May 1, 2014
The Civic Federation joined with the Federal Reserve Bank of Chicago on April 23, 2014 to co-host a conference on ways that municipalities in Illinois can avoid or resolve fiscal stress. Experts, practitioners and academics from around the country gathered to discuss Chicago’s fiscal future and how different state intervention and revenue policies around the country have impacted local governments. Attendees to the sold out conference included civic and business leaders and government officials.
Professor Robert Inman of the Wharton School at the University of Pennsylvania presented a framework for how a city can build a sound financial structure to fund the delivery of services residents and businesses need without pushing the cost of government onto future generations.
Professor Inman emphasized that cities are the engines of the United States economy and fiscally viable cities must develop and nurture strong institutions and provide the incentives necessary to ensure good public policies are implemented. The case of Detroit provides an example of how a city without such institutions can succumb to fiscal catastrophe. Over decades, Detroit implemented unsound policies resulting in unfunded pensions, high debt levels and lack of investment in infrastructure; it suffered through a weak economy characterized by high and growing unemployment and over-dependence on the auto industry; and it developed a demographic profile characterized by a high percentage of low-income Detroit residents and a falling population. Any of these issues on their own would be difficult for a city to deal with, but together they precipitated a severe drop in the “stock price” of the city— its property values— and eventually led to Detroit’s declaration of bankruptcy.
Professor Inman’s sound fiscal policy framework for cities starts with deciding what services to provide. He recommended that cities provide what the markets cannot, such as education and police and fire. He noted that government is good at providing social services because they have access to quality information through direct interaction with the public. How all those services should be funded is the next question, with Professor Inman preferring user fees as a more efficient source of revenue for enterprise or business-like services such as sanitation and water. However, services that are public goods such as police must be paid for with taxes. For tax structure, Inman favors matching resident taxes like the residential property tax for residential services and business taxes like business zone taxation for business services, but warned against ignoring the impact of increasing tax rates on the tax base. Rises in tax rates eventually decrease the amount of revenue because residents are free to move to a location where their demand for services matches the taxes they must pay.
Finally, Professor Inman held that structurally, a strong mayor form of governance is preferable to a strong council form of governance that disperses financial control. Inman also advocated contracting out for services to provide competition and empowering residents and businesses to tax themselves at the levels required to provide the service levels they desire. Finally, the examples of Philadelphia and New York City have demonstrated that it can additionally be helpful for there to be outside entities to help enforce sound fiscal policies with credible enforcement mechanisms. These can include state balanced budget requirements and independent financial control boards. The former helps keep cities honest in their budgeting and the latter can provide a resource of professional staff and serve as a necessary scapegoat to politicians facing difficult choices.
Session 1 – Chicago: City at the Turning Point
The first panel discussed recent budget, revenue and pension trends for the City of Chicago with a focus on the City’s financial future. The three panelists shared perspectives from within city government and from the rating agencies and put the city’s need for pension reform into the national context of pension reform litigation decisions. Sarah Wetmore, Vice President and Research Director at the Civic Federation, moderated the conversation.
Lois Scott, Chief Financial Officer for the City of Chicago, spoke about the central importance of pension reform to ensure the fiscal future of both the city and the funds themselves. She described how the city got into such a difficult pension situation over the past twenty years and explained that legislation awaiting Illinois Governor Pat Quinn’s signature would put two of Chicago’s four pension funds on the road to recovery at a more sustainable cost to taxpayers. Ms. Scott said the largest contributors to pension underfunding for Chicago included a state-imposed funding system that does not adjust the city’s contributions to match the financial needs of the fund, benefit enhancements including a compounded automatic annual annuity increase and investment losses during the two economic downturns in the 2000s. Ms. Scott noted that in the low inflationary environment of the past decade, the 3% compounded annual increase annuitants receive has been a major source of problems because the annual increase is two times the actual increase in inflation. It is for this reason that the legislation focuses on removing compounding from the automatic annuity increase and ties it instead to a measure of the level of inflation. Ms. Scott additionally praised labor groups for being a partner in developing the reform package. She said the Mayor will continue to call on the Governor to sign the legislation and then will urge the Illinois General Assembly to move forward with reform to Police and Fire pension benefits.
Richard Ciccarone, President and Chief Executive Officer of Merritt Research Services, examined the rationale behind how ratings agencies assign their public debt ratings and took a look at the role these organizations play in creating fiscal discipline in the public sector. Mr. Ciccarone said ratings have been based on the default history of the class of securities, combined with the strength of the government’s underlying economic base. This basis of evaluation has led the three major rating agencies to give 79% of cities top ratings of AA or AAA. Mr. Ciccarone questioned how such a large percentage of high ratings could create fiscal discipline among local governments. He then explored how the City of Chicago compared to other cities using various measures of financial condition. Chicago is an outlier with regard to its pension liabilities in comparison to “A” rated credits and also has low indicators of cash on hand and fund balance compared to “A” cities. However, Mr. Ciccarone showed that in comparison to other big cities, Chicago has a medium level of taxes per capita, possibly giving the city more room to take care of its pension liabilities than other, higher rated big cities like New York.
Looking at the national context in which pension reform litigation in Illinois will play out was Dr. Stuart Buck, Vice President for Research Integrity at the Laura and John Arnold Foundation. Dr. Buck described recent state supreme court and lower court decisions from around the country on the ability of states to change public pension benefits. He highlighted the similarity between Arizona and Illinois’ constitutional protection of pension benefits, which could mean that courts in Illinois will look to the Arizona Supreme Court’s decision to strike down pension changes there. However, there will likely be a difference in how the cases are argued as Arizona did not use the fiscal emergency framework that will likely be central to the State of Illinois’ argument for the constitutionality of pension reform. Dr. Buck additionally emphasized that even laws that seem absolute always have exceptions to them. Constitutional pension clauses should be no exception. Based on the experience in San Jose, California, where the State Superior Court struck down pension reforms but held that wages could be reduced, Dr. Buck recommended that in future legislation, the City of Chicago include similar offsetting provisions for reductions to employee wages if pension reforms are held to be unconstitutional.
Session 2 – To Intervene or Not to Intervene: How States are Helping and Hindering Local Governments
The second panel explored the different ways states help and hinder local governments through the different intervention structures and revenue policies. Rick Mattoon, Senior Economist and Economic Advisor at the Federal Reserve Bank of Chicago, moderated a discussion on best practices for state fiscal intervention and trends in state aid to local governments as well as a specific proposal for an Illinois authority to assist municipalities in distress.
Stephen Fehr, Senior Officer, State and Local Fiscal Health at the Pew Charitable Trusts, underscored the wide variety of practices states have with regard to local intervention. Some states, such as California and Alabama, have a “hands off” mentality with regard to local governments. At the other end of the spectrum is North Carolina’s local finance monitoring program, which is the oldest in the nation and is generally regarded as one of the best and most successful. States also vary with regard to the aggressiveness of the intervention and the different types of interventions they practice. A recent Pew study of state intervention programs made several recommendations as to how states can best improve local government finance, including being more proactive in detecting local government distress and designing intervention programs that involve all stakeholders and return control to local officials quickly.
Jim Spiotto, Managing Director of Chapman Strategic Advisors, presented a framework for the creation of a quasi-judicial organization in Illinois that would provide a forum for discussion, resources and recommendations to financially distressed municipalities on a voluntary basis. He noted that the Civic Federation’s Pension Committee had developed the idea in response to the threat to essential governmental services caused by unsustainably growing unfunded local government pension obligations. The committee members saw a need for an intermediate step before bankruptcy, which is expensive and damaging to a city’s reputation. The Illinois Municipal Protection Authority (IMPA) would examine city finances to determine whether taxes can be raised, whether other options such as public-private partnerships should be considered and whether cuts can be made to benefits and services. IMPA’s recommendations to the local government would focus on what services are sustainable and affordable and the organization’s skilled staff of experts could additionally help smaller stressed municipalities that might not have the resources to hire expert finance staff.
Professor Michael Pagano of the University of Illinois at Chicago presented the findings of a national study of cities’ fiscal condition, focusing on state-imposed and self-imposed revenue and expenditure limitation trends. He discussed the types of revenues municipalities are allowed to access across different states and the differing levels of autonomy states allow their local governments. In addition to state-imposed or self-imposed tax and expenditure limitations, which vary in their stringency, local government revenues are also affected by recent trends of lower federal and state aid to local governments. While states initially provided additional revenue to compensate municipalities subject to tax and expenditure laws, that state aid has diminished in recent years as states have had to cope with revenue losses of their own. In all, Professor Pagano concluded, cities can do well with more local autonomy but states must be ready and able to step in with controls. He also advocated for regional taxes that could be shared among municipalities as a way of mitigating fiscal stress.
City of Detroit Chief Financial Officer John Hill compared the fiscal crises experienced by Washington, D.C. in the 1990s and Detroit over the past decade. Mr. Hill noted some similarities in the circumstances that precipitated fiscal crisis in both cities: falling population, declining revenues leading to ongoing budget deficits, lack of financial controls and high unfunded pension obligations. In the case of Washington, D.C., Congress stepped in to create a Financial Control Board with significant financial and lawmaking authority that would remain in control until the capital’s budget met certain financial criteria for a number of consecutive years. An independent Chief Financial Officer position was created who cannot be removed except with permission of the Control Board. With the fiscal controls imposed by the Control Board and new CFO and after Congress relieved Washington of certain expensive programs such as its court system and Medicaid, the city was able to perform well enough to have the Control Board sunset within six years. Since then, Washington has maintained budget surpluses every year and still has an independent CFO and the threat of the imposition of a new Control Board as incentive to keep its fiscal house in order.
In comparison to Washington, Detroit has additional difficult problems such as a huge geographic footprint in comparison to its population and significantly deteriorated infrastructure. Mr. Hill told the members about the state intervention process that resulted in Michigan’s Governor appointing an Emergency Manager for Detroit and the city’s eventual bankruptcy filing in July 2013. He told attendees that Detroit has filed its plan of adjustment and hopes to exit bankruptcy in October 2014. However, it is extremely important for city and state leaders and residents to focus not just on the exit from bankruptcy but on formulating and following a plan for recovery. Currently, there are several recovery plans that have been proposed, but none of them have associated plans for implementation. The city’s plan of adjustment could drive the city’s recovery, but it will require ongoing effort by the city’s elected officials and the difficult work necessary to stabilize the city’s revenue collection and other systems on which the plan depends. Mr. Hill concluded that Detroit’s fiscal future could be stronger, but it will require an ongoing commitment to restructuring the city from the bottom up, adding services that make it attractive to new residents such as mass transit, and commitment from business leaders to reform as well as ongoing post-bankruptcy financial monitoring.
On behalf of the Federal Reserve Bank of Chicago and the Civic Federation Board of Directors, many thanks to all of our moderators, panelists and attendees. Thanks also to the staff of the Federal Reserve for their assistance. To download participants’ presentations, visit the Civic Federation website or the Chicago Federal Reserve Bank's website.