Category 4 – External, Economic/Technical
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Economic recession is one of the most visible causes of financial distress. Declining consumer spending, dropping property values, and unemployment have direct negative impacts on revenues like sales taxes, property taxes, and income taxes, not to mention implications for increased expenditures for programs like social services.
- Reform the budget process. The budget process may need to be reformed in order to help a government spend within its means. The traditional incremental budget process is ill-suited to this task. However, there are a number of reform options that can help.
- Fund balance policy and strategy. If you have built up a fund balance during the economic expansion, now might be the time to use it. Develop a policy and strategy with the board to make clear which portion of the fund balance is available for stabilizing the budget during economic recession and how much of that may be used during the current recession. Clearly define under what conditions the fund balance can be accessed and how much must be retained. Best Resources:
- Accelerate capital spending. An economic recession may provide a unique opportunity to reduce long-term capital costs. If the local construction market is depressed, then you may be able to obtain bids for construction of new assets that are significantly below your original estimates. Consider using debt to accelerate your priority capital projects. To use this strategy, you should have a solid capital improvement plan and debt policy already in place, as well as a clear understanding of the affordability of more debt. Best Resources:
Change in the Base of the Local Economy
Contributed by Richard Longworth
Fiscal distress occurs when the traditional basis of a local economy declines or goes away, or changes in such a way that it provides less support to the community than it once did.
The decline of a local industry or natural advantage is perhaps the most infamous cause of economic decline in a community or region. When the port silts up, the mine plays out, the factories close, or a new and better highway is built somewhere else, decline sets in.
A second form of decline takes place when the traditional economy changes in such a way that it provides less support to the community. This happens when local production stays strong but, because of improved technology and productivity, it no longer provides the employment it once did. The Midwest, for example, produces as many manufactured goods as ever, and exports even more, but employs fewer persons.
High taxes don’t necessarily lead to economic decline. The cities that are thriving in the new economy – Chicago, New York, London, Tokyo, and other global cities – are high-cost cities. Yet they draw the most desired companies, employing the most skilled and educated workers. The most desirable employers are willing to pay for the privilege of being in high-cost cities because of the benefits they provide.
- Reinvent your economic raison d’etre. When economic entropy happens, a community has to reinvent itself or face decline. The most successful cities (London, Cairo, Shanghai) repeatedly reinvent themselves. The less successful vanish (the ghost towns of the American West) or become backwaters (Venice). Allentown, Pennsylvania, saw its economic core, steelmaking, collapse in the 1970s and 1980s and reinvented itself as a local center for high-tech manufacturing. Best Resources:
- Measure economic performance. Improve measures of local economic performance to remain aware of entropy. General measures of economic performance could include population growth or employment. Measures that are attuned to the economic base should also be used. For example, follow trade publications that cover local industries and the fortunes of those companies and maintain open communications with business leaders in the community.
- Shrinking cities. For some communities, the situation is such that the recovery of former economic vitality is just not possible. These communities may need to look to become smaller and smarter – a phenomenon now known as “shrinking cities.” Shrinking cities is about reducing the physical footprint of the community to match the size of the population that lives there. This allows government services to be provided in a more compact area and ultimately preserves the viability of the community. Best Resources:
- Economic development programs. Local economic development programs can be designed to attract new industries and retain existing ones. There is no shortage of ideas for economic development strategies, with ideas like “creative cities” and “green cities” representing two that have received some attention in the popular media. The role of the finance officer is to help create an economic development policy that defines what kind of economic development programs the government will spend money on and then to help government evaluate economic development opportunities against its policy. Closely evaluate the processes any business must navigate when locating in the community; streamline and facilitate that navigation as a key economic development strategy. Best Resources:
- Metropolitan area restructuring. A decline in the local economic base may call for a restructuring of area governments. This might involve revenue sharing, regional taxes, consolidation, or shared services. Best Resources:
Contributed by Douglas C. Robinson and Charles L. Sizemore
Changes in demographics can cause fiscal distress by increasing the relative size of population segments that consume more in public services than they contribute in tax dollars.
Shifting demographics can also lead to distress if the demands of new constituents are not consistent with existing capacities. For example, a growing immigrant population may require bilingual education, requiring the development of an entirely new capacity in schools. Changing age demographics can also be a significant factor. Areas with slow-growing and aging populations may find themselves with excess capacity in their schools. Large fixed overhead costs combined with fewer children means a higher cost per pupil. Meanwhile, these same areas might face acute shortages of facilities for elderly citizens.
Perhaps most importantly, demographics play an important role in the level and composition of retail spending. Men and women in their late 40s tend to make the biggest overall impact on consumer spending. An area with a larger percentage of its population approaching that age should benefit from strong spending, a healthier job market, and greater sales tax revenue. Areas in which a large segment of the population has passed that critical age should experience much lower growth, all else equal.
The first step in mitigating the effects of changing demographics on your tax base is, of course, to understand what the demographic changes are. Does your community attract young couples with growing families? Is your constituency growing older? Are they, perhaps, becoming a community of “empty nesters” as their children move away?
Or, is there a very different trend underway? If your constituency consists primarily of families with infant children, will these children be requiring new school capacity in the years ahead? Within many U.S. communities attracting immigrants, linguistic considerations must also be considered. Is a significant segment of your constituency foreign born, thus perhaps needing bilingual services? Or, given the recent reversals in immigration rates, are you seeing fewer foreign-born constituents, thus giving your area a surplus of bilingual services?
These questions are not academic. Age trends and the age distribution of the population in your area can have very profound economic effects on local agency revenues. After all, a 25-year-old, fresh out of school, does not have the same means, spending capacity, or needs of a 40-year-old with two children and a mortgage. That 25-year-old is not going to buy as much in the local stores and restaurants - thus generating less in sales taxes - nor likely buy a large home - thus generating less in property taxes as well. But, if he or she stays and settles in the community, that will change over time as spending picks up.
We know from government statistics and consumer expenditure surveys that Americans, on average, tend to marry and start families in their late 20s. As the size of the family grows and as the children get older, household spending rises accordingly until the parents reach that critical “empty nest” age around 46-50, as seen in Chart 1. For higher-educated and higher-income households, the age is later, in the mid-50s, corresponding to a later age of family formation. When you are in college or grad school until your mid-20s or later, marriage and children have to wait.
Chart 1: Total Spending by Age
As the children leave the nest, the household begins to shift from an emphasis on spending to an emphasis on saving. Since most local agencies rely heavily on taxes tied directly to consumption (general goods, auto, furnishings, and real estate purchases, etc.), it is very important to know what these age trends are in your area. As an example, let’s consider auto purchases (Chart 2).
Chart 2: Vehicle purchases
Vehicle purchases are a little more erratic, allowing for the infrequent nature of the purchases. Still, there is a distinct trend, with spending peaking in the early 50s.
Charts 3 and 4 also illustrate consumer behavior. It should not be shocking that spending on diapers peaks at around age 30, given that most Americans have children in their late 20s.
Chart 3: Spending on infant diapers
But in Chart 4, we see a large secondary peak in spending in infant clothes. Why do the two charts not have similar patterns?
That question is easy enough to answer: grandma gets little satisfaction out of buying something as mundane as diapers, but cute little outfits is a different story!
Financial crises tend to accelerate or in some cases reverse demographic trends. This has certainly been true across America, but particularly in hard-hit states like California, Nevada, Arizona, and Florida as many young people have lost their homes in the wake of the 2008 meltdown and in some cases decided to delay family formation. But under most normal conditions, demographics change slowly and predictably, giving us time to plan accordingly. Generally speaking, we cannot “change” demographic trends. But we can be ready for them with proper planning. Take a cold, hard look at the budgeting numbers with respect to demographics. Are your assumptions reasonable?
A demographic shift in which the population is getting younger and lower income will mean lower sales tax revenues. One possible remedy for this would be to encourage the construction of retail capacity that will attract residents from surrounding areas. But be on guard, because your neighboring city might be planning the same thing. Adding excess capacity during a period of slack demand will only exacerbate the current trends.
The ideal way to increase property tax revenues is to encourage the building of new high-end residential and commercial properties. But this is simply not feasible during a period of excess supply and tight credit. Before supporting such projects, you have to ask the very legitimate question of “who is going to live, work, or shop here? Do current population and demographic trends support new development?”
Pension Investment Losses Require Catch-Up Contributions
Contributed by Girard Miller
The stock market meltdown during 2008 wiped out 25 percent of most public pension plans’ investment portfolios. The result for many is a huge increase in their unfunded liabilities, with funding ratios dropping nationally from about 85 percent in 2007 to 65 percent in 2009 on a real-time basis. Many public plans will use actuarial smoothing to delay the impact of the required amortization of these investment losses, but ultimately the average public employer, based on this author’s professional experience, may soon face pension contribution increases of 20 to 40 percent.
Armed with a “marked to market” valuation of the pension plan’s investment portfolio and a candid projection of the future annual contributions, you are better prepared to propose an increase in employee contributions to share in the costs of this problem during your next round of labor negotiations. Otherwise, the taxpayers will bear the entire brunt of these costs, either through tax increases or reduced services as future budgets are cut to pay for these increased expenses.
In some cases, plan design changes will be required in order to achieve a sustainable funding level (such as adjusting the retirement age). Ironically, this often means that new employees will receive lower benefits to pay for the vested pension promises made to retirees and older workers. This is why it is important to address the option of increased employee contributions as soon as possible, to capture additional funding for the plan before the older incumbents retire.
Some bond-market financial advisers promote the use of pension obligation bonds or OPEB bonds for an underfunded plan. The GFOA has issued a recommended practice [new page link to RP] urging considerable caution in the use of leverage to achieve improved funding. Further cautionary commentary on the market-cycle aspect of this topic can be found through an Internet search using the keywords “Benefits Bonds: POBs and OPEB-OBs.”
The costs to local government may escalate faster than revenues such that it becomes more difficult to fund the same level of service over time. Employee health-care benefit costs, for instance, have been increasing much more rapidly over recent years than the revenues of most local governments. Energy prices proved a vulnerability for many governments during their spike in the summer of 2008.
- Indexing. Contracts can be linked to an appropriate inflation index. The Consumer Price Index (CPI) is the most well-known example. Alternatives to the CPI include, for instance, Personal Consumption Expenditure (PCE) index, which measures how much it costs to buy a constantly evolving basket of consumer goods, and the Municipal Cost Index (MCI – developed by American City and County magazine), which is designed to show the effects of inflation on the cost of providing municipal services.
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