Local Governments on the Brink

By Mattoon, Richard H. | Chicago Fed Letter, May 2011 | Go to article overview

Local Governments on the Brink


Mattoon, Richard H., Chicago Fed Letter


This article examines the likelihood of local governments defaulting on their debt or filing for bankruptcy. Despite the challenging fiscal environment today, the vast majority of local governments are not likely to do either, if history serves as a guide for the future.

Local governments1 of all sizes are facing many challenges in 2011, partly because of their overwhelming dependence on property tax revenues to fund their operating budgets. The housing and commercial real estate busts are translating into declining taxable property values; simultaneously, cash-strapped state governments are looking to reduce their aid to local governments so that they can shore up their own budgets. As if this were not bad enough, many local governments also have to deal with underfunded public pensions, which demand larger and larger annual contributions to return to stability.

Given such challenges, many news stories have suggested that a wave of local government bankruptcies and credit defaults may occur in 201 1.2 Local government bankruptcy filings have been infrequent in U.S. history (e.g., only 600 municipal bankruptcy petitions have been filed since the first federal legislation permitting such bankruptcies was enacted in 1934). Still, some suggest that the problems confronting local governments are different this time around, making bankruptcies more likely. Adding fuel to this speculation has been the poor performance of the municipal debt market3 at the end of 2010 and into 201 1; over the past few months, many investors have exited the municipal bond market, and several communities have found it difficult to issue debt.4

In this article, I discuss local governments' fiscal conditions, which suggest that concerns about bankruptcy and default may be overblown. For one, the fiscal resources of local governments are deeper than commonly believed. Also, local governments often can take intermediate corrective budgetary action (usually at the insistence of the state) to avoid bankruptcy. Finally, in most cases this corrective action is preferable to the stigma that bankruptcy creates, particularly with regard to the issuance and performance of municipal bonds.

So how bad is it?

Tax revenues from the workhorse of local governments' tax systems - the local property tax - have not yet fallen as dramatically in recent years as some might think. While there have been declines in property values, administrative features of property tax systems have muted the effects of these declines into actual tax collections. In some cases, time lags in the property value reassessment cycle prevent home values from reflecting the current market conditions. In other instances, revenue collections are authorized for a set dollar value, and they do not change along with property values.5 According to the U.S. Census Bureau, property tax revenues made up 72% of all local tax revenues in 2007-08.6 Thus, the relatively stable performance of this tax should be welcome news to local governments.

That said, the revenue performances of some other sources have tended to be less robust. During the real estate boom, local governments feasted on development fees and real estate transfer taxes. Since then, these sources of revenues have largely evaporated. For example, in Chicago, revenues from real estate transfer fees peaked at nearly $250 million in 2006, before falling to less than $70 million in 2009.7

One great unknown is whether state governments will significantly cut (or at a minimum freeze increases in) aid to local governments in the upcoming budget year (which starts for most states on June 30) . Cuts in local aid (or freezes in raising aid) are quite possible because state governments will soon be struggling to make up for budget gaps due to the winding down of the federal stimulus funds. For example, the new revenues produced by the recent hikes in personal and corporate income taxes in Illinois will only go to the state government.

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