How California Detects Fiscal Distress in Local Governments

With the economic impact of the COVID-19 pandemic putting fiscal pressure on state and local government budgets, states are looking to identify municipalities most at risk of fiscal distress so that local officials can address problems early on, allowing them to perhaps avoid drastic measures such as cutting programs or services. In California, the state auditor’s office launched an online dashboard in October 2019 to rank more than 470 cities based on their fiscal health.

This interview with California State Auditor Elaine M. Howle, who has been in her position since 2000, has been edited for clarity and length.

Q: A couple of years ago, your office launched a dashboard to identify California cities that could be facing fiscal challenges. What were you hoping to achieve?

A: Our goal was to provide a data-driven, transparent interface—for the public, state and local policymakers, and other interested parties—that identifies cities at high risk of experiencing fiscal distress. Now, for the first time, Californians could go online and see a fiscal health ranking for more than 470 cities across the state. We designed the dashboard to include various layers that allow all types of users to obtain information about cities’ finances, from those who want a quick at-a-glance view to those who want to see the raw data behind each city’s scores.

Q: And it’s updated regularly?

A: We updated the information in November of last year and plan to continue updating it as new information becomes available.

Q: Were you tracking this information before 2019?

A: We had established our high-risk program more than five years ago, as authorized by law, to identify local government agencies that could be at high risk for waste, fraud, abuse, or mismanagement or that have major challenges associated with their economy, efficiency, or effectiveness. In the early years, this local government high-risk program helped us identify cities that could be fiscally distressed, and we requested and obtained approval to conduct audits of some of those cities.

Q: Why did you decide to add the dashboard?

A: Although we had information on our website about how we identified cities that could be facing fiscal challenges, we believed we could create an online tool to fulfill our responsibilities while also providing more transparency and accountability. So in October 2019, we launched the online dashboard.

Q: Why is it important for states to keep track of the fiscal conditions of cities?

A: State and local governments work together and rely on each other to ensure certain government services. And many government programs and public work projects require state and local assistance, so it’s important for the states and local governments to work together and for each to understand their fiscal conditions.

Q: And the fiscal conditions of cities affect the fiscal condition of the state, right?

A: Although cities aren’t a direct revenue source for the state, the health of their economies and finances obviously has a significant impact on the state. At times, the state has had to redirect resources to ensure the delivery of services; at other times, the state has reduced resources it provides to cities—which makes it even more critical to track the cities’ fiscal conditions. To ensure the well-being of all Californians, state representatives and officials should identify early signs of fiscal distress in our cities. That allows stakeholders and officials to take action early.

Q: What does it mean when California designates a city as high risk of fiscal distress?

A: It means that the city could be facing fiscal challenges and may be having difficulties funding services for its residents.

Q: What goes into determining if a city is at high risk?

A: Generally, several factors in the aggregate put a city at risk of experiencing fiscal distress: insufficient financial reserves to cover unexpected costs; revenue shortfalls due to emergencies or economic downturns; very high levels of debt compared to available income; insufficient amounts of cash on hand to pay bills in the coming year; lack of enough revenue growth to keep pace with rising expenditures; and a strained ability to pay for pension and other post-employment benefits (OPEB) for municipal employees.

Q: What data does your office collect for the dashboard?

A: We use audited financial reports for more than 470 California cities, and we also analyze unaudited pension-related information from CalPERS, our state public employee retirement system.

Q: That’s a lot of data for a lot of cities.

A: Yes, and the financial health of California’s cities varies greatly—they provide different services, they have different revenue sources, and they pay different employee salaries and benefits.

Q: How do you use this data to assess risk?

A: We perform various financial comparisons and calculations that we refer to as financial indicators. The results of these indicators measure each city’s financial reserves, levels of debt, cash position or liquidity, revenue trends, and ability to pay for employee retirement benefits. While some cities don’t appear to be at high overall risk of fiscal distress when you look at all the indicators, there may still be areas of concern when you look at the individual indicators.

Q: What’s an example of an indicator that you use?

A: Large amounts of debt and unfunded obligations for pensions and OPEB, such as health and dental benefits, can put significant pressure on a city’s finances. Rising pension and OPEB costs can add to the strain, especially when combined with flat or declining revenues. And funding levels for OPEB plans are generally much lower than for pension plans: More than 150 California cities offer OPEB benefits to their employees but haven’t set aside any money to pay for those benefits.

Q: What do you do once you determine that a city is facing fiscal challenges?

A: We conduct additional research and assessments to further evaluate the risks those cities face. Some cities may appear to be faring all right, for example, but may have insufficient levels of financial reserves needed to weather unexpected emergencies and economic downturns. These initial assessments inform whether we will seek approval from the Joint Legislative Audit Committee to conduct an audit of the city.

You can find our detailed methodology at https://www.auditor.ca.gov/local_high_risk/process_methodology.

Q: Since the pandemic began, have you used the dashboard any differently?

A: The dashboard currently reflects the fiscal health of California cities based on the most recent audited financial statements (through fiscal year 2018-19), which provided information about the extent to which each city had set aside sufficient financial reserves to weather any economic downturn—which the pandemic turned out to be. We compared that information with data from an economic forecast model to estimate the impact from the pandemic on city revenues such as hotel taxes, sales and use taxes, business license taxes, admissions taxes, and parking taxes—the revenues that we knew COVID-19 would significantly affect. That allowed us to gauge what cities were experiencing—a prospective view rather than a retrospective view.

Q: Which brings up the question: How are cities in California faring fiscally, given the budget impact of the pandemic?

A: The impact of COVID-19 really underscores the importance for cities to have sufficient reserves.

When we first published our dashboard, we identified 18 cities facing fiscal distress based on their fiscal year 2016-17 finances. In the two subsequent fiscal years, the number of cities at high risk for fiscal challenges decreased to 12 and then nine—which was not surprising, given the overall health of the economy and the very low unemployment rates during those years.

But at the end of fiscal year 2018-19, there were 40 cities with insufficient financial reserves. That raised concerns that these cities could be financially unprepared to deal with the economic consequences of unexpected emergencies and economic downturns.

The forecasts indicated that 32 California cities will lose general fund revenues that exceed 20% of their annual expenditures by the end of fiscal year 2020-21. Although the majority of these cities appear to have sufficient reserves to get through this, 11 of them may need to cut services or raise revenue to close their budget gaps.

Q: Do you have any plans to analyze California’s 58 counties in a similar way?

A: To date we’ve focused our efforts on evaluating the financial risks facing California cities, but we do intend to expand our analysis to include counties. When we brief state policymakers and other stakeholders on the results of our dashboard, this question often comes up because our local high-risk program includes counties and special districts. Expanding the dashboard to include county information will greatly improve the transparency of county finances for the public, state and local policymakers, and other interested parties.