DR. ERIC SCORSONEGOVERNMENT PUBLIC POLICY AND FINANCE

GROUPMICHIGAN STATE UNIVERSITY

WASHINGTON ASSOCIATION OF COUNTIESNOVEMBER 20 , 2013

Fiscal Sustainability: The Challenge and Promise

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

Roadmap for Today

Defining Fiscal Sustainability

Measuring Fiscal Sustainability

Managing for Fiscal Sustainability

Communicating Fiscal Sustainability

DEFINING FISCAL SUSTAINABILITY

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

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 present and future generations

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

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

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

“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

MEASURING FISCAL SUSTAINABILITY

The Fiscal Equation

Revenues = Spending

Over what time period?What sources of revenue?Changes in spending pressures?

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

Local Fiscal Sustainability Indicators

Govt. Revenue and fees

Govt. Spending

Asset Condition

Debt & Liability Condition

Economic Condition

Tax base Condition

Revenue Questions

Types of revenues (diversity, elasticity and flexibility)

Level

Growth or Change and Stability

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

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?

Detroit Tax Collection Trends (1938-2011)

Falling Property Tax Base

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

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

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

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

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?

Detroit Deficits and Spending

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

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

Adding it up….key elements on spending

1. Inflation or cost of providing current goods and services

2. Technological change in “what” and “how” services are provided

3. Changes in social and demographic characteristics of “demand” side

A. Residents, nonresidents, commuters

4. Current Services + Capital (investment and maintenance)

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

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

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

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

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

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)

Asset condition interpretation

An example: city of Detroit

Year Net Asset ratio

Net Financial Asset Ratio

Return on Assets

2006 .17 -1.07 .7%

2007 .16 -1.0 .4%

2008 .12 -1.12 -3.0%

2009 .09 -1.42 -3.5%

2010 .03 -1.66 -2.6%

Taken from Woods Bowman, 2011

Budget and Revenue Trends

 City Budget (% Change)

State Aid (% Change)

Total City Revenues

Govt. Inflation (% Change)

2000's -0.05% -2.60% -0.32% 3.87%

1990's 2.6% 2.5% 2.6% 2.9%

1980's 4.1% 7.6% 6.1% 5.6%

1970's 7.1% 11.8% 7.2% 7.7%

1960's 4.3% 6.4% 3.6% 4.2%

1950's 5.1% 4.3% 5.5% 4.1%

1940's 4.5% 3.1% 2.4% 6.5%

Overall Average 3.7% 4.6% 3.7% 4.9%

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

GOVERNANCE: MANAGING AND ADDRESSING FISCAL

SUSTAINABILITY

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

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

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)

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)

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”

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

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

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

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

Improve Budget Transparency

MI Citizen Guide to Local Unit Finances

Required by law of every local government in Michigan

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

Fiscal Sustainability

State Policy

Local Policy

Socio-Economic Conditions

Thank You!

Questions and Discussion……

Dr. Eric ScorsoneMichigan State Universityscorsone@msu.edu

Fiscal Sustainability: The Challenge and the Promise