California Cities Have a Revenue and a Spending Problem

Josh Barro is the lead writer for the Ticker, Bloomberg View's blog on economics, finance and politics. His primary areas of interest include tax and fiscal policy, state and local government, and planning and land use.
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Yesterday morning, I saw a presentation from Tom Tait, the mayor of Anaheim, California, on fostering economic development in a time of fiscal stress. He presented two charts that reinforce the fact that California's cities have both a revenue problem and a spending problem.

The first chart shows Anaheim's total compensation costs per employee, which rose about 70 percent from 2001 to 2012 (more than 30 percent after adjusting for inflation). Real wages per employee were flat over this period; the entire inflation-adjusted increase is attributable to benefits, which grew by 130 percent per-employee. This is Anaheim's spending problem: It's spending too much on employee benefits.

Health care inflation is a problem, and now Anaheim spends about $20,000 per employee on health benefits for today and in retirement. But that cost driver is secondary to pensions. As the California Public Employees' Retirement System's investment portfolio got battered over the last decade, Anaheim's required annual contributions to the system rose from 7 percent of payroll to 30 percent.

A government faced with this problem ought to have a variety of options. It could raise taxes. It could cut employees' pay or benefits, like many private firms that have closed pension plans and scaled back health insurance. It could beg the state for money. It could cut non-compensation expenses, though it is important to remember that a majority of the typical local government budget goes to compensation. Or it could reduce headcount.

Source: Anaheim Mayor's Office

But in California, reductions in headcount tend to be the only viable option. State law significantly restricts municipal governments' ability to raise sales or property tax rates, and they cannot levy income taxes at all. The state's long-running fiscal crisis meant it was not in a position to much aid troubled cities. And since Anaheim participates in the statewide pension system, it cannot control its own pension costs.

Without other good options, Anaheim shrank its government workforce. A lot. The city cut about 15 percent of general fund positions, or more than 200 jobs. (The general fund excludes entities like the city's water and power departments and its convention center authority, which might be non-public functions in other jurisdictions.)

Some governments have a lot of fat to cut and could stand a 15 percent headcount reduction. But California municipalities tended to start off with lean headcounts before the recession. Anaheim, like San Jose, is now down to 1 sworn police officer per 1,000 residents, half the national average for cities over 250,000 residents.

Source: Anaheim Mayor's Office

And this is why I say California cities have a revenue problem. Anaheim's general fund revenues are still well below their 2008 peak, even before adjusting for inflation and population growth. Raising taxes in a recession presents economic problems, just like spending cuts and staff reductions do. But the complete lack of flexibility on the revenue side stripped Anaheim and other cities of the option to weigh those costs against each other. Instead, the city was forced to focus on spending-side adjustments.

It's well known that Stockton could have avoided bankruptcy if it had not made such irresponsible choices about employee compensation. Less discussed is the fact that Stockton could also have avoided bankruptcy if it had a free hand to raise taxes. The city's $40 million structural deficit in fiscal year 2012 could have been closed with an additional $400 in property tax per home; the barriers to collecting that revenue are legal and political, not economic. California's atypical level of municipal fiscal distress comes from the fact that these revenue and spending problems exist simultaneously. It's too hard to raise taxes and too hard to cut spending in the right ways.

Coastal California has stronger economic fundamentals than inland California, so bankruptcy was never on the table in Anaheim or its peer cities. But, as with Stockton, greater flexibility on both the revenue and expenditure sides would have allowed Anaheim to manage the recession better.

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