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