Finance Advisor May 2010

MRSC In Focus › Finance Advisor May 2010

MRSC has joined with Tracey Dunlap, Director of Finance & Administration at the City of Kirkland, Mike Bailey, Finance Director, City of Redmond, and Glenn Olson, Deputy County Administrator, Clark County, to bring you the "Finance Advisor" column. The "Finance Advisor" will feature a new article each month with timely local government finance information and advice you can use.*

Assessing Options for Surviving the “New Normal”

May 2010

By Glenn Olson, Deputy County Administrator, Clark County

The Washington County Administrators Association had its annual meeting in April 2010, and I think the discussion there applies to cities as much as it does counties. We had a single topic of discussion for two days, which was:

Cities and counties cannot afford to sustain the work they do.

We all face a structural revenue deficit which began more than a decade ago with the implementation of Referendum 47 and its follow up Initiative 747. For many of us this impact was initially masked by extraordinary new construction through 2007 or 2008. Now, however, we have a “new normal.” The following is an assessment of the options we have to survive in this new fiscal environment, I have found myself referring back to this frequently as we strive to craft new solutions. I hope you find it as useful.

Solution Options

The only solution to the sustainability problem is to permanently close the gap between revenues and expenses. One solution that probably is not an option is for property tax growth to return to its former six percent per year increases. Even if the public was willing to support that change, it too would be unsustainable. At that rate property taxes would double every 12 years, exceeding the growth in personal income by a wide margin.

There is a finite list of options for any enterprise to align costs and revenues:

Cuts
Revenue increases
Economies of scale
Flexibility, regulatory relief
Efficiency, effectiveness

Cuts: Because city and county revenues increase more slowly than costs, cuts often create time-limited solutions. Deeper cuts can forestall deficits for longer, but ultimately basic costs, such as labor, health care, and capital construction, will overwhelm revenues. Certain exceptions apply here: “privatizing” labor, shedding particularly costly endeavors or dramatically reducing the proportion of expenditures going to salaries and benefits can more sustainably slow cost increases. But these efforts are confounded by a heavily unionized workforce and the very real public demand for services.

When doing the same or more with less fails, we all know we can finally do less with less to become sustainable. But even then, as with other cuts, doing less is not sustainable unless governments do successively less every year.

Revenues: Cities and counties can increase revenue, but as with cuts this may not create sustainable solutions. Core revenues like property taxes cannot, ultimately, grow faster than the law allows and cannot keep pace with the factors driving costs. Two of the main factors that drive city and county costs are population and inflation. Core revenues like sales or B&O taxes are more likely to keep up with these factors than property taxes, but even they may not maintain pace with costs:

These can fall disproportionately with economic downturns.
They are proportional to the cost of consumer goods and services which are produced ever more efficiently by the private sector, and so tend to increase in price more slowly than inflation (see Efficiency, below).
Even though more consumers are purchasing goods (in growing areas), their wages are falling when measured in real dollars. So real purchase amounts per consumer will decline over time.
For sales tax only a portion of the “breadbasket” used to measure inflation is taxed. Yet cities and counties must fund full inflation. Prices for the portion that is taxed tend to grow more slowly (for example, there is no sales tax on gasoline, other energy, and medical services, but electronics and clothes are taxed).
Governments purchase goods and services that are not included in the inflation “bread basket.” These costs inflate more rapidly, for things like new roads, services for the infirm, the indigent, and the elderly, and mandated goods and services that are not responsive to market pressure (jails, prevailing wage, health care, etc.)

Only in special circumstances can cities and counties collect tax revenues that grow in proportion to their costs, and even these create challenges. For example, the Real Estate Excise Tax (REET) grew with the market through 2007, but statute drove those funds mainly to support debt service, which could not be shed in the ensuing bust. Other, new taxes, such as utility taxes may fare better, but they cannot make up for the slow-growing property and sales tax revenue base.

Perhaps the only sustainable revenue increases are those that are tied to costs: fees for service and other cost recovery methods. These have been used extensively already, but may have further potential. They do, however, require a whole new level of tracking and a complete administrative infrastructure that cities and counties do not have fully in place.

Economies of Scale: Local governments can combine, or consolidate functions like IT, purchasing, parks, roads maintenance, and law and justice services. Savings come from lower overhead and administration costs, greater purchasing power, and un-duplicating infrastructure costs. But, as with cuts and revenue increases, savings here happen once. Then costs continue at the underlying rate of inflation and population growth.

It is true, however, that as the list of one-time savings grows, the duration between shortfalls increases, and citizens' overall costs do decline. But consolidations involve giving up control. This is more than just an economic choice for a city or a county. Perhaps because of this, consolidations are relatively rare, and their cost savings are not well documented. Nonetheless citizens, leaders and the press routinely champion the concept. Consolidations could be coupled with a statutory change to allow partnering agencies to pick the most permissive regulations that apply among them for a given activity.

Flexibility: This is most often mentioned in the context of state-provided dedicated and non-supplanting revenues. Cities and counties can often accomplish all of the policy goals the legislature has for money it appropriates to local governments, without the rules and limitations attached to that money. By the same token, what the legislature wishes to accomplish with various RCW changes (policies) need not be codified with extensive, complex, and often convoluted instructions about how (administration) to accomplish those policies. There are many requirements imposed by statutes, WACs and regulations that cause cities and counties to do more with no value added. Eliminating these requirements is a smart way to do less and increase efficiency. It costs the state nothing but may save cities and counties a good deal. This will be a WSAC priority for 2011, and hopefully one for AWC as well.

Efficiency: Efficiency (or effectiveness) is more output per unit of input; e.g., more work for less cost. In the private sector efficiencies produce the same or better products at lower costs, and so increase profits. A private sector manger is rewarded directly or indirectly every time he or she increases efficiency; a government manager is punished. The private sector manager boosts the company's bottom line with increased efficiency. Even painful efficiencies that cost jobs benefit the company and by extension, the people (left) working there. The government manager on the other hand, gets a baseline reduction that is unlikely to be restored, a number of irritated stakeholders, and a disadvantage compared to others who do not work to increase efficiency.

Notwithstanding the challenges of implementing a culture of efficiency in government, the policies enacted by the people of Washington State have been clear in demanding it through the initiative and referendum process, as discussed above. No matter how much cities and counties cut, when they are done cutting their costs will again begin to grow faster than their revenues. The only way to continue to provide the same levels of service without revenue increases is, by definition, through continuous, increased efficiency.

Analysis of Efficiency for Sustainability

Sustainability may only be realized through efficiency. Governments in general do not have a bias for efficiency, and in many instances, they may have just the opposite. The reason for this is not government employees. In fact, studies consistently bear out that government employees are among the best educated and potentially most productive workers in the American workforce. The reason is the incentive structure for private enterprises is almost the opposite of the incentive structure for government enterprises. Consider the following comparison of private and government enterprises in Table 1:

Table 1: Comparison of Private and Government Cost Centers

Private Enterprises	Government Enterprises
Generate revenue.	Generally do not generate revenue.
Survive to the extent they generate more revenue than costs, and	Survive to the extent that they generate more costs, and
Generally are not subsidized by revenues from other cost centers.	Are routinely subsidized by revenues that otherwise would be for other cost centers.
Like government, challenged by revenues that tend to grow more slowly than costs.	Like business, challenged by revenues that tend to grow more slowly than costs.
Solution to this problem is a bias for continual efficiency, because	Solution to this problem is rarely a bias for continual efficiency, because
Efficiencies increase profits.	Efficiencies reduce budgets.
Profitability ensures survival; losses ensure failure.	Budget increases ensure survival; budget reductions indicate failure.
Services generate money.	Money generates services.
Managers' self interest is served by finding efficiencies.	Managers' self interest is served by finding new and more costs.
Incentives generally align to stay lean and be more efficient.	Incentives generally align to grow and be less efficient.

As described above (see Efficiency), the typical private enterprise manager is rewarded for efficiency, while his government counterpart is punished. It would be easy to blame the budget process for this problem. In fact, the real blame is a deeply embedded structure called an incentive trap.

Incentive Trap: This is often called the 'Tragedy of the Commons,' a dilemma originally described by Garrett Hardin in 1968 as, “...a situation in which multiple individuals, acting independently, and solely and rationally consulting their own self-interest, will ultimately deplete a shared limited resource even when it is clear that it is not in anyone's long-term interest for this to happen.”¹

An incentive trap is a situation in which people's self interest is best served by overusing a finite resource. For example: imagine five people were given access to the same credit card and told they could buy anything they wanted until the credit limit was reached. The “winner” in this situation is the one who spends the most the fastest. This is the situation of every manager receiving current expense funding. These managers can only “win” by getting more of this resource. By definition their “more” can only be at some other manager's expense. The difference between these managers and their counterparts in the private sector is only that they have no ability to increase revenues; they can only affect the cost side of the equation.² Conversely, if there were a way for governmental managers to compete to increase their revenues, their incentives would begin to align just as do the incentives in private enterprise.

Incentive: How can we give managers a real incentive to compete to increase their revenues? Since government revenue is a compulsory, pro rata charge to citizens, there is no system-wide way to compete to get “customers” to “buy more of it.” That is why we are where we are today.

Summary

Revenue and reduction options both fall short of the sustainability test. The only sustainable solution is creating a bias for efficiency in government. This is a culture change, which in turn depends upon our ability to change the incentives that drive our culture.

1Wikipedia

2Fees for service and other revenues such as grants notwithstanding - managers are expert at extracting these revenues. Their success at getting these revenues demonstrates this is not enough to solve the sustainability problem.

Mike Bailey is currently the Finance Director for the city of Redmond. Previously he worked as Administrator of Finance and Information Services for the city of Renton and as the Director of Finance for the city of Lynnwood. Mr. Bailey also served as president of the Washington Finance Officers Association and is the Vice Chair of the GFOA Budget Committee. An experienced CPA and GFOA budget reviewer, Mr. Bailey co-founded the annual Budget and Fiscal Management Workshops held each summer. Mr. Bailey conducts numerous workshops and has authored various articles on local government finance, including Effective Budgeting in Washington State Cities published by the Association of Washington Cities.

Tracey Dunlap, P.E. is the Director of Finance & Administration at the City of Kirkland. Prior to joining Kirkland in 2006, she was a principal and shareholder in FCS Group, a regional financial and management consulting firm (14 years). An industrial engineer registered in the state of Washington, she has worked with jurisdictions throughout the Northwest to develop and implement cost recovery and fee strategies, set utility rates, and improve organizational efficiency and effectiveness. Tracey's experience also includes working for a large defense contractor (5 years) and a major financial institution (3 years). She has presented on a wide array of topics for organizations including WFOA, APWA, APA, WABO, and AWC.

Glenn Olson is the Deputy County Administrator for Clark County. He has been in Clark County since 1997, serving in various leadership positions during his tenure there. Previously Mr. Olson served 15 years in the Governors Office of Financial Management overseeing budget forecasts. Mr. Olson chaired the Washington State Public Works Board for Governor Locke. Currently he is the gubernatorial appointee representing local governments on the Select Committee for Pension Policy and on the Law Enforcement Officers and Fire Fighters Plan 2 (LEOFF2) Board, and he is the president of the Washington County Administrators Association.

*The Articles appearing in the "Finance Advisor" column represent the opinions of the authors and do not necessarily reflect those of the Municipal Research & Services Center.