would be a simple 2007; however, by 2011 this figure had riorated infrastructure. Hill went over the (instead of compounded) 3% or half of the dropped sharply, to 12.4%. Pagano said state intervention process that resulted Consumer Price Index, whichever is less. that he found evidence for a decline in in Michigan Governor Rick Snyder’s 3 For the full report (and related materials), state aid between 2007 and 2011 regard- appointment of an emergency manager see www.pewstates.org/research/reports/ less of how restrictive a state was about for Detroit and the city’s eventual bank- the-state-role-in-local-government- financial-distress-85899492075. localities’ revenue-raising options. States ruptcy filing in July 2013.4 He told attend- 4 that had imposed strict revenue-raising ees that Detroit’s emergency manager For more details on the filing, see Gene limitations on local governments during Amromin and Ben Chabot, 2013, “Detroit’s has filed a plan of adjustment with the bankruptcy: The uncharted waters of the late 1970s and early 1980s initially court and hopes to have the city exit Chapter 9,” Chicago Fed Letter, Federal Reserve boosted state aid to them following the bankruptcy in October 2014. However, it Bank of Chicago, No. 316, November. action, but the level of aid declined in the past decade, he noted.