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Big City Blues

What's wrong with cities, and why it matters to business.

1Feb

Pittsburgh doesn't look like a city that almost didn't pay its bills last year. Its streets are clean. Crime rates are low. A gleaming new convention center and two stadiums rise along the banks of the Allegheny and the Ohio, two of the city's three rivers. Pittsburgh's nonprofit sector, which includes world-class medical centers and three universities, is flourishing.

But just as a handsome house with a luxury car in the driveway may belie the owner's empty bank account, Pittsburgh's financial condition is bleaker than it looks. The city has run a structural deficit annually since the early 1990s. Debt service devours nearly a quarter of the annual budget. Pittsburgh's credit rating dropped to junk status in 2003 and remained there for most of 2004. Finally, to avert possible bankruptcy, city leaders filed for "distressed municipality" status with the state of Pennsylvania. The state now oversees Pittsburgh's finances.

For the city government, the struggle for solvency has brought a steady procession of committee reports, public arguments, and budget reductions. "It has been grueling," says Ellen McLean, the city's finance director.

Pittsburgh is not alone. Communities ranging from Atlanta and Buffalo to Chicago and San Diego are in dire shape. Compared with the fiscal troubles of the federal government, those of municipalities have received little attention from corporate executives. But sooner rather than later, businesses will feel the effects of local budget shortfalls, through higher taxes and fees, crumbling roads and bridges, and smaller police departments. Simply relocating may not be the answer — many suburbs now face the same fiscal pressures as inner cities.

Indeed, if conditions worsen — for example, if the property market were to tumble — what is now a collection of local problems could become a national crisis affecting all taxpayers. "If the housing market were to collapse tomorrow, the sting for cities would be enormous," says Michael Pagano, a professor of public administration at the University of Illinois at Chicago and author of a recent National League of Cities (NLC) study on city fiscal conditions. "With a record federal budget deficit and a war with no end in sight, I'm not sure where resources could be shifted to cover the local governments' budget woes," he adds.

The NLC study, which included a survey of 288 municipal CFOs, found that 61 percent of municipalities will be less able to meet their financial obligations in 2005 than they were in 2004. And last year was not a good one for cities: it was the third year in a row that general fund revenues, adjusted for inflation, declined. At the same time, costs — especially for public safety and health care — have soared. The result is predictable: with reserves dwindling, many cities are resorting to severe budget cuts and hikes in taxes and fees.

The trouble isn't limited to the old industrial cities of the Northeast. In fact, the study showed that communities in the West and Midwest — including some suburbs — are even worse off. Seventy-five percent of CFOs in Western cities reported deteriorating conditions, as did 74 percent of those in Midwestern cities, compared with 59 percent in the Northeast and 43 percent in the South.

Unfortunately, few are doing enough to solve their problems, according to experts. "For the most part, cities haven't confronted their problems head-on," says James Hughes, dean of the Edward J. Bloustein School of Planning and Public Policy at Rutgers University in New Brunswick, New Jersey. "Some are hoping that they'll grow their way out of it, but that notion is fading away."

Cash Crunch


How did American cities arrive at this point? The answer lies with a convergence of factors, some of them within the control of city governments, but many imposed from outside. Most obviously, the sluggish economy hit cities hard, raising expenses and holding down revenues. For example, city hospitals face much higher costs when residents lose their jobs and, with them, their health insurance. The same job losses can mean unpaid taxes. "Cities feel the effects of a recession before other communities, and the effects linger longer," says Henry Coleman, an economist at Rutgers.

And these days, cities can't rely on support from the states or the federal government. Because of the states' own budget woes, aid to cities fell 9.2 percent on average last year across the nation; federal aid to cities all but ended in 1987. This comes on top of a rise in unfunded mandates, such as the Clean Water Act, which impose new costs without new revenues.

There are also problems with local taxes. Many cities rely too heavily on either sales or property tax, exposing them to swings in the economy. And these taxes haven't kept pace with demographic and economic changes. For example, a growing proportion of those with jobs in the city now live in the suburbs, meaning that while they spend their days in town, their property taxes go to another local government. Similarly, the sales-tax base is shrinking. In 1960, goods (which are taxed) represented about 60 percent of all sales in the United States versus 40 percent for services (which usually aren't taxed). Today, that ratio has flipped. Surging online sales also cut into city revenues. "Sales tax is our single largest source of revenue, but it's eroding," says Jim Dailey, mayor of Little Rock, Arkansas.

The answer to such tax problems seems straightforward — cities need to recalibrate their revenue sources. But change can be hard. The states grant taxing authority to the cities in most cases, and politics often block efforts to levy new taxes or raise old ones. Add to that the restrictions that result from taxpayer revolts, and local governments find themselves in a bind.

For instance, Colorado's Taxpayer Bill of Rights requires a public referendum before any tax increase, and compels local governments to refund any surplus revenue. "It sounds good, but it's been really terrible for cities in this state," says Steve Burkholder, the Republican mayor of Lakewood (see "Suburban Blight," at the end of this article).

Of course, elected officials share some of the blame for cities' dismal finances. There are notable exceptions, but it's fair to say that some municipal governments are neither efficient nor farsighted. During the expansion of the 1990s, many didn't save much of the revenue pouring into their coffers. "To quell union problems during the boom years, many places gave out very generous pension programs and other benefits, but didn't fund them appropriately," comments Rutgers's Hughes. City finance officers often found themselves arguing in vain for better long-term planning.

This illustrates an important difference between a municipal CFO's job and that of a corporate CFO. While both oversee budgeting and daily financial matters, city finance officers have less power and must contend with the forces of electoral politics. "Politics is one of the biggest challenges of the job," says Kathleen Clarke, who has worked in municipal finance since the mid-1980s and is currently finance director for Darien, Connecticut. "You're in the job as a professional, trying to do what's best for the city. But that's not always the same as what the politicians or the citizens think is best."

Pittsburgh is a good illustration of how, in combination, such pressures can wreak havoc on a city's finances. As the first U.S. city in many years to flirt with bankruptcy, it also may be an early warning of further problems to come.

Pittsburgh's Plight


In a threadbare office within Pittsburgh's marble and steel City Council Building, chief accounting officer Peter Jannis enumerates the many causes of the city's plight: the police and fire unions, the nonprofits, the school board, the city council, and the bad decisions of previous mayors, to name just a few. During a separate meeting, finance director McLean offers a similar list, adding such factors as underfunded pensions, high debt-service payments, and state laws that limit the government's ability to control costs or raise new revenue.

But the basic problem is simple: while Pittsburgh's economy and demographics have evolved, its tax structure has not. Since the 1960s, the city, once famous for its grimy steel and glass industries, has lost many of its businesses and half of its population. Cleaner businesses have taken their place, especially nonprofits and financial services. Today, six of Pittsburgh's top eight employers are not-for-profits.

Unfortunately for the city, the nonprofits pay no taxes and the banks pay very little. Consider one small example: when Duquesne University decided to purchase a privately held building and use it as a dormitory, the property dropped off the tax rolls, depriving the city of approximately $800,000 a year. "The best thing going on here are the nonprofits, but they're choking the city," says Jannis, who works for the city controller.

As for the banks, they fall under a state law exempting certain types of companies from the city's business-privilege tax — an exemption that applies to half of Pittsburgh's businesses. And while the city's resident population is now only 330,000, there are another 300,000 who commute into Pittsburgh from the suburbs. These commuters, who arguably benefit from the city's infrastructure, contribute only $10 a year each via an occupational-privilege tax — an amount fixed by the state and unchanged since 1965.

While Pittsburgh's revenues have been virtually flat, its expenses steadily rise between 3 and 4 percent annually. The causes include unfunded mandates from the state and federal government and personnel costs, especially health care and pensions. According to credit-rating agency Fitch, health-care costs for states and municipalities climbed an average of 14.2 percent from 2000 to 2004.

Buy Now, Pay Later


But the main culprit is the city's contracts with public-sector unions, especially the police and fire departments. For years, the cost of the city's labor agreements has risen faster than inflation and faster than labor agreements in other parts of the country. "You'd be shocked to see what some of these guys make," says Jannis.

City officials blame a state law that, in exchange for a ban on striking, grants the unions the right to binding arbitration. But the arbitrators — whose selection is heavily influenced by the unions — aren't required to take into account the city's ability to pay. Local politicians have played a role in the largesse, too. "During every primary, the city council just showers the unions with everything they've been complaining about," says McLean. Today, 50 percent of the city's budget goes to public-safety expenses.

Soaring compensation for municipal employees has become a nationwide problem. Such cities as Philadelphia, San Diego, and Houston all find themselves saddled with high personnel costs and staggering unfunded pension liabilities. Unlike corporations, which must put money into their pension plans when assets fall below a certain level, local governments are free to contribute when they want to. The resulting temptation is to grant generous benefits today and push the liabilities into the future.

Pension problems have aggravated another of Pittsburgh's conditions: a crushing debt load, which totals $879 million in general obligation debt and hundreds of millions more owed by the city's authorities. (The city is responsible for some of the authorities' debt-service payments.) The city has borrowed to shore up its sorely underfunded pension plan, to cover budget shortfalls, and for economic development programs, which have a patchy record of success. In 2004, Pittsburgh devoted 23 percent of its budget to debt service. "The rating services consider 15 percent to be high," says James Roberts, a partner at Pittsburgh law firm Eckert Seamans and head of the state-sponsored team overseeing the city's recovery. "They don't have a word for 20."

Beyond this, there has been an inability — some say an unwillingness — to seriously contain costs sooner. "What has happened to Pittsburgh is the result of one-party politics, nostalgia, resistance to change, and a lot of denial by political and economic elites," says Robert Strauss, a professor of economics and public policy at Pittsburgh's Carnegie Mellon University and a persistent critic of the mayor and city council. Indeed, rather than confront the problems head on in the 1990s, the city resorted to a series of one-time measures, such as asset sales, accounting gimmicks, and debt extensions. "They've finally run out of those rabbits in a hat," says Jannis.

For her part, Ellen McLean — who plans to step down as finance director this month — argues that she and Mayor Tom Murphy have been trying to push cuts through the city council for years. "Just getting simple things like health-care cost-sharing has been like pulling teeth," she says. As the city's crisis escalated, the mayor did make some drastic cuts: in August 2003, the city laid off 446 employees (including 100 police officers), shut down recreation centers, closed public pools, and canceled a range of services, including mounted police patrols.

A Road to Recovery?


After much public wrangling, the mayor, the city council, and state legislators finally agreed in December to a stringent recovery plan. "If nothing had been done, the city would have a $75 million operating deficit in 2005 and would eventually face a $115 million annual deficit by 2009," says attorney Roberts. "You just can't sustain that for very long."

The plan calls for deep cuts and some new revenue streams, including a broad-based payroll tax to replace the ineffective business-privilege tax and a higher occupational-privilege tax. Nonprofits remain tax-free, but have agreed to voluntarily contribute $6 million to this year's budget. Act 47 also gives the city one valuable benefit: it releases Pittsburgh from the binding-arbitration rules, enabling it to force concessions from the unions, including a 17 percent pay cut for firefighters.

McLean is optimistic. "It's been very difficult to contain costs, but now we'll have a balanced budget and it will be locked in place."

Don Durfee is research editor of CFO.

Finance Pressure

Cities did have one advantage at the start of the recession in 2001: they had just enjoyed the longest economic boom — with its attendant tax windfalls — in the nation's history. When the celebrations stopped, though, most local and state governments found themselves wondering where the money had gone.

A few cities stand out as exceptions. One is Seattle, which has maintained strong reserves and the top credit rating from the three major rating agencies, and has earned praise for its financial management.

That's not to say these have been easy times for the city. In recent years, the Seattle area lost 7 percent of its jobs. The city is also coping with a recent statewide cap on property taxes that, combined with other restrictions, has reduced its 2005 revenues by $60 million out of a $700 million budget. In response, the Seattle government has sharply reduced its spending. "We were the hardest hit by the recession and have been the slowest to recover," says Dwight Dively, director of Seattle's Department of Finance.

It is all the more remarkable, then, that the city's reserves remain untouched — in fact, Seattle continues to add to them as much as state law allows. According to Dively, this is the result of an agreement between the mayor and the city council after the economic slowdown of the early 1990s. Puzzled that the revenues of the 1980s had vanished, the city council authorized a citizens' committee — which Dively staffed — to investigate. The committee devised a comprehensive approach to managing the city's emergency fund, and recommended setting aside money to better maintain city infrastructure. Since then, Seattle hasn't deviated from this policy.

How did the long-term perspective win out over the usual short-term political calculations? Dively attributes it to the quality of the elected officials over the years. "And who knows?" he says. "Maybe it's also some of the city's frugal Scandinavian ethic." —D.D.

Suburban Blight

In most ways, Lakewood, Colorado has little in common with Pittsburgh. For starters, it is a suburb of 144,000 people. Adjacent to Denver, the community is close to mountains, forests, and lakes. Unlike Pittsburgh, its voters are mostly conservative.

But Lakewood is facing a series of fiscal pressures that, while not on the same scale as Pittsburgh's, are proving equally painful. "I've been in office for five years, and I've had to cut the budget every year," says Steve Burkholder, now serving his second term as the city's mayor. "The first year it was the perceived fat, then it was the muscle, then the bone, and in this last year we did amputations."

The city has three main problems. The first is a very low sales tax — 2 percent. The tax accounts for about 60 percent of the city's budget, but revenues have dropped with the economic slowdown. The second is the growth of online shopping, which Burkholder estimates has cost the city $2.5 million in lost tax revenue. Finally, costs continue to rise sharply. Health-care costs are a particular strain — the government's premiums will rise between 15 and 20 percent this year.

What really puts the city in a bind, however, is Colorado's Taxpayer Bill of Rights, passed in the early 1990s. The law bars any local tax increases without a referendum and requires governments to refund money if the budget grows faster than the rate of inflation and the local economy. During a recession, this creates a quandary: the permitted budget shrinks along with the economy, but expenses don't. Lakewood has so far obtained an exemption to the refunding requirement, but in 2007, unless voters reauthorize the exemption, it may have to give back money at a time when revenues are already sinking. "We could be hit with a double whammy of a low tax rate and demands to refund money that's already been spent," says Burkholder.

Voters have rejected past efforts to increase the sales tax. This time, the mayor is launching an effort to engage the public in the budget-setting process. Throughout the year, the city will hold a series of community meetings. Says Burkholder: "We'll ask, 'What's important to you? Should we be spending more on cops, the arts, or on streets? Now, given the realities, what do you want us to do: increase taxes or cut services?' " —D.D.

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