Why Cities Can’t Go Bankrupt in Canada or Germany

There’s a lot America can learn from these two countries about how to avert municipal bankruptcies.
by | May 2014
The building where Germany's 16 states meet in Berlin.
The building where Germany's 16 states meet in Berlin. FlickrCC/pilot_micha
 

This story is part of Governing's annual International issue.

Detroit’s insolvency was a fiscal shot heard round the world. In Germany, the authors of an article on municipal debt for the German Institute for Economic Research gave Michigan a nod when they titled a draft report, Race to the Debt Trap? Nevertheless, we could learn from Germany, as well as from our neighbor Canada, how to avert the fiscal catastrophes of municipal bankruptcies.

A key lesson is in the roles of shared revenues, shared tax bases and implicit state responsibility for municipal debt. In Canada, one of the most decentralized countries in the world, provinces are responsible for most major social expenditures. They also receive large, unconditional transfers from the federal government -- so much so, in fact, that in some provinces such transfers are more important sources of revenue than their own taxes.

Canadian municipalities are essentially agents of provincial governments: Hierarchical budget and debt constraints restrict their revenues, direct their expenditures and control access to capital markets. But if a local government gets into financial trouble, the province generally comes to the rescue in a variety of ways, including adjusting municipal boundaries, taking over functions and in the extreme, taking control of its finances.

In Germany, which has 16 states, some 450 counties and 12,500 towns and cities, municipalities have responsibilities for public order, infrastructure, cultural institutions and public transport. To finance these essential services, German municipalities draw not only upon three local taxes (two property and a local business tax), but also allocated tax revenue from income taxes, federal value-added taxes and state-allocated grants. The shared tax base eliminates overdependence on a property tax and serves to balance disparities in both resources and needs at the local level.

Municipalities can’t go broke in either Germany or Canada. German states implicitly guarantee public debt incurred by municipalities. This means municipalities in great fiscal distress do not experience the kinds of interest rate spreads or disparities experienced in this country. German state regulators can take over a municipality in the event of looming insolvency and may mandate a “Haushaltssicherungskonzept” or a budget consolidation plan. This is not dissimilar from a Chapter 9 plan of adjustment that demonstrates how the municipality can return to a balanced budget within 10 years.

In Canada, local borrowing requires prior provincial approval and is severely limited. These constraints are a product of the implicit provincial responsibility for bailing out any municipal default and a legacy of the Great Depression, which in Canada led to a wave of local defaults amounting to about 10 percent of total municipal debt.

Unlike the U.S., Canada has continued to expand the size (relative to GDP) of provincial transfers to municipalities. Today, such transfers as a proportion of total local revenues remain close to half.

In the U.S., tax competition rules. Neither the federal government nor states share tax bases with localities. In Canada, although provinces have freedom to choose their own tax bases and rates, in practice most provincial income taxes are collected by the federal government under tax collection agreements -- with the condition that the same base is taxed as for the federal income tax. Moreover, the Canadian federal government collects corporation income taxes and personal income taxes for several provinces under such arrangements. Thus, instead of tax competition, the Canadian federal and provincial governments essentially tax the same bases. The federal government collects more from its taxes than its direct spending, so that, for many years, it has transferred much of the surplus through two large unconditional transfer programs to the provinces -- even as direct income maintenance programs for the elderly, children and the unemployed are largely federal.

Unlike the more difficult relationships between the three layers of government in this country, Germany and Canada appear to be models of shared dependency and fiscal responsibility. It’s hard to see how a Detroit could happen there.

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