Spending beyond Your Means during a Recession? Not So Much for Local Governments Constrained by Fiscal Rules

Lang (Kate) Yang
The Great Recession, which started nearly a decade ago, may feel like a distant memory for some, as the United States economy is expanding for a ninth consecutive year. However, local governments in the nation still experience turmoil in their finances. National League of Cities’ 2016 City Fiscal Conditions report shows that city revenue has recovered to about 96 percent of precession (2006) levels. While many cities have improved service provision efficiency or cut back services and workforce during the recession, another option to weather the shock is to run a deficit and spend beyond the means. While structural or persistent fiscal imbalances are undesirable for local officials and can even lead to credit rating downgrades, deficit financing during recessionary periods may be justified for maintaining the necessary level of public service provision when regular tax and other revenue collection does not suffice.

Local governments achieve deficit spending through either borrowing or dipping into their reserves, if they have built one going in to a recession. Neither option is free. Borrowing from banks or investors on the municipal bond market requires interest payments, while leaving that reserve alone usually means investment returns. To what extent local governments are willing to take on a deficit during the recession depends on factors including local governing structure, managerial preference and expertise, level of savings, access to the debt market, and the capacity of paying back debt or replenishing reserves after the recession ends.

It is the last factor and its relationship with tax and expenditure limits that I explore in the recent paper published in Local Government Studies. Tax and expenditure limits are fiscal rules imposed on local governments by state governments (through legislations) and statewide voters (through referendums) to limit how much revenue localities can raise in any given year. For example, the famous Proposition 13 in California limits annual real estate tax on a parcel of property to one percent of its assessed value and the assessed value can only increase by a maximum of two percent per year. For cities constrained by a tax and expenditure limit, their capacity of paying back debt or replenishing reserves is predictably limited. The paper explores whether these cities were less likely to deficit spend during and after the Great Recession than unconstrained cities.

Data collected from the largest 50 cities’ comprehensive annual financial report show that cities subject to a tax and expenditure limit indeed were less likely to spend beyond their means. Their expenditure levels grew at a slower pace. As a result, their net assets, which are assets net of any payback liabilities, decreased at a slower pace as well. The difference between cities subject to tax and expenditure limits and unconstrained cities was especially pronounced immediately after the crisis (years 2011 and 2012), possibly because cities first pursued other means of weathering the shock than cutbacks and because the hit on city finance is delayed compared to the hit on the general economy.

Many cities saw their streetlights shut off, community centers shuttered, and bus services cancelled during the recession. While some may rather prefer the cuts than spending, others may see the value of maintaining a stable level of service provision despite decreased revenue collection. Although the paper refrains from evaluating whether deficit spending in general is beneficial to city governments and residents, it is ultimately a decision up to the localities. The paper finds that fiscal rules imposed by a higher-level government have an impact on city financial decisions. This finding indicates that deficit financing following a recession is no longer a “pure” local decision. Financial management conservatism caused by tax and expenditure limits might have contributed to more painful cuts in some cities than others.

 

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Lang (Kate) Yang is an assistant professor at George Washington University. Her research interest includes state and local government taxation, budgeting, and financial management. Her recent publications in Public Budgeting & Finance and National Tax Journal examine how local governments respond to fiscal rules imposed by higher-level governments.

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