Fiscal Sustainability: The Challenge and Promise

1. Fiscal Sustainability: The Challenge and Promise Dr. Eric Scorsone Government Public Policy and Finance Group Michigan State University Washington Association of Counties November 20, 2013

2. Goals and Objectives My goal is to give you a set of tools and mental models for thinking about, measuring and communicating fiscal sustainability to your constituents To make you a good consumer of financial indicators and ratios measuring and implementing fiscal sustainability

3. Roadmap for Today Defining Fiscal Sustainability Measuring Fiscal Sustainability Managing for Fiscal Sustainability Communicating Fiscal Sustainability

4. Defining fiscal sustainability

5. Many Definitions of “Fiscal Sustainability” Revenues grow at rate of inflation + population (Ulbrich, 1997) Revenues must grow to meet continued provision of service and capital needs (Chapman, 2008) Ability of government to sustain its current spending and tax policy without threatening solvency or default

6. What is Fiscal Sustainability? Brundtland report (1987) defined as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs” Decision making & Governance that is future oriented and ensures that local government (county) can protect public health, safety and welfare of presentandfuturegenerations

7. Fiscal Distress vs. Fiscal Health • Fiscal Distress • Generally based on cash flow and immediate short term problems • Cash ratios and fund balance ratios • Fiscal Health • Based on long term sustainability of a governments finances and operations • Measured by assets, revenue and spending per capita and ability to provide services • Structural deficit or surplus

8. A Brief History of Budgeting • Prior to early 1900’s, government did not budget at all, just paid invoices as they came due • NYC developed the line item budget; look ahead one year and plan on revenues and spending • Fed. Govt. adopted budgeting in 1920’s • Annual budgeting represents a look ahead and potential impact of decision one year ahead

9. U.S. Government Fiscal Sustainability • Fiscal Indicator: Debt as a percent of U.S. GDP • Predicted that privately held debt will exceed 100% of GDP in 2030 • This matters if bond market decides that U.S. becomes a credit risk • Health care (Medicare) and Social Security will consume entire U.S. budget • Primarily baby boom generation

10. “Laboratories of democracy” 200 years ago, de Tocqueville noted that America’s strength lay in its local towns and villages Still true today, local governments can carve out different sustainable pathways in partnership with state government

11. Measuring fiscal sustainability

12. The Fiscal Equation Revenues = Spending Over what time period? What sources of revenue? Changes in spending pressures?

13. Fiscal Gap • Fiscal gap is the amount of spending reductions or revenue increases required to balance the government’s budget and avoid insolvency or default • Insolvency is not just promises to bondholders • Vendors and suppliers • Pensioners and retirees • Citizens and constituents

14. Local Fiscal Sustainability Indicators Govt. Revenue and fees Govt. Spending Asset Condition Debt & Liability Condition Economic Condition Tax base Condition

15. Revenue Questions Types of revenues (diversity, elasticity and flexibility) Level Growth or Change and Stability

16. Govt. Revenue per capita (Level) • Govt. revenue has two roles: • Critical to maintaining public services • Has a potential direct impact on local economy • Revenue component • Local taxes • User fees • Intergovernmental aid • Formula • Net operating revenue (inflation adjusted) / population

17. Revenues per capita interpretation • Falling revenue per capita my be inability to maintain services • May reflect: • Local policy choice • State imposed changes • Weakening tax base • Population is a tricky measure • What about in-commuters, tourists?

18. Detroit Tax Collection Trends (1938-2011)

19. Falling Property Tax Base

20. Revenue Growth and Stability • Will revenue grow at an adequate rate to support population and economic conditions? • Measures of revenue growth: • Change in revenue per capita • (Revenue in yr. 2 – revenue in yr. 1) / (revenue in yr. 1) • Use as many years as possible

21. Revenue Trend and Cycle Issues • Requires separating: • Underlying Trends from Business Cycles • Trend is long term idea of revenues and spending and service needs • Cycle is short term movement in revenues in particular

22. Govt. Spending per capita • Govt. spending has two roles: • Critical to maintaining public services • Higher than necessary spending (and tied to local taxes) can act as drag on economy • Spending per capita measures both of these roles simultaneously • Formula = net operating expenditures (inflation adj.) / population

23. Govt. Spending per capita interpretation Increased spending may be caused by new services added, changes to state mandates or demographic shifts What about productivity and internal efficiency? What is the relationship between revenue and spending per capita

24. Spending and Service Questions • How will spending pressures impact the growth in spending over time? • Population, inflation, land use…….. • What will the impact of technology be on spending and new or altered services? • Potential impact of state and federal mandates on spending?

25. Detroit Deficits and Spending

26. Rules of the game: Spending Mandates Election administration Property tax collection Civil and criminal justice system Process and maintain records Expected changes in state mandates may put pressure on county government spending per capita over time Expected changes may be based on history and looking forward

27. Rules of the Game: Budget rules State imposed balanced budget rules Does the state require a “balanced budget’ What is the definition of balanced budget Annual budgeting may actually encourage short term thinking

28. Adding it up….key elements on spending • Inflation or cost of providing current goods and services • Technological change in “what” and “how” services are provided • Changes in social and demographic characteristics of “demand” side • Residents, nonresidents, commuters • Current Services + Capital (investment and maintenance)

29. Debt & Liability Condition • Debt burden as a future fixed cost; usually a key issue in fiscal sustainability analysis • Types of debt • Leases • Bonds and notes • Unfunded liabilities • Formula: long term debt / assessed value or population

30. Debt and Liability interpretation • Debt levels as a relationship to population growth or decline • Is debt burden as a fixed cost rising as a percent of spending and why if so? • What is debt being used for? • Long term capital expenditures (maintenance accounted for?) • Operating costs

31. Socio-Economic Condition • To assess the tax base and the demand for government services • Formulas: • Population trends • Median age • Personal income per capita, source of income • Percent of households in poverty • Housing starts and age of housing • Property values, vacancy rates and home prices • Business activity and retail sales

32. Socio-Economic Condition interpretation Population growth may boost revenues but also capital and operating spending needs Older population may require a different mix of services Job and retail sales activity main drivers of potential tax base

33. Tax Base Condition Tax Based condition = economic condition + legal condition Economic conditions drive the potential revenue that can be collected (income, employment….) Legal conditions shape how much of this potential revenue can be realized and collected

34. Asset Conditions • Measures the stock of resources (cash and noncash) available to a government entity • Measures: • Net asset ratio = total net assets / total assets • Net financial asset ratio = (total net assets – capital assets) / (total assets – capital assets) • Return on assets = 100% * change in net assets / (total assets – capital assets)

35. Asset condition interpretation An example: city of Detroit Taken from Woods Bowman, 2011

36. Budget and Revenue Trends

37. Asset condition interpretation • Net assets is interesting but problematic because in general we aren’t going to sell government assets like roads • Net financial assets is a better measure because it removes capital assets and….. • Best measure may be return on assets • Should be at least 2.5% (inflation and we can also adjust for population growth

38. Governance: Managing and Addressing Fiscal sustainability

39. The Governance Equation An intangible but crucial factor Ability to go beyond measuring and discussing fiscal sustainability…..to implement fiscal sustainability principles Requires long term thinking and an ability to recognize that different versions of the future exist and there is a need for debate, discussion and compromise

40. Strategies and Options • Revenue growth limits = population + inflation (personal income) • Conduct 3-5 year financial projections (minimum) • Ensure a robust rainy day fund (worst case scenario) • Recognize revenue volatility • Use performance or priority based budgeting • Improve budget and long term finance transparency

41. Revenue and Spending limits • Limits make sense to ensure that government growth is “reasonable” • Washing and Michigan are tied for second most restrictive revenue limits • Not reasonable, creates a fiscal crisis • Population + inflation + 1% or (income)

42. 3-5 yr. Forecasting Challenges How do we know what the future looks like? (forecasting problem) How do we know if we are “kicking the can down the road”? (information problem) What if we disagree about priorities or even defining fiscal sustainability? (compromise problem)

43. Forecasting problem • How do we look so far in the future? • 3, 5 10 years or more • Identify domains that are more easily assessed than others • Pensions and retiree health care are more easily assessed • Economic conditions may be volatile, what does the past tell us • Spending may be easier if we can use population and inflation as drivers • Recognize that every good forecast has a “range” around which the true values are likely to occur • Scenario planning: May need to explore several scenarios rather than one “forecast”

44. Compromise problem • We will not all agree on what the future looks like • Attempt to establish boundaries over view of what the future should like • How far apart are we really? • Use skilled facilitation if necessary • Find common ground • Generally we agree on a lot more than at first glance

45. Rainy Day Fund How big should it be? How to protect it from use in non-emergencies? Minimum of 5-10% of total governmental spending but may require depending on experience with revenue volatility Some will argue it should be much higher to sustain spending in a downturn

46. Revenue Volatility Revenue volatility will be a reality, we just don’t know when Many forecasts act as if revenues will grow in a straight line Revenue volatility can only be removed if revenue options move in different directions during business cycle

47. Performance Based Budgeting Ensure that government is as efficiently as possible meeting service demands of citizenry Lays out short and long term priorities and how budget is targeted to meet those priorities Can be used to educate state about spending mandate pressures

48. Improve Budget Transparency MI Citizen Guide to Local Unit Finances Required by law of every local government in Michigan

49. Communicating about Fiscal Sustainability • Challenge is shifting publics attention from the “here and now” to the impact on future generations • Balancing the need to provide services now and in the future • Using enhanced tools such as community scorecards and citizens guide • Go beyond the budget and audit

50. Fiscal Sustainability State Policy Socio-Economic Conditions Local Policy