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Service Solvency: An Analysis of the Ability of Michigan Cities to Provide Adequate Public Service

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May 1, 2017 - Author: Robert Kleine, Interim Director and Mary Schulz, Center for Local Government Finance and Policy

Michigan has more cities under state supervision than any other state, as many of our cities are suffering from fiscal stress. There are three major reasons for this. First, the Great Recession of 2008-09 crushed property values in Michigan. From 2008 to 2012, the taxable property value (hereafter referred to as taxable value, or TV) of cities fell 18.1 percent. Since 2012, the TV of cities has increased only 0.3 percent despite the economic recovery. The main reason for this slow recovery is the constitutional cap on TV, which limits the increase to 5 percent or the rate of inflation, whichever is less. Second, the state government cut revenue-sharing payments to cities by 14.6 percent from 2008 to 2015. Twenty-three cities experienced cuts of 20 percent or more. Third, Michigan places more revenue-raising restrictions on cities than almost any other state. (See Sapotichne et al., Beyond State Takeovers, MSU Extension White Paper, East Lansing, Michigan, 2015.)

The general fund (operating) expenditures of Michigan cities were reduced 4.3 percent from 2008 to 2015. This allowed most cities to balance their budgets, but a number of cities cut expenditures to the point of service insolvency, that is, services are so low as to place the viability of the city in jeopardy. The concern is that when the next recession hits, the cities on this list could be in danger of bankruptcy, and a number of other cities could be added to the list.

Using audit reports and F-65 reports from the Michigan Department of Treasury, this report identifies Michigan cities that may be service insolvent or on the verge of service insolvency based on 2015 data. The analysis is divided into five population groups and the City of Detroit. If a city’s general fund spending is 75 percent or less than the average city in its population group, has a fund balance equal to less than 2 months’ expenditures (based on a Government Financial Officers Association [GFOA] recommendation), has per capita TV of less than $20,000 and levies 20 mills or more, the city may be service insolvent. These criteria were selected by the authors based on their years of experience in the state-local finance field. There is also quantifiable support for these criteria. The spending criterion of 75 percent of the group average was used because it covers 90 cities, about one-third of all cities. Twenty mills was used as a criterion as it is the charter limit for cities. The
$20,000 per TV criterion was selected because about 1/3 of all cities fall below that level, and it is also 1/3 below the state average of $30,160 (excludes Detroit). There are 93 cities with TV per capita below $20,000 (32.5 percent of all cities). Sixty of these cities (64.5%) have higher millage rates than the group average.
Sixty-nine of these cities (74.2 percent) spend less than the group average. The average unassigned and unrestricted fund balance for all cities as a share of GF expenditures (2015) was 22.6 percent. As noted above, the GFOA recommends that cities have two months of expenditures in reserve (16.7 percent). There are 62 Michigan cities, 22.3 percent of all cities, which do not meet this standard.

One conclusion drawn from our analysis is that cities with TV per capita much below $20,000 will, in most cases, struggle financially and provide a less than desirable level of services. The ranking of cities by TV is shown in Appendix C on pages 40–43.

Cities in southeastern Michigan are generally under more fiscal stress than cities in other parts of the state, mainly because the auto industry is concentrated in this region, and this is where most of the larger, older cities are located. From 2008 to 2012, TV declined by more than 20 percent in 68 cities; all but two of these cities are located in southeastern Michigan.

Although property values can fall sharply, they can only increase slowly due to the constitutional cap on TV: 5 percent or the rate of inflation, whichever is less. If TV increased at an annual rate of 1.5 percent, it would take a city that suffered a 20 percent decline 15 years to recover the lost property values, not adjusted for inflation. In real terms, these cities will never recover their losses.

For many cities, the reality is worse. For example, from 2008 to 2012, Ferndale’s TV declined 20.1 percent and declined another 1.1 percent from 2012 to 2015. If TV in Ferndale increases at a 1.5 percent annual rate going forward, which appears unlikely, it will be 2031 before its TV returns to the 2008 level. If inflation increases, TV will increase faster but so will service delivery costs. Adjusted for inflation, Ferndale will never recover its lost property tax revenue.

As shown in Exhibit 9 on page 20, 32 cities are identified as service insolvent or on the verge of service insolvency. On average, these cities expend 87 percent of the group average (cities that spend more than 75 percent of the group average but meet the other three criteria are in most cases classified as on the verge of service insolvency), reduced their expenditures 10.7 percent from 2008 to 2015, have a
TV of $13,700, levy a millage rate of 30.78 (adjusted for nine cities that levy an income tax) and have a fund balance of 14.5 percent of expenditures.

There is a high correlation between TV per capita and expenditures per capita. A number of regressions were run with per capita expenditures as the dependent variable and TV, millage rate, a dummy for the 22 cities that levy an income tax and population as the independent variables. Population was not significant and was dropped. Of the three remaining variables, TV per capita was a significant determinate with a t-value of 37.4. Both the millage rate (t-value of 9.4) and the income tax (t-value 0f 4.1) are significant. The equation explained 83.6 percent (R-square) of the variation in per capita expenditures.

Without changes to state policy, many of our cities will continue to struggle financially and could face bankruptcy in the next economic downturn. Judge Steven W. Rhodes granted the City of Detroit the ability to file for Chapter 9 bankruptcy in large part due to the court’s determination that the city was service-delivery insolvent. Service-delivery insolvency might streamline the eligibility process for a municipality to qualify for Chapter 9 bankruptcy.

Several policy changes could provide long-term fiscal stability for our cities, including increased revenue, a change to the revenue-sharing formula to guarantee cities a minimum TV per capita, elimination of the
Headlee millage rollback provision and state bonding to retire the unfunded pension liability of local governments.

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Tags: center for local government finance and policy, msu extension, municipal finance, service solvency

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