Europe's Stricken Cities

Across the Continent, deficits are spiraling

If your car runs over a pothole in the western German city of Leverkusen, blame Lipobay. Safety concerns about the onetime blockbuster drug, marketed as Baycol in the U.S., punctured profits at drugmaker Bayer, the biggest taxpayer in this city of 160,000. The result: a 33% drop in Leverkusen's business-tax receipts. The city's financial crisis has had such a catastrophic effect on services that Mayor Paul Hebbel recently dressed in rags and stood in front of the Reichstag in Berlin, begging for money. Other German mayors whose cities are struggling on shrunken tax revenues joined him. They collected only a few euros, but made their point. Says Hebbel: "The cities are really in bad shape."

Germany isn't alone. Milan could face a downgrade of its municipal bonds, while Lille, France's fourth-largest city, has asked for emergency aid. Even wealthy Stockholm county may have to raise taxes because of runaway spending on health care. Across Europe, there's a wave of decentralization as national governments offload more responsibility for public services onto local governments. Meanwhile, rising unemployment strains local social services while hurting tax receipts. So far, bright-lights cities such as Rome and Paris aren't seriously affected. But the pain is spreading. "If the downturn continues, and if you continue to see new responsibilities transferred to local governments, their situation could deteriorate," warns Carol Sirou, a public-finance specialist at Standard & Poor's ratings services in Paris.

German cities are the worst off in Europe because so much of their tax income is tied to business profits, which can fluctuate dramatically from year to year. In France and Italy, by comparison, city budgets depend primarily on real estate taxes, where receipts are more stable. The total budget deficits of German cities have more than doubled since 2001, to more than $10 billion. Relief for cities was central to Gerhard Schröder's speech to Parliament on Mar. 14, in which he outlined his plan to reform the ailing German economy. The municipal budget crunch is one reason that Germany has exceeded European Union deficit limits.

Will the great cities of Europe start looking like New York in the 1970s? Not yet. So far, Europe's urban financial woes are visible mostly in small ways, such as peeling paint in school hallways or overflowing trash bins in public parks. But cities such as Berlin, the hardest-hit of Germany's big cities, have already cut subsidies for the arts and reduced the police budget. If the trend continues, it could start to affect the quality of urban life, the one area where Europe clearly beats the rest of the world. Seven of the world's 10 most livable cities are in Europe, according to a recent survey by New York City-based Mercer Human Resources Consulting.

One German city that didn't make Mercer's list is Offenbach, a dingy, working-class community of 116,000 residents adjacent to Frankfurt. Offenbach has the dubious distinction of being the city hardest hit by the collapse in business- tax receipts. The decline was more than 100% because Offenbach had to refund money to some businesses that had overpaid in previous years. "We collected more dog tax than business tax," laments a city official. Offenbach closed its only public pool years ago and has since slashed items such as school maintenance. Even in relatively wealthy Frankfurt, Mercer's fifth most livable city, teachers routinely have to paint their own classrooms.

One obvious solution is to reduce German cities' dependence on business taxes. Schröder addressed the issue in his recent speech, endorsing a proposal to expand the business tax to operations such as law firms that are exempt. But he drew derision from German mayors when he offered to provide low-cost loans. Many cities are already so heavily indebted that state authorities, who issue debt on behalf of municipalities, won't let them borrow any more. Total debt by local governments in Germany is $107 billion, or about 8% of the total government debt. "The communities in the worst shape have the least chance to take part," complains Burkhard Exner, treasurer of the city of Potsdam, the former summer retreat of the kaisers. Today, officials don't have enough money to finish renovating Potsdam's historic city hall.

In their desperation to raise money, some cities have resorted to controversial methods such as so-called cross-border leasing. U.S.-based trusts agree to long-term leases for city property such as sewer systems or even streetcars, paying most of the "rental" up front. The trusts then lease the same property back to the cities and split the U.S. tax deduction, providing the city with cash up front. The mechanism exploits a loophole in U.S. tax law and means that U.S. taxpayers are effectively helping to bail out German cities. The circular tax dodge is an obvious target for U.S. authorities, especially in light of strained U.S.-German relations. Critics also charge that the deals contain hidden dangers for German municipalities. In years hence, they may find themselves obligated to pay for facilities they no longer need. "The contracts that we have done have an appropriate balance between opportunity and risk," insists Rainer Kampmann, treasurer of Gelsenkirchen. The city of 280,000 raised $22 million last year by leasing property that included school buildings and the sewer system.

Ironically, German cities typically have good credit ratings because state and federal governments are obligated to bail each other out. Berlin, which also has the status of a state and can issue its own bonds, is rated Aa3 by Moody's Investors Service, even though debt is $12,500 per capita, more than four times the level in Bavaria.

If there is a silver lining to the crisis, it is that hard times are forcing financial discipline on local governments. "The potential for greater efficiency isn't yet exhausted," says Birgit Stach, a project manager at the Bertelsmann Foundation, which has sponsored research on the plight of German cities.

The same austerity effect is spreading across Europe. Naples, the hardest-hit of Italy's big cities, was forced to slash spending after the national government took control of local government. More efficiency is good, of course, but often the most-pinched cities are already suffering. In Lille, France, local government is seeking emergency aid to redevelop abandoned industrial sites, hoping to attract new business. "The local government would like to do more, but it lacks the means," says Bernard Hasbrouck, director of economic development for the Lille metropolitan area. If Europe's slack economy begins to tarnish its beautiful cities, the whole world will mourn.

By Jack Ewing in Frankfurt, with Carol Matlack and Christina Passariello in Paris

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