State Strategies to Detect Local Fiscal Distress

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A worker washes the windows on a building in Stockton, California. Stockton is one of several localities that received nationwide attention because of bankruptcy filings in recent years.

Overview

As local governments across the country struggle to resolve budgetary challenges, some states are exploring ways to help their counties, cities, towns, and villages avoid defaulting on loans or filing for bankruptcy.

Local governments are grappling with growing liabilities, including pensions and other post-employment benefits¹ as well as costly infrastructure needs² and reduced state and federal aid.³ In many communities, revenue and spending have not returned to the levels seen just before the Great Recession began in 2007. In fact, as of 2015, only 7 percent of U.S. counties had recovered to pre-recession levels based on indicators analyzed by the National Association of Counties: jobs, unemployment rates, economic output, and median home prices.⁴ Even as the recovery has proved sluggish and uneven, the reality of the next downturn is beginning to loom. Although economists are divided on when that will occur,⁵ some local governments are already beginning to plan for the next recession.

State policymakers have a critical stake in ensuring the fiscal health of localities so that they can maintain essential services to residents and protect the vitality of their economies, which generate revenue for governments at all levels. James Spiotto, an expert on municipal distress who has testified before Congress on the topic, said that although states do not necessarily take on the financial liabilities of local governments, they are ultimately responsible for the disposition of failed municipalities. In other words, Spiotto said: “The state is always going to be responsible if the local government fails. [The state is] the parent.”⁶

Despite this responsibility, many states historically have done little to track the budgetary well-being of local governments. Most routinely collect documents such as audits, financial reports, and budgets from local governments, but less than half analyze this information to try to detect signs of fiscal distress or, more generally, take the fiscal pulse of localities. The reasons for this vary. Some states view these tasks as beyond their responsibility, some say they lack the money and staff, and others say that because they don’t have the legal authority to intervene even when distress is evident, they see no reason to try to monitor local fiscal health.

As many states have learned, however, taking a hands-off approach to local government fiscal health can lead to costly surprises. Several localities have received nationwide attention because of bankruptcy filings in recent years, including Detroit; Jefferson County, Alabama; Stockton, California; and Central Falls, Rhode Island. In addition, the threat of default and possible bankruptcy is looming in Atlantic City, New Jersey. In the case of Detroit, the state of Michigan spent $195 million from its rainy day fund to help the Motor City exit bankruptcy.

In general, however, insolvencies remain relatively rare. Over the past 60 years, only 64 counties, cities, towns, and villages have filed for bankruptcy.⁷ That is in part by design: Twenty-one states do not allow local governments to file for bankruptcy, and several others place conditions on these filings.⁸

Although local government bankruptcies are not a widespread problem, many localities struggle to meet the needs of their residents. The concern, as Governing magazine put it, is “the ones on the edge—the ‘distressed cities’ … that likely will never declare bankruptcy but are nonetheless struggling to become economically viable again.”⁹ There are myriad examples of municipalities and counties in serious enough fiscal distress to erode critical services and hamper the community’s ability to thrive.

States can do more than just wait to react to the next fiscal emergency; they can work proactively to detect local distress and then use that data to determine the best steps to take. In 2013, The Pew Charitable Trusts explored how and when states intervene in local governments in The State Role in Local Government Financial Distress.¹⁰ The report described the stages of municipal difficulty, from distress to crisis to bankruptcy; the reasons for state intervention; and approaches states can take, including refusing to become involved even when local governments ask for help, intervening on a case-by-case basis, and repeatedly exercising state authority to make decisions for local governments. The report recommended that states monitor the fiscal conditions of local governments with an eye toward helping them avoid full-blown crises, if possible.

This follow-up report examines the range of policies and practices that states have in place to assess and track fiscal conditions at the local level, with a focus on whether and how states try to detect local fiscal distress. To operate a “fiscal monitoring system” for purposes of this research, a state must actively and regularly review the finances of at least some of its general purpose local governments, such as counties, cities, and towns, to monitor fiscal conditions or detect problems.¹¹ The research includes analysis of relevant state statutes and interviews with officials in all 50 states. To learn about the issue from the perspective of local governments, researchers also talked with officials from municipal leagues across the country. These efforts add up to the most comprehensive study to date of fiscal monitoring across the country.

Pew’s research found:

• 22 states¹² make some effort to monitor the fiscal health of local governments, meaning that they actively and regularly review financial information from local governments with the aim of trying to detect fiscal distress or, more generally, assessing their fiscal conditions.
• Of the 22, eight can be classified as “early warning” states, meaning that they have laws defining when local governments are in “fiscal distress” and systems to identify signs that a locality is declining toward such a condition.¹³
• State efforts to monitor local government fiscal health vary widely in scope, frequency, and who does the monitoring. Options available to deal with fiscal distress are also very different.

Based on this research, states should adhere to certain key principles when designing fiscal monitoring systems:

• Formal systems and processes that spell out how fiscal monitoring should work, along with when and how states and local governments should respond when various stages of fiscal distress are detected, help promote transparency and predictability. Establishing specific indicators, for example, helps ensure that monitoring happens consistently, no matter who is conducting the analysis. Codifying monitoring in statute strengthens the commitment to detect fiscal distress and help local governments even in times of tight budgets and through administration changes.
• Detecting distress early can help local governments address fiscal problems before they become unmanageable.
• Good working relationships between state and local governments are critical. Although state oversight of local governments can naturally lead to tensions, some states have succeeded in working with localities cooperatively, so that local governments view the state as a partner, not an enforcer. When well-designed and operated, fiscal monitoring systems can be mechanisms for regular communication between levels of government.
• States should undertake fiscal monitoring with the goal of avoiding state intervention or the need to take over local decision-making authority, if possible. Intervention is costly for the state, typically not welcomed by local residents or officials, and difficult to execute well. States should focus on helping these governments get back on their feet and move toward fiscal sustainability.

Some state officials feel that they have little reason to worry about the fiscal health of local governments. A number of them said municipal distress is not an issue in their state, citing fiscally conservative cultures or mechanisms set in place by their states to attempt to ensure local fiscal health, such as limits on taxes, expenditures, and borrowing.

The reality, however, is that a record of fiscally healthy local governments cannot guarantee what will happen in the future. One Rhode Island official said the Central Falls bankruptcy, filed in 2011, “was certainly a wake-up call … for everyone. … Before, no one really envisioned a municipality going bankrupt.”¹⁴

Just as governments at all levels learned from previous crises, states have an opportunity to re-examine their roles in helping local governments avoid or grapple with fiscal distress. That would follow the model set when the Great Depression prompted New Jersey and North Carolina to adopt rigorous local monitoring and intervention systems in the 1930s, and the financial crises of the 1970s and 1980s in cities such as Cleveland, New York, and Philadelphia spurred initiatives in multiple states.

As many local governments struggle to adjust to the reality of decreased or stagnant revenue and increased costs, several states—including New York, Rhode Island, and Tennessee—have either adopted fiscal monitoring systems or strengthened existing ones in recent years. Ohio and Colorado are among the states considering strengthening their systems to detect fiscal distress. For states that want to figure out how local governments are faring and whether any may be headed for fiscal crisis, this report analyzes the fiscal monitoring landscape across the country.

Endnotes

1. The Pew Charitable Trusts, A Widening Gap in Cities: Shortfalls in Funding for Pensions and Retiree Health Care (2013), http://www.pewtrusts.org/~/media/legacy/uploadedfiles/pcs_assets/2013/ pewcitypensionsreportpdf.pdf.
2. Andrew Flowers, “Why We Still Can’t Afford to Fix America’s Broken Infrastructure,” FiveThirtyEight, June 3, 2014, http://fivethirtyeight.com/features/why-we-still-cant-afford-to-fix-americas-broken-infrastructure.
3. Christiana McFarland and Michael A. Pagano, “City Fiscal Conditions 2015,” National League of Cities (2015), http://www.nlc.org/Documents/Find City Solutions/Research Innovation/Finance/CSAR City Fiscal Conditions 2015 FINAL.pdf.
4. Emilia Istrate and Brian Knudsen, “County Economies 2015: Opportunities and Challenges,” National Association of Counties (January 2016), http://www.naco.org/resources/county-economies-opportunities-challenges.
5. Victoria Stilwell and Catarina Saraiva, “Here’s When Economists Expect to See the Next U.S. Recession,” Bloomberg, Sept. 11, 2015, http://www.bloomberg.com/news/articles/2015-09-11/here-s-when-economists-expect-to-see-the-next-u-s-recession.
6. James Spiotto (managing director, Chapman Strategic Advisors), interview by The Pew Charitable Trusts, Feb. 29, 2016.
7. Hearing on Puerto Rico’s Fiscal Problems: Examining the Source and Exploring the Solution, Before the U.S. Senate Judiciary Committee, 114th Cong. (Dec. 1, 2015) (statement of James E. Spiotto, “Is Chapter 9 Bankruptcy the Ultimate Remedy for Financially Distressed Territories and Sovereigns Such as Puerto Rico: Are There Better Resolution Mechanisms?”) http://www.chapmanstrategicadvisors.com/insights-publications-18.html.
8. The Pew Charitable Trusts, The State Role in Local Government Financial Distress (July 2013), http://www.pewtrusts.org/en/research-and-analysis/reports/2013/07/23/the-state-role-in-local-government-financial-distress.
9. Liz Farmer, “Bankrupt Cities? What About Distressed Cities?” Governing magazine, March 2014, http://www.governing.com/finance101/gov-bankrupt-cities-overshadow-distressed.html.
10. The State Role in Local Government Financial Distress.
11. For this study, we excluded special purpose districts such as fire districts, as well as school districts, to narrow the scope of the work.
12. The states are Colorado, Connecticut, Florida, Iowa, Kentucky, Louisiana, Maryland, Michigan, Minnesota, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Ohio, Oregon, Pennsylvania, Rhode Island, South Dakota, Tennessee, and Washington.
13. The states are Louisiana, Nevada, New Jersey, North Carolina, Ohio, Pennsylvania, Rhode Island, and Tennessee.
14. Susanne Greschner (chief, Rhode Island Division of Municipal Finance), interview by The Pew Charitable Trusts, Sept. 17, 2015.