Early Warning Systems Can Help States Identify Signs of Fiscal Distress

States have a pivotal interest in the fiscal health of their localities so that they can continue providing vital services to their citizens. Local government budgets have begun to feel the impacts of the recession, which probably will continue for some time. By implementing and improving early warning systems, states can proactively identify fiscal weaknesses and provide assistance to their local governments when necessary, potentially helping them avoid fiscal disaster.

The Great Recession of 2007-09 challenged the budgets of many local governments, eroding their ability to provide services such as water, sewer, and road upkeep to residents. This incentivized states to adopt or strengthen fiscal monitoring systems, which can identify financial instability before it becomes a crisis.

In a white paper for The Pew Charitable Trusts, Eric Scorsone and Natalie Pruett of the Michigan State University Extension’s Michigan Center for Local Government Finance & Policy assessed local government early warning systems through case studies in Colorado, Louisiana, Ohio, and Pennsylvania. Each of these states applies various financial ratios—an approach known as ratio analysis—and other indicators to identify signs of local fiscal distress. Ratio analysis uses fractions that capture financial or economic activity within a locality—such as total expenditures over total revenues—to measure solvency, the ability to pay debts and liabilities over the short or long term. Ultimately, the authors determined that there isn’t one optimal system and instead offer several recommendations for states to build or improve their early warning systems.

The authors present detailed descriptions of the four states’ systems and analyze trade-offs and implications of the indicators employed to measure different types of solvency. They offer a variety of recommendations for states to consider, including use of indicators for four types of solvency:

• Cash solvency, which is the ability of the local government to pay its debts in the immediate short term.
• Budgetary solvency, which means solvency in the next one to three years.
• Long-run solvency, which pertains to solvency in the next 10 to 20 years and may be associated with long-term needs such as infrastructure maintenance and pension liabilities.
• Service-level solvency, which indicates that the government can meet the service priorities of residents, local businesses, and community groups.

Using data from each state, the authors demonstrate that more indicators generate more signals of fiscal distress, and thus if a state wants to err on the side of caution for a type of solvency, it should include more indicators for that type of solvency.

Additionally, the paper suggests that states apply ratios that show how a local government’s indicators change over time as well as ratios that capture a “snapshot” of the locality at a specific moment in time. Using a combination of changing and static indicators allows states to understand the current condition and trajectory of their fiscal health. For example, the Ohio Financial Health Indicator System considers the amount of property tax revenue collected by a locality in proportion to its total revenue as an indicator for long-run solvency, and the system looks at this indicator both for the most recent year and for how it has changed compared with one and three years prior.

The authors also recommend using benchmarks for the selected indicators to help localities understand how they are performing across different dimensions of fiscal health. These benchmarks can compare the locality with itself over time, with statewide benchmarks, or with a benchmark established from research. Each state in the analysis applies at least one type of benchmark in its early warning system. In conjunction with benchmarking, the authors suggest employing a composite score for localities that contains measures for individual ratios and for fiscal health as a whole. For example, Pennsylvania’s system measures a municipality’s performance for each indicator by comparing it with a statewide benchmark in addition to generating a composite score to represent each municipality’s overall fiscal health. This ranking system allows Pennsylvania to identify the localities most in need of assistance and then use the more specific indicators to disentangle each locality’s particular issues.

Pew’s own research identifies the benefits of the types of early warning systems discussed in Scorsone and Pruett’s work. Findings indicate that early warning systems aid local governments’ fiscal health by helping to identify and address problems before they become unmanageable.

Municipalities will probably feel the fiscal impact of the pandemic for years to come and may require help, such as technical or financial assistance, from their states. As states recover from the recession of 2020, their ability to discern which localities are most in need of assistance will be critically important. By identifying local fiscal distress early, states can offer the support and assistance that local governments need to prevent distress from turning into disaster.

Jeff Chapman is a director and Katy Campillo is an associate with The Pew Charitable Trusts’ state fiscal health project.