Is Your City in Good Financial Shape?
by Michael Coleman
Michael Coleman is fiscal policy advisor to the League. More information on city finance is available on his website at www.californiacityfinance.com.
Asafe and secure community depends on fiscally healthy local governments, which are able to provide public services needed by the community with a balance of revenues and costs over time — even as the community changes and even in the face of economic, natural and political risks. The financial condition of your city government depends on economic and political factors as well as sound policies and management. Is your city in good financial health?
The character of your city’s finances is strongly related to the character of the local economy, both within the city and the region. Examine your major industrial sectors, the larger employers located in the city, where and for whom your city residents work, and your city’s demographics. Consider how all these different components are interrelated.
Assess the character of your city’s tax base by evaluating the proportionate residential, commercial and industrial components. Examine the size, structure and diversity of your tax base, especially your major tax revenues such as property and sales taxes. Who are the leading payers of local taxes and what are their economic interrelationships?
The allocations of some major revenue sources depend largely on the statewide economy. For example, the primary factors in the allocation of Motor Vehicle In Lieu Tax (also known as the Vehicle License Fee or VLF), the Highway Users Tax and the Proposition 42 sales tax on gasoline are allocated to cities based on: 1) total statewide revenue collections; and 2) your city’s population relative to the statewide population in cities. But most of the major tax revenues for cities are more directly affected by local economic conditions. To varying degrees and in differing ways, these include property tax, sales tax, business license tax, utility user’s tax, hotel tax and the property transfer tax.
Spending is another important element of the fiscal picture. Your city’s spending is driven over time by: 1) service levels in response to service demand; 2) the costs of labor; and 3) the costs of goods and contracted services. For most expenditure categories, the important cost drivers stem from regional economic conditions. Currently, as new government accounting standards are forcing the computation and full disclosure of public employee retirement costs (see “How GASB 45 Will Affect Your City or Agency: What You Need to Know”), these costs and their implications for the fiscal condition of cities are becoming increasingly urgent issues. Local governments throughout the country are facing questions about employee benefit levels and their ability to fund them over time.
Once you’ve assessed the current financial situation of your city, the more critical questions are “Where are you going? What will it take to keep your city financially healthy over time?” To answer these questions, you must:
• Examine revenue patterns over time;
• Project service costs and service levels in response to service demands over time; and
• Compare these financial trends.
Ideally, taxes would be structured to yield sufficient revenues to fund the tax-supported service demand into the future, so that no new or increased taxes will be necessary.
A different mix of revenues means a different pattern of revenue growth. Since the 2004 swap of VLF for property tax, all cities have substantially more property tax — with its growth related to local property values, growth and turnover — and much less VLF, with its growth related to statewide vehicle registrations and local population totals.
What if things don’t go as planned? An essential part of assessing your city’s financial condition is considering risk. Risk to your financial condition may come from:
• Unforeseen economic changes that affect your revenues;
• Environmental or social events that affect your costs (for example, a natural disaster);
• Actions of state, federal or other governments; or
• Actions of private parties, including lawsuits or tax referenda.
Economic risk is the potential for revenues to fall short of costs due to changes in the local or wider economy. Consider the volatility of your various revenue sources. For example, economically induced fluctuations in property taxestend to be delayed and smoothed largely due to provisions of Prop. 13. In contrast, city sales tax revenues, which are tied to taxable sales in your jurisdiction, fluctuate more immediately and dramatically in response to changes in your city’s economic conditions. The more volatile your overall revenue mix, the more important it is to maintain sufficient fund reserves as a fiscal shock absorber. The city revenue mix should not be overly dependent on any particular economic sector or groups of taxpayers.
With an unprecedented 84 percent voter approval, Prop. 1A of 2004 established strong new constitutional protections for the three largest, most vulnerable sources of general purpose city and county revenues: property tax, local sales tax and the VLF. Prop. 1A also strengthened local governments’ position against unfunded mandates. Prop. 1A has substantially reduced the political risk to California city finances, but recent events attest to the fact that some risk remains.
This year’s major state and federal legislative battles regarding video service franchising had taxpayers and local officials strongly concerned about local franchise revenues. Under AB 2987 (Nunez, Chapter 700, Statutes of 2006) local video service franchises for TV and cable will now be replaced by state-issued franchises. The franchises will be issued by the state Public Utilities Commission but franchise payments, including Public, Educational and Governmental (PEG) access fees, will be made to locals — set at rates comparable to current local franchise rates. This measure sets franchise conditions and standards in state law. Despite explicit intent language that cities and counties are to be kept financially whole by this change, the state intrusion into this previously local policy arenaraises the specter of new financial risks.
Likewise, the more than 140 cities and counties that apply utility user’s taxes (UUTs) to telecommunications are vulnerable to changing economic and technologic forces that the existing structure of UUTs may not readily accommodate. Local governments will continue to face issues of the applicability of their UUTs as the line between voice and data communications blurs, the telecommunications market and technology change, and some state and federal policy-makers seek to block changes in the tax structure in concert with these changes. Moreover, the precedent of AB 2987 raises the specter of similar state and federal moves that could crush local authority and discretion in this area.
Ensuring that your city is in good fiscal health requires well crafted and practiced fiscal policies, sound fiscal management and long-range planning. New financial reporting requirements from the Governmental Accounting Standards Board (GASB) are forcing better disclosure of current and future assets and liabilities of state and local agencies (for more information, see “How GASB 45 Will Affect Your City or Agency: What You Need to Know” on page 19). This provides opportunities to look at these diagnoses and determine the best course of action to keep our cities and communities healthy and secure.
Diagnosing Your City’s Fiscal Condition: 10 Important Questions
1. Are operating revenues per capita keeping up with inflation? What is the trend in per capita operating expenses relative to inflation?
2. Examining each source of revenue, are revenues keeping up with projected service demand and expenditures? Are tax revenues covering tax-supported service costs over time?
3. How volatile are revenues in response to economic changes?
4. To what extent are revenues vulnerable to the actions of state and federal governments or other governmental entities? What is the overall political risk of the city’s revenue mix?
5. What portion of operating revenues is fixed costs? (Fixed costs include debt service, retirement benefits and other liabilities both funded and unfunded, and mandated spending.) How is it changing?
6. What percentage of operating revenues is restricted to specific purposes, and how is this changing over time?
7. To what extent are one-time revenues used for operating purposes? How has this practice changed over time? What is the policy rationale regarding this practice?
8. Are user-charge revenues covering service costs over time? To what extent are general purpose revenues or functions subsidizing user services, and how is this changing over time?
9. Is the level and composition of your city’s debt structure reasonable?
10. What are the levels of unreserved fund balance as a percentage of operating revenues? What are the trends? Are these levels sufficient?