A Predictive Model of Fiscal Distress in Local Governments

Article excerpt

ABSTRACT. This paper investigates the financial risk factors associated with fiscal distress in local governments. We hypothesize that fiscal distress is positively correlated with revenue concentration and debt usage, while negatively correlated with administrative costs and entity resources. The regression model results in a prediction of the likelihood of fiscal distress, which correctly classifies up to 91% of the sample as fiscally distressed or not. The model also allows for an analysis of the impact of a change in a risk factor on the likelihood of fiscal distress. A decrease in intergovernmental revenues as a percent of total revenues and an increase in administrative expenditures as a percent of total expenditures have the biggest influences on reducing the likelihood of fiscal distress.

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Local governments provide invaluable services to the citizenry, which include fire, police, water, sewer, parks, and recreation. Local governments also provide a wide array of public and social services, and contribute to the quality of community life. The citizenry count on local governments to respond in times of trouble and to help maintain the quality of life; however, local governments can do this only if they maintain their own fiscal health. Thus, a local government's ability to avoid fiscal distress directly affects its ability to sustain its current level of services (Honadle, Costa & Cigler, 2004).

Fiscal distress has been a topic of concern for nearly half a century. Older, industrialized cities in the Northeast United States began to suffer from fiscal distress in the 1960s (Howell & Stamm, 1979), as the industrial revolution began to decline. Cities that relied on manufacturing and steel production found it difficult to attract new capital investments and began to increasingly rely on long-term debt financing to fund short-term operating expenditures (Howell & Stamm, 1979). Local government fiscal distress became a major news item in the mid-1970s, when New York City experienced a near fiscal collapse. The energy crisis and high inflation of the 1970s contributed to New York City's financial crisis, yet many analysts blamed New York's problems on poor management, budget deficits, and expensive social programs (Fuchs, 1992). In fact, other cities were experiencing fiscal distress at the time and managerial practices had little to do with it (ACIR, 1985a).

In 1985, the Advisory Commission on Intergovernmental Relations (ACIR) issued a report, stating that the causes of local government fiscal distress are usually beyond the control of the state or local government and can affect all types of communities, including urban and rural, small and large, and newer and older municipalities. ACIR found that local government fiscal distress is usually the result of a complex array of factors, which include but are not limited to the strength of the local economy, the resources and needs of the taxpayers, the support received by other governments, and the condition of the local government's infrastructure (ACIR, 1985b).

It is unrealistic for local governments to expect to receive protection under the federal bankruptcy laws (Watson, Handley & Hassett, 2005). Firstly, federal bankruptcy laws make local governments prove actual insolvency, not imminent risk of insolvency. Therefore, local governments almost never qualify for bankruptcy protection. Secondly, local governments provide essential community services. Therefore, creditors hesitate to force local governments to liquidate their assets in order to pay their debts (AICR, 1985a). Instead, local governments are forced to succumb to the workout plans of financial control boards and state oversight agencies (Lewis, 1994). However, even when the fiscal distress is resolved with the assistance of outside agencies, it jeopardizes the continuation of essential government services. …