ESSAYS ON ISSUES THE FEDERAL RESERVE BANK JANUARY 2014 OF CHICAGO NUMBER 318a Chicag o 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%).