MSU Extension Center for Local Government Finance & Policy

The Covid-19 pandemic has caused a new set of challenges and operational difficulties, impacting all levels of government. In the United States, local governments are typically the frontline providers of critical public health and public safety operations, both of which are in great demand and pressure during the pandemic. In addition to the day-to-day fiscal issues that local governments can face, the onset of a major pandemic-induced recession has presented a second wave of fiscal problems for local governments. In this situation, state and local governments are seeking out new tools to assess risk and vulnerability and to chart new options moving forward.

Historically, state governments have played an important role in tracking local government finances in areas such as budgeting rules and practices, accounting requirements, and debt issuance. State governments have assigned the role of tracking and administering financial rules on local fiscal health to a variety of agencies and departments, including state auditors, revenue and treasury departments, and community development departments. These agencies are assigned to review potentially thousands of local government entities. Each of these local entities may have a variety of accounting and financial issues and may work on different fiscal calendars.

Since the 1970’s and the near bankruptcy of New York City and Cleveland, state governments have ramped up efforts to use financial data to explicitly track local fiscal health and identify problems before an acute crisis occurs. The goal of a risk identification, or fiscal early warning, system is to assist state agencies by triaging the huge amount of available financial information and determine where financial problems are likely to arise or may exist. For several years now, state governments have been using information contained in local government financial audits to calculate fiscal indicators, or ratios, and use those to identify potential problems at the local level. The metrics, or index, calculated in such a system is often measured against some type of numerical grading scale indicating whether or not a problem exists. At that point, a state agency can provide additional training, seek out input from local officials, or, in some cases, require additional local actions with the intention of preventing a fiscal crisis from occurring.

Any such fiscal early warning system faces the overall problem of identifying a financial problem in a local government where 1) a problem does not exist or 2) a problem is missed. The metrics or index used could cause a state to misidentify a local government as distressed when it is not or, alternatively, cause a state to miss a local government that is distressed. This misidentification is no different than the advantages and potential problems involved in using indicators such as blood pressure or temperature as a quick gauge of human health.

Since the 1970’s, some state governments have developed analytical tools to identify, track, and manage financial risk and vulnerability. State governments have historically used fiscal indicators from audited financial statements to determine if a local government is potentially in or will soon be in fiscal distress. Using financial data from financial audits, which has become the standard approach to fiscal early warning or fiscal risk identification, has some specific advantages and as well as disadvantages relative to other approaches.