Category Archives: State-local governrnent

Alternative financing for state and local governments: Do ‘managed competition’ and asset sales or leases make sense?

By Rick Mattoon

State and local governments are finding themselves in a fiscal bind. According to the National League of Cities’ annual fiscal survey, city governments report that their general revenues will decrease by 2.3% in 2011 and they anticipate a further decline in 2012. In particular, property taxes are falling (estimated to decline by 3.7% in 2011), with additional declines expected in 2012 and 2013. Compounding matters for local governments is the fact that their tax revenue declines are coupled with decreasing or frozen aid from state and federal governments.

State governments don’t seem a whole lot better off. The Center on Budget and Policy Priorities estimated that 29 states face budget gaps for fiscal year (FY) 2012, totaling $44 billion; and it expected this total budget gap to grow throughout the spring as revenue growth slows. This comes in the wake of the previous four years during which cumulative deficits reached $500 billion.

Given this stress on core revenues, it isn’t surprising that state and local governments may be looking to unconventional financing measures to shore up budgets. Two ideas that are frequently mentioned are “managed competition” (the idea of allowing existing government services to be competitively bid out) and asset sales or long-term leases. In the case of managed competition, discrete government services are put up for bid and often existing government units are allowed to bid against outside providers for providing a service such as collecting trash or processing permits or licenses. In the case of asset sales or leases, the idea is to immediately monetize the value of a particular asset that in many cases is not directly related to the core function of local government. In both cases, a clear objective is to improve the efficiency with which either a program or an asset is managed and to free up resources for government to focus on central operations. For example, in the case of Chicago’s lease of the Chicago Skyway, a guiding question was should the city be operating a toll road (i.e., would a city government be more efficient at operating a toll road than a private company and could resources devoted by a city government to maintaining a toll road be better spent elsewhere).

On March 14, the Civic Federation and the Federal Reserve Bank of Chicago will co-sponsor a conference called Beyond Parking Meters—The Future of Public and Private Partnerships in Illinois. (for agenda and registration– click here). This half-day conference will examine how local and state governments should approach these types of alternative financing and what the pros and cons of these types of arrangements are. Specifically, the program will examine what types of government activities might be best suited to competitive service delivery, as well as what management and labor have learned from such programs. In examining asset sales and leases, key questions will include how to properly value public assets and structure and manage either an asset sale or lease to ensure that taxpayers are protected.

Fortunately, several previous studies are available to help guide any discussion about the privatization of either a public service or an asset by a government. In 2010, the Chicago Council on Global Affairs’ Emerging Leaders Program issued a report titled “No Free Money: Is Privatization of Infrastructure in the Public Interest?”

The key findings from the report were:

• Financial realities mean that privatization will continue;

• An effective policy would balance financial and equity consideration and define what constitutes “the public interest”; and

• Privatization is neither good nor bad but an economic tool that can be used well or badly.

In addition, the report suggests that proper oversight is critical for evaluating the long-term impact of any privatization. A concern is while the upfront savings might be significant, privatization may constrain future government actions. In the case of an asset sale, the asset can only be sold once, and after the proceeds from the sale are spent, future programs might be in jeopardy if they had previously relied on the revenue stream that the asset produced when it was owned by government. Similarly, there may be equity concerns if public access to an asset (such as a toll road) is suddenly limited by higher tolls imposed by the private firm now managing the asset.

When it comes to managed competition, the Government Finance Officers Association (GFOA) issued a best practice statement in 2006.

The statement lists key factors in considering managed competition: service level, cost, efficiency, effectiveness, quality, customer service, and ability to monitor the service providers’ work. The statement emphasizes the need to address stakeholders’ concerns and, in particular, to correctly estimate the in-house versus outsourced cost of providing the service. To do this correctly GFOA suggests governments address the following four factors:

• Determine and use a service definition that includes an analysis of service levels and performance standards to be used.

• Calculate the in-house costs that could be avoided in outsourcing the service. An important element includes estimating the direct and indirect costs related to the service. In some cases, some indirect costs may still exist even if the service is contracted out.

• Estimate the total costs of outsourcing, including the contractor’s bid price, the government’s contract administration costs, any transition costs, and any impact the contract might have on revenue.

• Finally, compare the cost savings from contracting out with the costs incurred to evaluate whether the savings will be significant.

A final source for framing privatization issues comes from the Illinois Commission on Government Forecasting and Accountability. The commission’s report titled “Government Privatization: History, Examples, and Issues” does a particularly good job at providing national and international examples of privatization and describes common measures for correctly valuing assets, such as appraising the net present value, estimating the internal rate of return, and calculating the weighted average cost of capital. These technical measures are critical to getting the valuation of the asset right.

Clearly, local and state governments will increasingly look to alternative financing structures over the next several years to help balance their service and revenue needs. Making alternative financing arrangements correctly requires appropriate accounting and asking the right questions at the beginning of the process. If you would like to find out more, please join us on March 14.

Alternative financing for state and local governments: Do ‘managed competition’ and asset sales or leases make sense?

By Rick Mattoon

State and local governments are finding themselves in a fiscal bind. According to the National League of Cities’ annual fiscal survey, city governments report that their general revenues will decrease by 2.3% in 2011 and they anticipate a further decline in 2012. In particular, property taxes are falling (estimated to decline by 3.7% in 2011), with additional declines expected in 2012 and 2013. Compounding matters for local governments is the fact that their tax revenue declines are coupled with decreasing or frozen aid from state and federal governments.

State governments don’t seem a whole lot better off. The Center on Budget and Policy Priorities estimated that 29 states face budget gaps for fiscal year (FY) 2012, totaling $44 billion; and it expected this total budget gap to grow throughout the spring as revenue growth slows. This comes in the wake of the previous four years during which cumulative deficits reached $500 billion.

Given this stress on core revenues, it isn’t surprising that state and local governments may be looking to unconventional financing measures to shore up budgets. Two ideas that are frequently mentioned are “managed competition” (the idea of allowing existing government services to be competitively bid out) and asset sales or long-term leases. In the case of managed competition, discrete government services are put up for bid and often existing government units are allowed to bid against outside providers for providing a service such as collecting trash or processing permits or licenses. In the case of asset sales or leases, the idea is to immediately monetize the value of a particular asset that in many cases is not directly related to the core function of local government. In both cases, a clear objective is to improve the efficiency with which either a program or an asset is managed and to free up resources for government to focus on central operations. For example, in the case of Chicago’s lease of the Chicago Skyway, a guiding question was should the city be operating a toll road (i.e., would a city government be more efficient at operating a toll road than a private company and could resources devoted by a city government to maintaining a toll road be better spent elsewhere).

On March 14, the Civic Federation and the Federal Reserve Bank of Chicago will co-sponsor a conference called Beyond Parking Meters—The Future of Public and Private Partnerships in Illinois. (for agenda and registration– click here). This half-day conference will examine how local and state governments should approach these types of alternative financing and what the pros and cons of these types of arrangements are. Specifically, the program will examine what types of government activities might be best suited to competitive service delivery, as well as what management and labor have learned from such programs. In examining asset sales and leases, key questions will include how to properly value public assets and structure and manage either an asset sale or lease to ensure that taxpayers are protected.

Fortunately, several previous studies are available to help guide any discussion about the privatization of either a public service or an asset by a government. In 2010, the Chicago Council on Global Affairs’ Emerging Leaders Program issued a report titled “No Free Money: Is Privatization of Infrastructure in the Public Interest?”

The key findings from the report were:

• Financial realities mean that privatization will continue;

• An effective policy would balance financial and equity consideration and define what constitutes “the public interest”; and

• Privatization is neither good nor bad but an economic tool that can be used well or badly.

In addition, the report suggests that proper oversight is critical for evaluating the long-term impact of any privatization. A concern is while the upfront savings might be significant, privatization may constrain future government actions. In the case of an asset sale, the asset can only be sold once, and after the proceeds from the sale are spent, future programs might be in jeopardy if they had previously relied on the revenue stream that the asset produced when it was owned by government. Similarly, there may be equity concerns if public access to an asset (such as a toll road) is suddenly limited by higher tolls imposed by the private firm now managing the asset.

When it comes to managed competition, the Government Finance Officers Association (GFOA) issued a best practice statement in 2006.

The statement lists key factors in considering managed competition: service level, cost, efficiency, effectiveness, quality, customer service, and ability to monitor the service providers’ work. The statement emphasizes the need to address stakeholders’ concerns and, in particular, to correctly estimate the in-house versus outsourced cost of providing the service. To do this correctly GFOA suggests governments address the following four factors:

• Determine and use a service definition that includes an analysis of service levels and performance standards to be used.

• Calculate the in-house costs that could be avoided in outsourcing the service. An important element includes estimating the direct and indirect costs related to the service. In some cases, some indirect costs may still exist even if the service is contracted out.

• Estimate the total costs of outsourcing, including the contractor’s bid price, the government’s contract administration costs, any transition costs, and any impact the contract might have on revenue.

• Finally, compare the cost savings from contracting out with the costs incurred to evaluate whether the savings will be significant.

A final source for framing privatization issues comes from the Illinois Commission on Government Forecasting and Accountability. The commission’s report titled “Government Privatization: History, Examples, and Issues” does a particularly good job at providing national and international examples of privatization and describes common measures for correctly valuing assets, such as appraising the net present value, estimating the internal rate of return, and calculating the weighted average cost of capital. These technical measures are critical to getting the valuation of the asset right.

Clearly, local and state governments will increasingly look to alternative financing structures over the next several years to help balance their service and revenue needs. Making alternative financing arrangements correctly requires appropriate accounting and asking the right questions at the beginning of the process. If you would like to find out more, please join us on March 14.

Charting Illinois’s Fiscal Future—Conference Preview (Rick Mattoon)

On June 17 and 18, the Federal Reserve Bank of Chicago and the Institute of Government and Public Affairs at the University of Illinois will co-host a program examining Illinois’s current and future fiscal prospects. (To register and view complete agenda click here ) The conference comes at a time when the national recession has left states and local governments with significant budget stress and falling revenues. The Center on Budget and Policy Priorities estimates that states face deficits of –$180 billion in FY2011 and –$120 billion in FY2012. For Illinois the problem is acute, given that the state had a structural deficit prior to entering the recession. Simply put, as Illinois’ expenditures outpaced its revenues, the state responded by building up a backlog of unpaid bills and otherwise issuing debt to balance the books.

How bad are things in Illinois? Current estimates suggest that Illinois’s budget gap for the upcoming fiscal year ranges from $11 billion to $14 billion and that its total indebtedness is approaching $120 billion if pension and other potential retiree liabilities are included. A recent Pew Center for the States study listed Illinois among the 10 worst states in terms of fiscal condition. The same organization also cited Illinois in a separate study for its underfunded pension liability, which it pegged at over $54 billion in 2007.

The conference will focus on strategies for improving the fiscal performance of Illinois in both the short run and the long run. For example, Allan Proctor, who serves as a consultant to governments and has worked as both the Deputy Budget Director for New York City and the Executive Director of the New York State Financial Control Board, will discuss strategies New York used to improve fiscal discipline and budgetary transparency in the wake of its financial crisis in the 1970s.

What systems and governance structures can be helpful in improving budget decision making? The Institute for Government and Public Affairs has been working on a multi-year project in Illinois to produce a consolidated state budget that provides a clearer picture of state obligations and available resources. This tool will help with future budget projections and allow for better budget planning.

On the important topic of pension liabilities, the conference will feature three experts—Lance Weiss (Gabriel, Roeder, Smith) Fred Giertz (University of Illinois) and Jim Spiotto (Chapman and Cutler). They will discuss how Illinois developed such a massive underfunding of its pensions and assess recent pension reform legislation and how much more needs to be done. In addition, this session will analyze the state’s responsibility for meeting unfunded pension obligations and whether any new mechanisms might help municipalities restructure pension debt.

Laurence Msall of the Civic Federation will give his perspective on how Illinois might best restore fiscal stability. The Civic Federation has launched a special initiative (The Institute for Illinois Fiscal Sustainability) that has suggested many short- and long-term strategies for cutting spending and restructuring revenues. Matt Murray from the University of Tennessee will give a multi-state perspective on which tax and expenditure strategies make the most sense in meeting the budget needs of the state while minimizing economic disruption.

The conference will also look at measures other states have used to either limit budget growth or improve fiscal decision making. These include the Priorities of Government program in the state of Washington and the local tax limitation measure, Proposition 13, in California.

The conference will conclude with a session on the implications of fiscal insolvency for the economic climate of the state and, in particular, for businesses looking to make significant investments in Illinois.

Illinois is at a fiscal crossroads. We hope you will be able to join us in investigating how we can improve fiscal performance in the state.

Charting Illinois’s Fiscal Future—Conference Preview (Rick Mattoon)

On June 17 and 18, the Federal Reserve Bank of Chicago and the Institute of Government and Public Affairs at the University of Illinois will co-host a program examining Illinois’s current and future fiscal prospects. (To register and view complete agenda click here ) The conference comes at a time when the national recession has left states and local governments with significant budget stress and falling revenues. The Center on Budget and Policy Priorities estimates that states face deficits of –$180 billion in FY2011 and –$120 billion in FY2012. For Illinois the problem is acute, given that the state had a structural deficit prior to entering the recession. Simply put, as Illinois’ expenditures outpaced its revenues, the state responded by building up a backlog of unpaid bills and otherwise issuing debt to balance the books.

How bad are things in Illinois? Current estimates suggest that Illinois’s budget gap for the upcoming fiscal year ranges from $11 billion to $14 billion and that its total indebtedness is approaching $120 billion if pension and other potential retiree liabilities are included. A recent Pew Center for the States study listed Illinois among the 10 worst states in terms of fiscal condition. The same organization also cited Illinois in a separate study for its underfunded pension liability, which it pegged at over $54 billion in 2007.

The conference will focus on strategies for improving the fiscal performance of Illinois in both the short run and the long run. For example, Allan Proctor, who serves as a consultant to governments and has worked as both the Deputy Budget Director for New York City and the Executive Director of the New York State Financial Control Board, will discuss strategies New York used to improve fiscal discipline and budgetary transparency in the wake of its financial crisis in the 1970s.

What systems and governance structures can be helpful in improving budget decision making? The Institute for Government and Public Affairs has been working on a multi-year project in Illinois to produce a consolidated state budget that provides a clearer picture of state obligations and available resources. This tool will help with future budget projections and allow for better budget planning.

On the important topic of pension liabilities, the conference will feature three experts—Lance Weiss (Gabriel, Roeder, Smith) Fred Giertz (University of Illinois) and Jim Spiotto (Chapman and Cutler). They will discuss how Illinois developed such a massive underfunding of its pensions and assess recent pension reform legislation and how much more needs to be done. In addition, this session will analyze the state’s responsibility for meeting unfunded pension obligations and whether any new mechanisms might help municipalities restructure pension debt.

Laurence Msall of the Civic Federation will give his perspective on how Illinois might best restore fiscal stability. The Civic Federation has launched a special initiative (The Institute for Illinois Fiscal Sustainability) that has suggested many short- and long-term strategies for cutting spending and restructuring revenues. Matt Murray from the University of Tennessee will give a multi-state perspective on which tax and expenditure strategies make the most sense in meeting the budget needs of the state while minimizing economic disruption.

The conference will also look at measures other states have used to either limit budget growth or improve fiscal decision making. These include the Priorities of Government program in the state of Washington and the local tax limitation measure, Proposition 13, in California.

The conference will conclude with a session on the implications of fiscal insolvency for the economic climate of the state and, in particular, for businesses looking to make significant investments in Illinois.

Illinois is at a fiscal crossroads. We hope you will be able to join us in investigating how we can improve fiscal performance in the state.

State-local Debt and Unfunded Employee Benefits

A combination of events surrounding the recent recession have left many state and local governments with gaping budgetary holes. A recent report by the Center for Budget and Policy Priorities estimates that states face a combined budget deficit of $375 billion for fiscal years 2010 and 2011.

Rather than raise taxes and cut spending cuts sufficiently, some governments, including Illinois , continue to add to their debt obligations to pay for current operations and debt service.

Widening deficits and mounting debt raise concerns that state and local governments will become seriously strained in meeting debt obligations and servicing their debt. If so, disruptive cuts to public services or punitive spikes in tax rates will likely take place at some future crisis point. Such sudden and possibly ill-considered corrective measures are not likely to help the cause of economic growth and development. Even before a crisis develops, a large debt overhang means uncertainty in the minds of would-be investors and in-migrants to the region as to how the obligations will eventually be paid down and, more specifically, uncertainty regarding which taxpayers will be impacted.

To be sure, not all debt accumulation diminishes a government’s capacity to repay its obligations or to finance public services. State–local government debt issuance often finances long-lived assets such as roads, school buildings, airports, and convention centers that are expected to pay for themselves, either directly through revenue streams such as highway tolls or other user fees, or indirectly by increasing economic growth and productivity of the local economy. However, to achieve such ends, judicious choices among alternative investments must be made; debt-financing of current consumption must be avoided.

The U.S. Census Bureau systematically gathers information on the outstanding debt of all state and local governments. The table below reports the Census data for the latest year available, 2007. All state and local governments reported debt outstanding of $2.4 trillion for fiscal years ending in 2007.

In the table above, long-term debt overwhelms short-term debt outstanding. In theory, long-term debt may be preferred since the borrower has more time flexibility in meeting the ultimate re-payment of principal. However, the long-term option of repaying principal on public debt may make it less visible to the electorate who must monitoring borrowing and spending by elected officials.

In examining overall debt of state and local governments in Seventh District states—both short- and long-term combined, debt levels are generally seen to vary by size. To standardize, we divide debt outstanding by each state’s gross state product (GSP; see last column). GSP measures the total production value of goods and services from all sectors within a state for the year. It is equivalent to gross domestic product (GDP) for the national economy. By standardizing debt by the size of the state’s economy, we may reflect the state’s ability to repay debt by taxing productive activity.[1]

By this measure, all Seventh District states save Iowa would seem to be straining their debt-issuance capability compared with the national average. However, the measure is imperfect in several ways. For one, debt that is issued in fast-growing states may be financing infrastructure that will be needed for tomorrow’s (larger) population. It follows that tomorrow’s economy will be larger in these states too and provide greater potential for repaying today’s outstanding debt. However, Midwestern states have not been growing rapidly at all, so it seems unlikely they will grow their way out of debt.

The Census measure of debt outstanding also excludes an important category of debt that is thought to be potentially pernicious. In addition to the explicit debt illustrated above, which is issued through government bonds, state and local governments often accumulate non-bonded liabilities for pension and retiree health care. In the case of pensions, both governments and employees typically contribute to dedicated funds which are calculated to meet retiree payouts[2]. But state and local governments can choose to defer the funding of their full obligations to meet future pension and retiree health benefits (OPEBs) of today’s public employees and retirees. And unlike borrowing to finance long-lived infrastructure, such obligations reflect public services consumed today or in the past that will be paid out in the future. Accordingly, unless the state or local economy grows robustly of its own accord, such debts may grow sufficiently large to cause fiscal strains and stresses in future years.

Even before the recent recession, some governments had accumulated significant unfunded pension and retiree health care debt obligations (OPEBs). These are estimated in a recent a study by the Pew Foundation . The Pew report takes a conservative approach in producing these estimates. Excluded are the unfunded obligations for public employee pensions and OBEPs of local governments. Such local government plans can be very sizable, and the state versus local split varies by state.

As shown below, the Pew study reports that state governments had compiled an estimated $731 billion in such debt as of 2008. Measured as a claim on the U.S. GDP for 2008, state government debt represented just over 5 percent of GSP (last column, author’s estimates). Among District states, both Illinois and Michigan debt of this variety exceeded national averages by wide margins.

The ability of state and local governments to redeem debt obligations is difficult to evaluate, even in the best of circumstances. Much as with private debt issuance, such evaluation requires careful scrutiny as to the purposes to which debt proceeds are used; the question being whether these purposes will pay dividends in the future[3] or not. While inherently valuable, pension and other obligations for today’s or yesterday’s public employee services often have no such future dividends. Accordingly, state and local governments should exercise caution in deferring funding of these obligations. So, too, in their role as watchdogs of the ongoing decision making of elected officials, citizens and the electorate should carefully consider the full price of expanding public services, including pensions and OPEBs.

_______________________________________________________________________________________________________

[1]Not all product or wealth of a state can be readily reached by the tax or revenue system in place. For this reason, other measures of capacity may account for the “reachable” tax base under existing tax and revenue statutes and arrangements. (Return to text)

[2] In addition to being nonbonded, the legal obligation to meet pension payout expectations may differ from state to state. (Return to text)

[3] In contrast, government-funded educational services may enhance the productivity and income streams of future workers who remain in the state, some part of which may be taxed to redeem pension obligations incurred in the past. (Return to text)

State Government Fiscal Performance in the Seventh Federal Reserve District: How bad is it? How bad will it be?

By Rick Mattoon

Throughout the nation, state governments have been crying uncle as revenues have hit a tailspin and expenses for Medicaid and public welfare have accelerated. Estimates of the cumulative deficit facing state governments exceed $100 billion, and the National Association of State Budget Officers is calling this the worst fiscal situation facing the states since World War II. Not surprisingly, states in the Midwest are feeling stress. Here I provide an update on current fiscal issues in Seventh District states (Illinois, Indiana, Iowa, Michigan, and Wisconsin), and I describe the impact on the region of the federal stimulus package (American Recovery and Reinvestment Plan).

Illinois

Illinois’s new governor, Pat Quinn, presented his budget on March 18. In response to current estimates of the state budget deficit ranging from $9 billion to $11 billion, the proposal includes a series of tax changes. Foremost is an increase in the state income tax rate for both individuals and businesses. The personal income tax rate would increase from a flat 3% to a flat 4.5% and would include an increase in the standard deduction from $2,000 to $6,000. The corporate tax rate would increase from 4.8% to 7.2%. The changes would raise about $3.1 billion in revenues. The governor also proposed increases in fees for several licenses, along with a cigarette tax increase.

On the spending side, education expenditures would receive a modest increase. Transportation funding would see a substantial gain through the multiyear, $26 billion “Illinois Jobs Now” program. Much of the funding would come from increases in driver’s license and auto registration fees.

The depth of the state’s problems has been highlighted by several recent reports. The comptroller’s report estimates the current backlog of unpaid bills at $4.5 billion. A March 2 report by the Civic Committee of The Commercial Club of Chicago found that total liabilities (including those for state workers’ pensions and health care) now exceed $116 billion, or $10,000 per resident. The report noted that these liabilities are a chronic problem for the state—that is, they form a structural deficit, which was caused by prior budget actions. This structural deficit is now being exacerbated by the recession.

Indiana

The state’s economy has had one of the sharper reversals of fortune with the December unemployment rate rising to 9.2%, second worst in the Seventh District. In response, Governor Mitch Daniels has proposed a two-year budget of $28.3 billion, which includes an 8% cut for all state agencies, a 4% reduction in higher education spending, and no increase in K–12 education. The state also has the luxury of a $1.3 billion budget reserve, although the governor’s proposal does not draw on any of these funds.

On February 20, the state’s Democratic-controlled House of Representatives passed a one-year $14.5 billion plan. The plan received no Republican support and is likely to be revised in the state’s Republican-controlled Senate. A major sticking point is that the House’s plan requires spending $200 million of the state budget reserve as well as using $540 million in stimulus money for Medicaid. The bill also allows for some creative accounting by allowing schools to pay for utility bills out of capital funds. There is also a debate about which capital projects to support, with the Democrats favoring several higher education projects and the Republicans favoring prison expansion.

A final side issue has been a proposal to abandon the biennial budget in favor of a one-year budget. Proponents suggest that this would be more prudent in times of fiscal uncertainty. The governor opposes this, believing that more fiscal discipline is required in adopting a biennial budget.

Iowa

In the face of faltering revenues, Iowa legislators have been trimming Governor Chet Culver’s proposed $6.2 billion budget for fiscal year 2009–10. So far $133 million in cuts have been approved by the legislature. In addition it has been proposed that $100 million from the state’s reserve funds be spent in the next budget. The governor has also cut $30 million from the current budget to close a smaller current budget gap. The legislature is also investigating revenue-raising options including eliminating corporate tax breaks that are not designed to create jobs. There is also a proposal to create a middle-class tax relief program, which would be funded by ending federal deductibility in state income taxes.

On the positive side, a member of the state’s Revenue Estimating Conference suggested that the revised revenue projections for the state appear to be holding steady. The conference makes its next formal projection on March 20.

Finally, Iowa anticipates receiving $1.9 billion in stimulus funds from the federal government.

Michigan

Michigan—with the highest unemployment rate in the nation (11.6%)—continues to struggle. The state has faced a budget deficit every year since 2001. This year will be no exception. The estimated deficit for the next budget (beginning on October 1) is $1.4 billion. Governor Jennifer Granholm’s proposed budget will cut $670 million and calls for 1,500 state employee layoffs. The state is also planning on using $464 million in federal stimulus funds to help with Medicaid payments. The state’s budget director has been frank in stating that Michigan has two deficits—a structural deficit that has been ongoing since 2001 and a cyclical deficit that is compounding problems. Michigan intends to spend $313 million of the federal stimulus money during the current fiscal year.

Wisconsin

Governor Jim Doyle unveiled his plan to close an estimated $5.9 billion budget gap for the next biennium. On the revenue side, the governor proposed $1.4 billion in new taxes, including a new higher income tax bracket for families earning more than $300,000, an 85 cent increase in the cigarette tax, a new tax on multistate companies, a tax on oil companies’ windfall profits, and a sales tax on Internet downloads. Most of the tax package was signed into law on February 18. The budget also assumes $2 billion in federal stimulus money.

On the spending side, $2.2 billion is expected to come from reductions to state agency budgets and $245 million from “budget efficiencies.” No layoffs are included in the budget. The proposed budget would have Wisconsin spending in 2011 what it spends in 2009.

What will be the impact of the federal stimulus money?

Seventh District states would be facing even tougher times if it had not been for the passage of the federal stimulus package. With money flowing into transportation, education, and Medicaid, the states have been able to avoid raising revenues through taxes (and other means) and cutting expenditures. On the broadest level, the following two charts illustrate the estimated multiyear impacts of the federal stimulus package’s major proposals on Seventh District states.

Click to enlarge.

Click to enlarge.

Relative to other federal aid efforts in past recessions, this package is notable for bolstering education spending. Previous programs tended to target Medicaid, unemployment insurance, and infrastructure. This package adds education to those other areas.

There are also estimates available for stimulus funds that have already been allotted as of March 12.

Click to enlarge.

Click to enlarge.

Concluding thoughts

Despite federal stimulus money, state governments in the Seventh District are under significant stress. In some cases, sharp downturns in the local economy are partially to blame (e.g., Michigan and Indiana), but structural imbalances in state fiscal systems are in many cases compounding cyclical declines in the economy. The issues concerning restructuring state revenues in the face of current economic conditions will be the topic of a special program at the Chicago Fed on May 12. Click the link for more information on the conference Assessing the State and Local Sector: Where Will the Money Come From?—sponsored by the Federal Reserve Bank of Chicago, National Association of State Budget Officers, and National Tax Association.

The Economic View from the State Budget Trenches

By Rick Mattoon

It is hardly a secret that most state governments are facing tough times. Indeed, state governments are reporting that slower economic activity is affecting revenue collections. A recent fiscal survey by the National Conference of State Legislatures found a combined $140 billion deficit over the current and next budget years. Here, I am reporting the economic news coming straight from the state budget trenches in the Seventh Federal Reserve District.

For most states, some mechanism prompts an economic forecasting commission or other body to provide a prediction on where a state’s economy is headed. This type of forecast is a key component of the state budgeting process and takes advantage of the local expertise on the state’s economic conditions, which are often masked in national or regional forecasts.

Iowa

The Tax Research and Analysis Section of the Iowa Department of Revenue produces an Iowa Leading Indicators Index on a monthly basis. This index provides a useful benchmark for the state’s economic condition. The figure below shows the performance of the index relative to nonfarm employment since 1999. The index’s recent performance has shown seven straight months of decline since its peak in May 2008, and it has fallen at an annualized rate of 4.8%. However, the index score of 105.6 (1999=100) indicates that Iowa’s economy is still performing better than most states’.

Click to enlarge.

The index has eight components: yield spreads (ten-year Treasury notes vs. three-month Treasury notes), residential building permits, agricultural futures price index, diesel fuel consumption, average weekly unemployment claims, average weekly manufacturing hours worked, new orders index and an Iowa stock market index. Each component has a unique standardization weighting in the index.

Illinois

On November 19, the Illinois’ Commission on Government Forecasting and Accountability issued its economic and revenue update for fiscal year (FY) 2009. The commission is a bipartisan joint legislative committee with a professional staff that provides fiscal and economic information to the Illinois General Assembly.

The commission’s forecast, published in November 2008, is as follows:

Click to enlarge.

The commission also considers the implications of its forecast for state revenues. The commission suggests that base revenues for FY2009 will be down 1.9% ($550 million) from the previous year. See the following table:

Click to enlarge.

The commission also has an estimate for the revenue shortfall for FY2009 versus the budgeted expectations. This estimate is more pessimistic with revenues coming in over $1.3 billion short of budget expectations.

Michigan

Michigan’s House Fiscal Agency provides frequent updates on revenue trends and periodic updates on the state’s economy.

The November revenue forecast showed FY2008 year-to-date revenue up 8.2% for 13 major taxes and the lottery. The gains reflect changes to Michigan’s tax structure, particularly for personal income and business taxes.

In addition, the University of Michigan does a statewide economic forecast. The most recent one was released on November 21. The forecast highlights Michigan’s weak labor market conditions and anticipates that employment in the fourth quarter of 2008 expected to fall at an annual rate of –4.7%. The first half of 2009 is not likely to be much better with a predicted annual rate drop of –3.2%. Even with modest recovery in the second half of 2009, employment is forecasted to drop at an annual rate of –2%. Not surprisingly this translates into anemic nominal personal income growth of 0.7% in 2009 and 1.2% in 2010.

Wisconsin

The Wisconsin Department of Revenue issues a quarterly Wisconsin Economic Outlook. This document includes useful detail on employment and income trends in the state and a comprehensive forecast of the U.S. economy. The August report noted the slowdown in the state’s economy and projected that job growth in the state would turn negative this year. After job growth of 0.5% in 2007, declines of 0.5% and 0.4% in 2008 and 2009 are predicted. This anemic job growth will spill over into personal income growth, forecasted to be a weak 3.4% in 2008 and 2.6% in 2009. (The report notes that the 2008 income growth was aided by the federal stimulus action.) In contrast, personal income rose 5.3% in 2007.

The state budget director recently announced that November revenue projections for FY2009–FY2011 were off an estimated $3.5 billion from the June projections. There is now an estimated budget deficit of $5.4 billion (17% of the budget) from fiscal 2009–11 budget years. This is the largest deficit in Wisconsin’s history.

Like other states in the Seventh District, Wisconsin is just beginning to recognize the weakness of its revenue collection. The latest monthly statements for October showed revenues declining –2.5% for the month, although year-to-date revenues are still positive at 2.4%. On an individual tax basis (year to date), the personal income tax is up 5.6% (because of tax law changes), while the sales tax has declined –2.5% and the corporation tax is down –20.8%.

Indiana

Indiana’s bipartisan State Budget Committee issues periodic revenue and economic forecasts for the state. The most recent forecast was issued on December 11, and it predicted the state would collect $721 million less in tax dollars in the current budget cycle compared with a forecast that had been made one year ago. The state’s budget surplus has shrunk from $1.4 billion to $600 million in response.

The more pessimistic revenue forecast is based on an economic forecast produced by IHS Global Insights. The IHS forecast suggested that the current recession would be the longest in post-World War II history and would see unemployment hitting 9% before the state’s economy improves.

Vanessa Haleco-Meyer provided valuable assistance in producing this blog.

The fiscal state of the states (and municipalities): Not so good

By Rick Mattoon

Plenty of evidence is emerging that state and local governments are headed into a major fiscal pinch. Tax revenues are decreasing across the board, as everything from corporate profits to employment declines. The big question is how well are the states positioned to weather this storm? Is there anything different in the nature of this economic slowdown that will make circumstances more difficult?

Based on some preliminary evidence, the future looks challenging. The Center on Budget and Policy Priorities released a survey of state budget conditions on February 25, 2008. The survey reported 25 states having budget deficits for fiscal year 2009. Specific estimates of the magnitude of the deficits were available for 21 states. These particular states report an aggregate gap of between $36 billion and $38 billion, representing roughly 8% to 9% of total general fund spending. Of the states in the Seventh Federal Reserve District reporting a gap, Illinois has a $1.8 billion deficit (6.6% of general fund); Iowa, $350 million (6%); and Wisconsin, $652 million (4.8%).

The center’s report notes that one of the more vexing fiscal problems is the current instability of property tax revenues related to the housing downturn and mortgage foreclosures. In the 2001 recession, states were able to push expenditures on to local governments because property tax revenues were relatively stable. In the current housing crisis, it is more likely that local governments will be asking state governments for help.

The report also finds that states are rapidly drawing down rainy day funds. These fund levels peaked at 11.5% of annual state spending in fiscal year 2006 and are estimated to decline to 6.7% of state spending by the end of this fiscal year. It is unlikely that this is sufficient to see the states through even a shallow recession.

A final national development is that at the February meeting of the National Governors Association, the governors requested that the federal government offer a fiscal stimulus package for the states aimed at financing infrastructure investments. It is unlikely that this will go anywhere. In the 2001 recession, the federal government offered a $20 billion aid package to the states. Half of the $20 billion was earmarked for a temporary increase in the share of federal support for Medicaid programs, with the remaining half set aside for general grants based on population.

A closer look at the impact of the housing downturn on state and local revenues

The fallout from the subprime loans and foreclosures has had a negative effect on state and local revenues. The United States Conference of Mayors (and the Council for the New American City) hired the consulting firm Global Insight to estimate the implications of the mortgage crisis. The firm estimates that U.S. gross domestic product (GDP) will be $166 billion lower than otherwise because of the crisis and that 524,000 fewer jobs will be created. The firm further estimates a $1.2 trillion decline in property values in 2008.

The report provides estimates of metropolitan growth rates and changes in tax revenues for selected metros and states. For example, the estimated real gross metropolitan product (GMP) growth rate for metro Chicago in 2008 will be 2.23%. This represents a 0.56% reduction, or $3.9 billion decrease, attributable to the mortgage crisis. Metro Detroit’s real GMP growth rate is estimated at 1.3%. A reduction of 0.97% is attributable to the housing slowdown representing a $3.2 billion decline in GMP.

As for changes in tax revenues, the following table provides the fiscal impact estimates for ten states.

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As the table illustrates the fallout goes beyond just property tax revenues. Sales taxes decline because of the reduction in big-ticket items, such as appliances and furniture, that occur during a housing slump. Transfer taxes—the taxes on the passing of a title to property from one person (or entity) to another—fall in response to the lower volume of transactions; in recent years, transfer taxes had become increasingly important to municipalities. All in all, such trends suggest significant challenges.

What is the fiscal state of the states? Not very good. And it appears that the housing slowdown will make conditions more challenging than was found during the 2000-01 downturn.

OPEB … Oh No!

By Rick Mattoon

Beginning in the 2008 fiscal year, state and local governments with over $100 million in revenues will begin to report the accrued liability they face for funding non-pension post-employment benefits. In government parlance this is referred to as OPEB—other post-employment benefits—with the largest expense being comprised of retiree healthcare. Given that state and local governments have long provided healthcare benefits to both working and retired employees, why is the identification of this burden on the government’s books creating such consternation?

The answer to this question can be divided into three parts—government worker demographics, the size of the obligation and how government has traditionally paid for retiree healthcare, and the difficulty of restructuring employee benefits once granted.

Government worker demographics. Following the national trend of an aging population, a large share of the workforce of many state and local governments is approaching retirement eligibility. For example, the Illinois Comptroller reports that in FY2006, 65% of public employees in the state were either in their 40s or 50s, up from 41% in 1986. As these workers retire, the pressure on healthcare expenditures is skyrocketing. A report by the Pew Center on the States reports that in California, retiree health costs will rise from $4 billion in 2006 to $10 billion in 2012 and $27 billion in 2019.

The size of the OPEB liability and traditional method by which government has paid for OPEB costs. Prior to GASB 45, which requires governments to record their OPEB liabilities, most states simply met their retiree benefit costs on a pay as you go basis, where costs are paid out of current revenues. As such, few states actually put aside money to fund OPEB costs. While governments have saved to meet pension obligations, the Pew Center report estimates that 97% of the OPEB liability is currently unfunded. Estimates of the outstanding OPEB liability range from $370 billion (for a subset of governments that have reported their liability) to $1.5 trillion for the entire sector. The size of the unfunded balance differs considerably from state to state (see figure below).

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Difficulty in restructuring retiree healthcare. In the private sector, a clear strategy for limiting a firm’s exposure to retiree healthcare costs has been to either eliminate or restructure healthcare benefits. A survey by the Kaiser Family Foundation reports that only one-third of large companies still offer retiree health insurance and that these companies have often reduced their premium contribution, leaving the retiree to shoulder a larger share of the tab. The state and local governments that have been the most active in addressing OPEB costs have taken on changes to health benefits, but this has led to several difficult bargaining sessions with public employee unions and frequent legal challenges.

Are there strategies for meeting OPEB obligations?

On March 12, the Chicago Fed and the Civic Federation will host a half-day conference on what governments are doing to meet their OPEB obligations.

Presentations will include officials from the Ohio Public Employees Retirement System (OPERS) and Oakland County, Michigan. Both of these governments have been seen as innovative leaders in identifying and developing a strategy to fund OPEB expenses. Ohio had accumulated over $11 billion in assets by FY2006 to meet OPEB obligations and has moved to restructure benefits as well by placing a cap on lifetime benefits and increasing co-payments and deductibles. While the state has an unfunded liability of $6.5 billion, it has shown fiscal discipline in consistently reducing its outstanding liability.

Oakland County has used a series of fiscal tools over the last 20 years to meet its OPEB liability. These have included:

–in 1985, creating a tiered vesting schedule for retirement;

–beginning in 1987, adopting a policy to fund the full actuarially required contribution (ARC) for retiree healthcare liabilities;

–in 1988, creating a self-insurance pool for active and retired employees;

–in 2000, creating a VEBA trust which allowed the County to create a tax-exempt investment plan; and

–closing the retiree health care plan and creating a defined contribution plan in 2006.

The March 12 Chicago Fed/Civic Federation program will also bring in a number of Illinois governments to discuss their evolving strategies for meeting OPEB costs. This will include representatives from the city of Aurora, the Metropolitan Water Reclamation District, and the Chicago Public Schools. Illinois governments face a particularly acute problem. The Civic Committee of the Chicago Commercial Club has estimated that the state’s unfunded OPEB liability is $48 billion. Given that the state also faces an unfunded pension liability of $40 billion, developing a strategy to meet this challenge will be exceedingly important. Discussions in Illinois have already examined such strategies as issuing OPEB bonds, creating irrevocable trust funds and selling assets to allow for one-shot infusions of capital to help meet OPEB obligations.

For many states, meeting the twin responsibilities of pension and OPEB funding will be dominant public finance issues for some time to come. Given the increasing pressures of funding elementary and secondary education, Medicaid, and deferred infrastructure costs, creating a strategy for managing labor related benefits costs will be critical to the health of the state and local sector.

State-local Business Taxation

To most people, the subject of tax structure is a sleepy one. An important exception is when looming changes to the tax structure raise the prospects for who will pay for public services (and how much they will pay). In characterizing this debate, Senator Russell B. Long of Louisiana once said, “Don’t tax me, don’t tax thee, tax that fellow behind the tree!”

Public discussion also becomes animated when considering whether state and local tax structures (or changes to them) will hinder economic growth and development. That is to say, will tax hikes on business drive away jobs and income?

A recent symposium held at our Bank gathered experts together to consider emerging trends in business taxation. In recent years, there have been significant changes to business taxation in Midwest states, such as Ohio and Michigan. Ohio enacted a modest tax on business gross receipts in 2005, replacing a local tax on capital machinery and equipment. Michigan has phased out its largest business tax and is now considering how to replace the revenues that it formerly generated with its Single Business Tax.

The State of Illinois was considering a large “business” tax on business gross receipts to fund education and a subsidized health care initiative. To pay for it, Governor Rod Blagojevich advocated a large business tax on gross receipts because it would be paid by those who could afford it. Interestingly, the Lieutenant Governor Pat Quinn disagreed on the very same grounds.

Who was correct? As with many such matters, there is no certainty. But at the business taxation conference, I stated that I did not favor the Illinois gross receipts tax, at least on equity grounds. I argued that our most common principle of equity in taxation is a poor guidepost by which to design a state’s business tax structure. By equity, most people mean “ability to pay” such that taxation should progressively burden high-income households relative to low-income ones. The trouble with this approach is that businesses are not households. Businesses are organized groups of people ranging from line workers to mid-managers to active owner-entrepreneurs to silent capital-owning partners.

So who are we really taxing? We are not really sure. In particular, the taxation of business activity often results in changes to product prices that burden consumers rather than wealthy individuals. In the same vein, business taxation can sometimes result in lower wage offers to a firm’s workers. The ultimate result of such “tax shifting” may mean that a tax intended to “soak the rich” may have the opposite result. For example, it is easy to see (and universally accepted) that unduly high taxes on companies that sell gasoline in a state or city are largely shifted forward to consumers of gasoline in that state or city. Why would the companies pay inordinate taxes on the gasoline they sell in Chicago, for example? The answer is that they would not and they do not. This is in part because gasoline (energy) companies sell their products and services into many markets worldwide. Accordingly, when taxes on gasoline are pushed too high in any one locale, the price of gasoline rises until it becomes profitable for companies to sell it there. And since gasoline is presently a necessity for nearly everyone in the industrialized world, low-income households end up paying taxes on it that are a larger share of their household income as compared with the share of high-income households. The intent to achieve equity, in this instance, is foiled.

More generally, analysts have only a fuzzy and foggy notion across the breadth of business taxes as to which ones (and how much of them) are actually shifted to workers and to consumers. And so, to achieve equity, tools such as direct income redistribution or manipulation of the individual income tax are more reliable for this purpose. For this reason, I argue that it is preferable to design state and local business taxes around our notions of efficiency rather than on equity.

In looking at the efficiency of taxing businesses, it is important to recognize that business organizations do use costly government services, including police, fire protection, roadways, and legal protections. Having businesses pay for such services, then, is not only fair, it is efficient in several respects.

In paying state and local governments for their public services, businesses will be motivated to articulate their service needs to these governments, just as customers do with service providers in market situations. In turn, this will promote growth and development in states and localities. The resulting negotiation and conversation between governments and businesses will help identify those essential roads, bridges, and property protections that make businesses more productive. So too the process of haggling over the price and cost of government services to businesses will tend to keep governments cost efficient.

This give and take between business and government will only take place if a state’s business taxes are structured as a user charge and not set unduly high in an effort to redistribute income.

The purposeful conversation on business taxes and business service levels will also spill over in positive ways to government service provision to households. In recognizing that “business” taxes are not really subsidizing household services, such as education and health care, households and their representatives will more carefully evaluate the costs and benefits of government services.

The structure of taxes can be a sleepy one. However, those who doze off during the debate may very well find themselves stuck with the tab.