When we think of Michigan cities under fiscal stress, usual suspects like Detroit, Flint, Pontiac, and Hamtramck (the city for which Michigan’s “financial emergency” status was created in 1988) come to mind. Detroit’s history-making bankruptcy and subsequent $200 million state bailout now serve as a real-world case study in municipal finance mismanagement. Despite this focus on the worst offenders, the list of Michigan cities experiencing financial difficulties is not limited to the struggling former industrial centers. Even growing, affluent communities like Ann Arbor and Bloomfield Hills (the wealthiest city in Michigan) cannot escape the forces driving local government debt..
City and county budgets across Michigan are under attack from the dual threats of shrinking revenue and rising expenses. Revenue generated from property taxes and state shared revenue has declined precipitously in recent years. The housing market collapse that triggered the Great Recession of 2007-2009 erased decades of gains in property values eroding the single most important revenue source for local governments in Michigan. Taxable values are slowly rebounding as housing prices creep higher, yet Michigan’s restrictive property tax laws prohibit any significant increase without voter approval. The recession was equally devastating for state budgets, and many, including Michigan, have responded by slashing revenue sharing programs that local governments have come to rely on.
On the expense side, local governments face rising legacy costs in the form of retiree pension and healthcare benefits. Local governments have traditionally provided generous retirement benefits to employees, often as part of compensation packages negotiated through collective bargaining and written into union contracts. However, the most generous benefits packages were negotiated decades ago when local governments were on sound fiscal footing and had fewer retirees to support. As the number of retirees increased and healthcare costs surged, local governments have been forced to devote an ever-larger portion of general fund revenue to financing these benefits.
In the following, I will examine these problematic trends in detail and evaluate the most recent budgetary outlook for local governments in Michigan.
Property Tax Revenues Plunge
As in most states, local governments in Michigan depend heavily on local property taxes to finance daily operations. In Michigan, however, more than 93% of local government tax revenue is derived from property taxes compared to the national average of only 74% (Tax Policy Center, 2013). This dependence on property taxes has persisted despite efforts to curtail the property tax burden beginning with the “tax revolt” of the 1970s.
In 1978, the same year California voters approved a law capping property tax at 1% of cash value, Michigan voters approved the “Headlee Amendment” which added several tax and expenditure restrictions to the state constitution. Three provisions in the amendment restrain the revenue raising capacity of local governments by limiting increases in property tax collections. First, voters must approve any new local government tax increase not in place at the time of the Amendment’s passage. Second, if the existing property tax base is broadened (perhaps an exemption written into state law is eliminated), then each jurisdiction must reduce its maximum authorized property tax rate so that the same amount of revenue is collected as before the base broadening.
Third and most consequential, the “Headlee Rollback” provision requires that, if the assessed value of all property in a jurisdiction increases faster than the annual rate of inflation, the jurisdiction must reduce the property tax rate “so that the increased tax levy on existing property is no greater than the rate of inflation” (Kennedy, 1998). In 1994, Michigan voters again limited the allowable increase to “the lesser of the rate of inflation or 5%” as part of a comprehensive school funding referendum known as Proposal A. Voters must approve a “Headlee Override” if the jurisdiction wishes to reverse the rollback and restore the original operating millage (Under the 1978 law, local governments could alternatively “roll up” millage rates when annual increases were less than the rate of inflation. Proposal A eliminated this provision.) (Scorsone and Skidmore, 2011).
The immediate effect of these property tax limitations was to restrain local government revenue during the housing boom of the 1990s and early 2000s when annual increases in property values easily exceeded the rate of inflation. More recently, they have stymied local government efforts to recover from the lean budget years following the Great Recession. As noted above, local tax collections plummeted along with property values during the housing crisis. Prices have recovered substantially throughout 2013 and 2014, yet inflation remains historically low thus precluding local governments from recouping lost revenue without a Headlee Override. Indeed, communities across Michigan are seeking overrides when residents go to the polls later this year.
While tax on real property will continue to rebound with the housing market, local governments in Michigan may permanently lose the ability to levy the personal property tax (PPT) on industrial machinery and small business equipment. The PPT is an important source of revenue for communities with large manufacturing bases, yet officials in those same communities have complained that it saps competitiveness and “penalizes businesses willing to expand and invest in new equipment” (Oosting, 2014). Indeed, business owners lament having to pay an annual tax on their equipment after paying the 6% sales tax at the time of purchase. Bob Fish, cofounder and CEO of Biggby Coffee, was astonished when he received his first PPT bill in 1995. “Can you imagine being taxed on your living room furniture or kitchen appliances every year? That’s what the PPT is like for local small businesses” (Fish, 2014).
With the governor’s encouragement, a bi-partisan group of lawmakers approved a PPT reform bill in late 2013 that would phase the tax out completely by 2023. To address the revenue loss to local governments, the bill replaces the PPT with a portion of Michigan’s 6% use tax on out-of-state purchases (currently earmarked for the general fund) along with an optional special assessment levied on manufacturers that are newly-exempt from the PPT. While these replacements are guaranteed to reimburse local governments for 100% of lost PPT revenue used to fund K-12 operating costs and essential services like police and fire, they are estimated to replace only 80% of PPT revenue used for non-essential services (Michigan Economic Development Corporation, 2014). This could pose a problem for communities like Auburn Hills and River Rouge, which rely on the PPT for 22% and 57% of tax revenues, respectively (Crumm, 2014).
Before it can go into effect, the PPT reform measure must be approved by voters in the August 2014 primary election due to the use tax redirection. Despite potential revenue shortfalls for local governments it is widely expected to pass with broad support from business coalitions and elected officials from both parties (Oosting, 2014).
Deep Cuts in Revenue Sharing
The second budgetary conundrum for local governments in Michigan is a steep decline in state-local revenue sharing. Enacted in 1933, Michigan’s unrestricted revenue sharing program is designed to supplement local budgets as the taxing authority of local governments is curtailed or eliminated (as discussed above). Michigan has a two-pronged revenue sharing program that consists of both constitutional and statutory components. The Michigan Constitution requires the state to distribute 15% of annual sales tax collections to local governments based on population. The remainder is allocated by a statutory formula adopted in 1998 which distributes funds based on a jurisdiction’s “service delivery needs, infrastructure maintenance requirements, and fiscal capacity to generate local tax revenue.” (Michigan Municipal League, 2014).
Because it is written in to the Michigan Constitution, lawmakers cannot alter constitutional revenue sharing without a vote of the people. However, the legislature and governor can decrease the statutory amounts at will and have done so repeatedly to plug holes in the state budget (Michigan’s financial troubles began around 2001—six years before the Great Recession—as the auto industry began its downward spiral). In fact, the statutory formula was never fully implemented over the planned 10-year phase-in period because of the state’s budgetary woes (MML, 2014).
According to a Michigan Municipal League analysis, local governments would have received an additional $6.2 billion between fiscal years 2001 and 2014 if the program had been fully implemented and funded. In FY2014 alone, communities would have received $1.8 billion under a fully funded program compared to the $1.1 billion that was actually appropriated. The City of Detroit, now in bankruptcy, missed out on over $730 million in revenue sharing funds during this period. In fact, the MML points out that several other cities currently under financial emergency could potentially be in the black if they had received the full revenue sharing amount under the 1998 law (MML, 2014).
Critics of the MML report (which would likely include former governor Jennifer Granholm and lawmakers in office at the time who struggled to balance the budget) argue that “the state would have been the one facing bankruptcy had revenue sharing money not been reduced” (Midland Daily News, 2014). In response the MML notes that sales tax revenues (which fund revenue sharing) actually increased from $6.6 billion to $7.7 billion from 2003 to 2013. Moreover, the state has improved its financial position tremendously in recent years, turning deficits into surpluses, while failing to increase the revenue sharing budget. In fact, Governor Snyder’s Economic Vitality Incentive Program (EVIP) implemented in 2011 forced local governments to conform to additional criteria just to receive their share of the reduced amount (thanks to intense local backlash EVIP has been eliminated for FY2015). For these reasons the MML charges state leaders with failing to make difficult choices to cut state spending and instead “using local money to pay their bills” thus “creating most, if not all, of the financial emergencies at the local level” (Minghine, 2014).
After more than a decade of revenue sharing cuts, there is finally relief on the horizon for local governments in the FY2015 budget. Constitutional revenue sharing will increase by approximately 3 percent and the statutory portion by 6 to 7 percent for cities, townships, and villages (Gray, 2014). For the first time in 14 years, Michigan counties will receive 100% full funding of revenue sharing totaling over $211 million (Michigan Association of Counties, 2014). Future increases to the revenue sharing budget will depend on the state’s fiscal position, continued lobbying efforts by local governments, and of course, lawmakers’ priorities.
Soaring Legacy Debt
As local governments grapple with revenue shortfalls over which they have little control, they must also confront an expenditure crisis that is a product of past spending decisions. Without exception, every Michigan locality currently in financial emergency is saddled with crushing legacy debt in the form of unfunded accrued liabilities (UAL) from retiree pension and healthcare obligations. In fact, many local governments in otherwise good financial standing are struggling with UAL. These benefits are a product of generous employment terms agreed to by local governments during good times. Though many were negotiated into union contracts, nonunion employees too were regularly offered defined benefit pension and healthcare plans that require little to no employee contribution and are very costly to employers.
Local governments have typically calculated and funded pension obligations over the course of an employee’s career and are thus in relatively good shape in this UAL category. It is the category known as Other Post-Employment Benefits (OPEB) where they have fallen behind. While local governments have been legally obligated to contribute to pension funds to a certain degree, the first laws governing OPEB contributions did not exist until 2007. Consequently, many localities did not even calculate outstanding OPEB liabilities until recently (Scorsone and Bateson, 2013). For this reason, they have been described as “a ticking time bomb ready to wreak financial havoc on localities at the first sign of a downturn in revenue” (Holeywell, 2012).
A 2013 analysis by Eric Scorsone of Michigan State University found that 311 local government units in Michigan (excluding counties) representing 67% of the population provided some level of OPEB totaling $13.5 billion in liabilities. These are funded at an astonishingly low 6% for a total of $12.7 billion in unfunded local OPEB liabilities statewide (in comparison, local government pension UAL is $3.1 billion statewide). Detroit’s UAL of $4.9 billion represents 39% of the total and was a decisive factor in the city’s bankruptcy. A whopping 86% of the total is generated by localities in 10 southeast Michigan counties (Scorsone and Bateson, 2013). Their finances under the microscope, local governments are beginning to fund OPEB liabilities at higher rates, require higher contributions from current employees, and eliminate expensive defined benefit plans altogether.
Though defined benefit retirement plans are quickly becoming artifacts of a bygone era (they are now virtually nonexistent in the private sector), local governments have a legal and moral obligation to honor promises made to employees, shortsighted as they may have been. Fulfilling those obligations has meant cutting deeply into other areas of the budget. Much of the burden has fallen on current employees who have seen their wages stagnate and benefits reduced sharply. Nonessential services like parks, roads, and social programs have suffered deep cuts in most communities. Even essential services like police and fire have been unable to avoid the budget scalpel as a direct result of UAL. Moreover, ratings services like Moody’s are now taking UAL into consideration when issuing municipal bond ratings, potentially leading to higher borrowing costs (Scorsone and Bateson, 2013).
Despite years of shrinking revenues and growing expenses, there is light at the end of the tunnel for Michigan’s local governments. Property values are rising, revenue sharing funds are increasing, and localities are taking steps to bring legacy costs under control. The improving economy will help, yet the specter of financial emergency—or worse, bankruptcy—looms large in the minds of local leaders who wish to avoid the fate of Michigan’s largest city.
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