Budgets Flying Blind

With economic uncertainties undermining forecasts of future revenue, local budget makers are reluctant to be optimistic.
February 2002
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

For the first time in a decade, local governments are fashioning next year's budget during a full-fledged recession. Even grizzled veterans who remember the two downturns of the past 20 years face new challenges.

In recent years, forecasting season has been a time to break out the bubbly. Projecting revenues consisted of laying a straight edge to graph paper, plotting the upward march of dots, knocking off a percentage point or so to play it safe and then happily waiting for results to surpass expectations. Not this year. This year, the forecasters, both amateur and professional, are prognosticating with the economy in a nosedive, and they are pretty much flying blind.

Not that they have ignored the signposts. This time last year, forecasters saw the economy slowing, but most thought recession could be avoided. By mid-2001, economic indicators had gone decidedly negative and plunged in the 9-11 aftermath. Now, the uncertainties are whether the economy's dive will belly out by mid-2002 and how strong the recovery will be. Local budget makers, in particular, are reluctant to be very optimistic.

Many local governments are caught in a fiscal pincers: If they are fiscally self-reliant and have a diversified revenue system, then their own revenue sources are exposed to economic cycles. But if they rely more heavily on state payments, then they are exposed to the vagaries of state tax collections. The state governments, which have both more elastic revenue systems and expenditures that are sensitive to economic fluctuations, are being rocked by declining revenues. All states are in a cost-cutting mode and eyeing cutbacks in aid to local government. Meanwhile, although some local taxes and charges are declining in reaction to the softened economy, these impacts are likely to be softer and come later than those at the state level, a fact not lost on savvy state legislators.

The tourism and travel decline are emblematic of the complexities. For state and local economies that rely on travel and convention business, this is tough for two reasons. The immediate fiscal impact can be limited. Often, the travel-associated taxes are earmarked for promotional activities or for paying off bonds sold for convention facilities. Thus, general revenues are not much affected. But more importantly and indirectly, the local economies are damaged as employees are let go and properties close. The problems become cumulative over time: As governments tighten up spending, local businesses are hurt and more people need assistance. It's that delayed dropping of the second shoe that really hurts.

Subtler problems exist, as well. In the early 1990s, local budgets got a boost by refinancing long-term, tax-exempt debt. This worked because long-term interest rates were down and short-term rates remained relatively high. Governments sold debt at low, tax-exempt rates in the long end and reinvested the proceeds at relatively high, taxable yields in the short end. This resulted in considerable savings, much of which could be enjoyed up-front by many state and local budgets in the early 1990s. But this time, short-term interest rates have fallen and are very low, while long rates appear stuck at relatively high levels.

The low short-term interest rates also affect another revenue that has become increasingly important to local governments. That is the earnings on investments. Ten years of prosperity left governments in good shape with plentiful reserves and astute cash-management practice that has yielded good incomes. Maximizing investable funds and keeping them invested have meant lots of extra dollars for the typical budget. But, low short-term interest rates mean that surplus funds are earning only half of what they did a year ago. That also means that spending reserves is less costly in terms of forgone revenues.

There is a silver lining of sorts for many local governments, but it can exact a political price: Housing prices in many places are way, way up--fueled by low interest rates and continuing demand. Higher prices means higher assessments and, if tax rates are held constant, higher tax bills. But that's the political crunch: There's nothing politically palatable about passing along higher tax bills to homeowners who may be facing lower incomes and are worried about their jobs. This same phenomenon happened in the early 1990s, when the lag in assessments caught the crest in home prices of prior years just as market values were plummeting. A tidal wave of reassessments devastated property-tax revenues and local finances in California the last time around.

The lessons of 2001 are that recessions are not dead and economies are both complex and volatile. Figuring out how your region and jurisdiction's finances fit into the mosaic of national and international fluctuations is back in style. Make room at the table for the forecasters, their stock is sure to go up.