Chp 5 summary

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c h a p t e r

Be not the first by which the new is tried, nor the last to lay the old aside.

– Alexander Pope

Service charges and regulatory fees

While general and excise sales taxes have gained prominence in local government budgets, services charges and fees represent the largest source of local revenue. This shift to charges has occurred in part because of taxpayers’ resistance to higher tax burdens, particularly increased property taxes. Service charges and regulatory fees are well suited to the “finance-it-yourself ” environment that currently pervades all levels of government.1

As discussed in Chapter 1, goods and services produced by government can be divided into three categories: public, private, and merit (or mixed). Public goods and services, such as snow removal, benefit all citizens, cannot be sold in units, and can be financed only from general tax revenues. At the other extreme are private goods and services, such as water, sewerage, and electric power; unlike private goods produced by the private sector, which are sold in a competitive market, these services are produced and sold by the government because the opportunity for profit is insufficient to attract a private provider (as in the case of public transit) or because the large capital investment naturally limits provision to a monopolist (as in the case of water service). Governments rely on their proprietary powers, granted in state or local law, to charge consumers for these services. If revenue from the sale of a service is sufficient to cover its costs, the government tracks the revenue and expenses using a self-supporting enterprise fund.

Between public and private goods lie merit goods, which are private goods endowed with a public purpose. For example, a municipal airport provides individual benefits that can be denied to those unwilling to pay for them, yet it also benefits the whole com- munity by improving business opportunities and thereby helping to create jobs. Thus, a portion of the cost of merit goods should be borne by all taxpayers, with the remaining

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private portion of benefits financed through service charges to users. Public education, which is probably the best example of a merit good, lends itself to privatization through such measures as the provision of government vouchers to individual users.

Figure 5–1 shows the types of benefits-based levies that governments use. Also as dis- cussed in Chapter 1, local governments look to different sources of legal authority when adopting these levies. A few benefits-based levies—for example, gasoline and hotel/ motel occupancy taxes—derive their legal basis from the taxing powers of local govern- ments. State laws also grant local governments limited regulatory powers for preserving and promoting the health, safety, and welfare of the community by issuing licenses and permits. A license authorizes an individual or business to engage in an ongoing activity—for example, to operate a motorcycle on local streets. By contrast, a permit authorizes a business or individual to undertake a particular task—for example, to use particular streets at a particular time for an organized parade. Within limits prescribed by law, governments charge a fee for a license or permit as compensation for the cost of regulating the activity. The accompanying sidebar addresses the distinction between proprietary and regulatory powers for raising revenue.

Development charges, such as impact and building inspection fees, compensate local governments for the cost of regulating new construction and for the impact of the construction on public services. In other cases, a special assessment is used to recoup the value of private benefits accruing to property owners. Revenue from the levy usually cannot exceed the increase in property value that results from the improvement, such as widening a street. In some states, regulatory rather than taxing powers provide the legal basis for a special assessment, as in the case of a sidewalk installation.

The role of service charges and regulatory fees in local government Economically, charges and fees score high marks for both equity and efficiency. Un- doubtedly, their greatest virtue is to reduce the wasteful use of some government- produced services, thereby reducing the pressure to expand public facilities to meet artificially inflated user demand and constraining the growth of the government budget. When a service is financed with tax revenue, users have no incentive to limit their use, so they create an apparently greater demand, which governments feel obligated to

Type of benefits-based levy Legal authority Example

Benefits-based taxes Taxing powers Gasoline tax for street improvements

User charges Proprietary powers Water service charges

License and permit fees Regulatory powers Health permit

Development charges Regulatory powers Zoning fee

Special assessments Taxing powers Public improvement assessment

Figure 5–1 Benefits-based levies commonly used by local governments

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meet. When the same service is sold to users, citizens purchase only what they want, and consumption by those who use the service only because they think it is free diminishes. In the terms of economists, prices ration goods and services to those who value them the most, thereby maximizing economic neutrality. The sidebar on page 110 summarizes some of the advantages of service charges.

As an illustration, consider the per capita water consumption in two hypothetical cities— Alpha and Delta. Alpha meters water use and charges users for the full cost of the quantity consumed, but Delta finances all water services through its property tax. Predictably, per capita water consumption in Delta greatly exceeds that in Alpha because users who per- ceive the water as “free” have no incentive to control their level of use. The greater demand for water leads Delta to increase water production capacity well beyond that of Alpha.

Local government dependence on revenue from service charges

Although local governments had increased their dependence on service charges and regulatory fees before Proposition 13 was ratified in 1978, the tax revolt accelerated this trend. In the past decade, however, the combined effects of a deep recession (2007–09) and declining state and federal grants-in-aid have forced local governments to increase their use of local taxes.

A comparison of the role of user charges (current plus utility charges) versus prop- erty taxes indicates this shift. For municipalities, user charges represented 37.6 percent of general own source and utility revenues in 2007, a decline from almost 42 percent in

Raising revenue: Proprietary versus regulatory powers A gray line exists between a service charge levied under a government’s proprietary powers and a license or permit fee levied under its regulatory powers. Both involve an exchange (quid pro quo). In the case of proprietary activities, the exchange in- volves a good or service: a service charge for water, tuition for credit hours, etc. In the case of regulatory activities, the ex- change grants a privilege: a fishing license, driver’s license, or building permit.

But there are a couple of important differences. The proprietary exchange involves goods or services being pro- vided. Each month city residents receive a water bill for the amount of water they consumed in the preceding month. Each semester students receive a tuition bill for the forthcoming semester. By con- trast, the regulatory exchange involves no goods or services being received. It only involves the provision of a license or permit as a result of the regulatory activity (or conversely, a fine being assessed for violating the boundaries of the regulated activity).

Another difference is that the pro- prietary activity involves governments providing a private good or service. A regulatory activity involves granting a privilege that is created by law. Without a license or permit, a person cannot legally engage in the regulated activity.

In the case of regulatory activities, governments usually issue permits for privileges (fishing, hunting, owning a dog, building a house). Privileges are granted by statutes (laws passed by legislative bodies) and can be taken away (driver’s license revoked). Occasionally, however, governments also may regulate rights, such as speech, or assembly, or gun ownership. Rights are granted by con- stitutions (e.g., the Bill of Rights). In the case of the basic rights granted by the First Amendment to the U.S. Constitution (speech, religion, petition, assembly, and press), the U.S. Supreme Court has ruled that governments may regulate the time, place, and manner in which the right is used but cannot regulate the content of the constitutionally protected right.

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2002. Property taxes, on the other hand, increased to 27.8 percent in 2007 from 22.8 per- cent in 2002. For counties, user charges made up 30.4 percent of general own source and utility revenues in 2007, essentially the same as in 2002, whereas property taxes increased from 38.4 percent in 2002 to 40.1 percent in 2007.2

Generally, smaller municipalities rely more heavily on service charges than larger ones do, probably because the latter have more diversified revenue sources while the former have more limited tax bases.3 As is apparent from Table 5–1, cities rely much more heavily on utility charges than counties do. For many cities, especially those with large amounts of tax-exempt state or federal property (such as university towns), utilities provide an important mechanism for subsidizing their general funds. Utility operations are often required by local ordinance or charter to provide a return on investment to the city, as well as franchise fees comparable to what a private utility would incur for the exclusive privilege of providing utility services.

Bernd Huber and Marco Runkel use economic theory to explain the growing popularity of user charges, especially for such services as toll roads, higher education tuition, and public health care.4 They contend that in order for governments to compete effectively for investment capital, which has become increasingly mobile in the global economy, governments must keep their tax rates lower than they otherwise would in the absence of intergovernmental competition. Thus, to fill the gap made by forgone tax revenue, local governments increase service charges. Huber and Runkel conclude from their theoretical analysis that the more intense the competition among governments, the greater the reliance on user charges.

Services financed by charges and fees

When local governments review their services to identify candidates for charging fees, they must perform two tasks. First, they must decide which services can be sold to users (divis- ibility). This involves identifying activities that provide private benefits and whose benefits can be denied, with minimum cost, to those not paying for the service (excludability).

The second, more political task involves deciding which services should be financed by service charges. In making this decision, managers must consider four issues:

Advantages of service charges Charges reduce wasteful consumption of public services by heightening users’ awareness of the cost of providing the service.

Because service charges are based on the quantity consumed by each user, they give local governments a clear indi- cation of the level of service preferred by citizens, thereby reducing the tendency to expand government facilities to meet apparently increased demand.

Service charges are equitable: Those using the service pay in proportion to the benefits they receive from it. Those who do not use the service do not subsi- dize those who do.

Service charges improve local government productivity by increasing managers’ awareness of the cost of services. Charges to users also slow the growth of local budgets by ensuring that decision making is based not on interdepartmental budgetary politics but on the relationship of service levels to demand.

Service charges provide a market- based alternative to regulating through rules and administrative orders. In other words, they can be used to influence private behavior toward socially desir- able ends.

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1. Is it more equitable to charge users for the service or to levy a tax? If the service possesses the attributes of a private good, it is more equitable to charge users than taxpayers.

2. Do surrounding cities, towns, or counties levy a charge for the service? Regional precedent makes it much easier politically for a local government to assess a fee for the same service.

3. How do citizens feel about increases in local taxes? Managers should require proponents of a new or expanded service to include the use of service charges in their proposals.

4. What effect will the charge have on the use of the service? Normally, charging for a service reduces demand; that is, demand is price elastic because consumers can choose to reduce their consumption of the service. For services that have widespread benefits to the community, however, such reductions are undesirable. For example, charging full cost for residential use of a landfill may increase illegal dumping along roadways and in vacant lots. When it comes to increasing prices, change in demand varies for different services, depending on the availability of substitutes.

For utility services, price elasticity is low; there are no substitutes short of reducing consumption, and going without the service is usually not an option. But for many other governmental services, consumer demand is more sensitive to price changes. In general, the greater the change in price, the greater the effect on service use. For this reason, local governments should avoid large and irregular price increases. Small, annual adjust- ments in prices have much less adverse effect on demand and thus on revenue yields.

Local government policy makers are often astounded by the lengthy list of activities for which charges and fees are collected. The following sidebar lists some of the more common services for which local governments collect charges, and the sidebar on page 113 does the same for some of the more commonly regulated activities for which license and permit fees are assessed. For example, utility services, such as water and wastewater treatment, have long been financed by direct charges to users, including wholesale con- sumers such as other governments. Some governments even generate a profit on these services, which is used to subsidize services paid for from the general fund.

Table 5–1 Service and utility charges as percentages of local government general revenues, FY 2006–07

Revenue source Counties Municipalitiesa

Property taxes 40.1 27.8

All other taxes 18.1 24.0

Service charges 28.3 19.0

Utility charges 2.1 18.6

Other nontaxes 11.4 10.6

Total 100.0 100.0

Total general revenue (in millions)b $223,203 $394,622

Source: U.S. Census Bureau, State & Local Government Finance, Historical Data: 2007, Table 2, census .gov/govs/estimate/historical_data_2007.html.

a Combines cities and townships.

b Combines general revenue from own sources and utility revenue.

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Services for which local governments commonly charge a fee

Recreation and leisure activities Athletic fields (P) Athletic leagues (F)* Auditorium/civic center rental (F) Boat harbors (F) Concession rental (F) Equipment rental (F) Greens fees (F) Law library (F)* Parks (P) Public library services (P) Recreation center rental (F) Recreation classes (F)* Swimming pools (P) Tennis courts (P) Web-based data services (F)

Utility services Connection (F) Drainage (F) Lateral permits (F) Pro rata connection (F) Retail wastewater service (F) Retail water service (F) Septic tank dumping (F) Tap permits (F) Temporary use of meter or hydrant (F) Wholesale water and wastewater (F)

Public works Abandoned-vehicle removal (F) Barricades (F) Curb and street cuts (F) Maps (F) Right-of-way access (F) Weed cutting (P)

Police protection Accident and offense reports (F) DWI processing (F) False alarm call (F) Funeral escorts (F) Other special-occasion escorts (F) Police services at special events (F) Serving warrants (F) Vehicle impoundment (F)

Planning and economic development Annexation (F) Development guide or manual (F) Fairgrounds rental (P) Historic landmark designation (P) Maps (F) Plat processing (F) Zoning variance (F)

Sanitation and animal control Animal holding (F) Animal impoundment (P) Carcass retrieval (P) Euthanasia (F) Landfill (P) Large-item solid-waste pickup (F)* Litter abatement (P) Rabies vaccination (P) Solid-waste collection (F) Street cleaning (P)

Health Ambulance service (P) Hospitals and nursing homes (F)* Inoculations (P) Mental health services (F)*

Transportation Airport landing (F) Bridge tolls (F) Bus fares (P) Hangar rentals (F) Parking garages (F)* Parking meters (F)* Special-occasion bus rentals (P)

Miscellaneous Advertising on public space (F) Cemeteries (P) Commodity sales (F) Document search (F) Election filing (F) Farmers’ markets (P) Meeting room rentals (F) Photocopying records (F) Public housing (P) Vending machine space rental (F) Wi-Fi service (F)

Notes: (F): Price should be set at full cost of providing the service.

(F)*: Full-cost pricing should be required only for certain classes of users; a partial subsidy should be provided for some users, such as the elderly, children, and nonprofit organizations.

(P): Fee for service should be set so as to recover only part of the cost of the service. A partial subsidy is justified for any one or all of the reasons discussed in the chapter.

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The 1987 amendments to the federal Clean Water Act ushered in a new category of utility charges: storm-water drainage fees. To meet the federal mandate for water quality standards for runoff, many local governments, especially in flood-prone areas, adopted these fees, which are distinct from wastewater treatment fees. Fees may be a flat rate

Activities commonly regulated by local governments

Amusement and recreation Bicycles (registration) Billiard and pool halls (license) Boats (license) Camping (permit) Carnivals and circuses (permit) Coin-operated machines for entertainment (license) Dance halls (license) Fireworks (permit) Fishing and hunting (license) Massage parlors (permit) Movie theaters (license) Outdoor concerts (permit) Parades (permit)

Animal regulation Dog and cats (license) Kennels (license)

Building construction Alarms (permit) Billboards (permit) Building (permit) Building movers (license and permit) Concrete contractors (license and permit) Demolition (license and permit) Driveway curb cutting (permit) Electrical contractors (license and permit) Elevator installation (permit) Fence contractors (license and permit) Grading (permit) Heating contractors (license and permit) Home repair (license) Manufactured-housing installation (permit) Plumbing contractors (license and permit) Street excavating (permit)

Food service Alcoholic beverage sales (license) Food handlers (permit) Restaurants (health permit)

Businesses and occupations Bottled water (license) Christmas tree sales (license) Collection agency (license) Distressed goods sales (license) Dry cleaning (license) Electronic repair (license) Flammable-liquid storage (permit) Itinerant merchants (license) Jewelry auction (permit) Lawn sprinklers (license) Motor vehicle repair (license) Motor vehicle towing (license) Parking lot (license) Pawnbrokers (license) Residential garage sales (permit) Retail cigarette dealers (license) Rug and carpet cleaners (license) Sign permits (F) Solid- and liquid-waste haulers (license) Taxi and bus carriers (license) Ticket brokers (license) Tree service contractors (license) Wood vendors (license)

Health care facilities and services Ambulance drivers (license) Hospital and convalescent home (license) Private ambulance vehicles (permit)

Planning, zoning, and development Barricades (permit) Certificates of occupancy (fee) Floodplain development (permit) Plat approval (fee) Waterway development (permit) Zoning variance (fee)

Other Charitable solicitation (permit) Concealed weapons (permit) Loudspeakers (permit) Trash burning (permit)

Source: This is an updated version of an earlier list in Stanley E. Wilkes Jr., A Guide to Revenue Administration for Small Cities (Arlington: Institute for Urban Studies, University of Texas at Arlington, 1981).

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per lot or scaled to lot size. Fee structures that are even more sophisticated consider the permeability of each surface area (lot or property boundary) and the expected amount of runoff it generates.

As resistance has grown to a greater reliance on taxes, local governments have looked to other services for which users can share in the cost. Recreation and leisure, public works, police and public safety, planning, economic development, public health and sanitation, and public transit all have become candidates for at least partial cost recov- ery through user charges. In recent years, the search for chargeable activities has been enlarged to include advertising in public spaces, such as on government vehicles and buildings. Unlike utility services, for which revenue is accumulated in separate enter- prise funds, revenue from these governmental services is typically comingled with tax revenue in the general fund.

While local governments tend to have wider latitude in the rates they charge for services, state law and court rulings have generally limited fees for licenses and permits to the cost of regulating the activity. Local governments have relied on their authority to promote the health, safety, and general well-being of their communities to license a wide range of private activities, including pet ownership, amusement and recreation, new con- struction, various professions and trades, food service, and land use. Seldom do the fees for these privileges cover the full cost of regulating the activity, and unless state or federal law stipulates otherwise, the revenues are almost always comingled with general taxes.

Constrained tax revenue has pushed some local governments into imprudent ven- tures in their quest for nontax revenue. As noted in Chapter 1, local governments operate a host of “businesses,” from radio stations to casinos, some of which have proven quite profitable. But other ventures have proven financially fatal. Harrisburg, Pennsyl- vania, invested heavily in a trash-to-energy incinerator that proved unprofitable, leaving the city teetering on bankruptcy.5

Local governments often confront unrealistic expectations from citizens to reduce taxes while maintaining or even increasing services. In the case of revenue policy, gov- ernments are best served by incremental changes tested on a small scale before being expanded to the jurisdiction as a whole. There are no pots of gold awaiting discovery, and promises to the contrary are certain to lead to disaster.

Local governments have introduced charges for the growing array of services spawned by new technology, such as access to online data and to Wi-Fi, a city- or countywide broadband wireless network that provides high-speed Internet service to citizens at a fraction of the cost of other modes of service. Increasingly, more trans- actions—from paying taxes, utility charges, and traffic citations to providing input on strategic plans and initiatives—are occurring through online portals. Not only does this technology lower the cost of doing business with city hall, but it also provides cities with a tool for attracting technology-dependent industries. Yu-Che Chen and Kurt Thurmaier conclude that given the mix of private and public benefits from online transactions, local governments should use a combination of service charges and general revenues to finance their e-government services.6

Policy issues in the adoption of service charges Service charges pose policy issues that are quite different from those that local officials encounter with taxes. These issues include

• Keeping charges in line with costs

• Pricing strategies

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• Choices in cost recovery

• Provisions for a policy statement on service charges and regulatory fees.

Keeping charges in line with costs

Charges for utilities and other self-supporting services accounted for in a businesslike enterprise fund receive careful scrutiny because governmental accounting standards require that rates be sufficient to recover all costs. Often an outside firm will be retained to undertake a cost-of-services study to identify both the direct costs and indirect costs of providing a service, arrive at a defensible basis for the charges set, and ensure that the rate structure fairly distributes the cost of the service among users. Charges for general fund services, by contrast, rarely receive the same scrutiny—in part because they are not self-supporting and because the revenue is comingled with tax revenues in the general fund. Because of the infrequent scrutiny, rate adjustments—when they come— are substantial, often to compensate for a substantial revenue shortfall; this has the effect of depressing user demand for the service, at least in the short term.

The following actions are recommended for keeping charges more in line with the cost of service provision.

List services More systematic monitoring of charges for governmental types of services begins by asking each department to compile a list of services for which it cur- rently levies a charge or fee. The budget office (or finance office, if no separate budget office exists) should oversee this task. Departments should cite the legal basis for each charge, along with information on the rate and amount of revenue it yielded during the previous fiscal year.

Codify charges and fees by function Because legal authorization for charges is scattered throughout the local code, local governments should consider codifying charges and fees by category or function. One approach is to list all charges in one ordi- nance and all regulatory fees in another, making reference to the underlying ordinances authorizing their use. An alternative is to group charges and fees by function and then adopt an ordinance setting the rates for each functional area.

Review charges and fees annually The next step involves each department re- viewing the charges and fees it administers as part of the annual budget preparation pro- cess. Departments should complete an online form that identifies the expected revenues from the service at current rates and the cost recovery ratio (revenues divided by cost). Periodically (although not annually), a cost-of-services study of governmental types of services should be undertaken to establish a baseline of the potential revenue available from users of each service, the portion of full cost that should be recovered from con- sumers, and the indirect costs that should be assessed for internally provided services.

Recommend adjustments where appropriate As part of the detailed revenue analysis submitted to the city or county manager, the budget office should include a list of all governmental services for which a charge or fee is assessed and the proportion of cost recovered by the charge or fee. In consultation with each affected department, it may recommend adjusting the charge or fee to better match the cost recovery target.

Pricing strategies

As a general rule, public managers have less experience in pricing goods sold to their consumers than their counterparts in the business sector. For private sector managers,

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price decisions involve knowing the prices of competitors and positioning their goods so as to garner a greater share of the market. Public administrators, on the other hand, have less of an opportunity to learn the demand structure of their market because they have few or no competitors in their service area with which to compare prices and service quality. For example, a university offered a premium reserved parking option in a newly constructed parking garage; the assumption was that patrons would be willing to pay the $1,575 annual charge to park in a reserved space on the first level rather than half that rate for a nonreserved space on higher levels. Two parking spaces were sold in the first year that the option was available.

For public managers, the key to effective pricing of services is to know your consumers. As discussed in later chapters, when formulating their operating budgets, especially for general fund services, managers spend considerable effort trying to assess the preferences of their citizens. When the same level of effort is not expended to know the preferences of consumers, a mismatch between price and consumption is inevitable.

Most state laws and court decisions require that prices be reasonable and not arbi- trary. In most states, local governments may earn a reasonable return on their investment (a profit), especially for enterprise services such as water, sewerage, and electric power. Deciding on the right price for a service requires that public officials resolve how rates should be structured so as to equitably reflect the cost of serving different types of users.

Where the level of service consumption varies among users and where the cost of serving different user groups varies, charges should approximate the average cost of serv- ing each group in order to avoid inequitable and often unintended subsidization of one group of consumers by another. Also, wherever possible, individual service use should be measured through metering or other means to ensure a more equitable allocation of the cost of providing the service. In addition to the equity gains, metering ensures more effi- cient use of the service since it is the user who bears the cost of wasteful consumption.

Local governments use one or a combination of several of the following procedures for pricing their services.

Flat-rate pricing In cases for which measuring use is not feasible, a flat rate is usu- ally assessed, based on the average cost of serving each class of user. However, flat rates provide no incentive to reduce wasteful consumption, so they should be employed only in cases where it is administratively infeasible to measure use. In Denton, Texas, which uses a flat rate for its residential and commercial solid-waste collection (Figure 5–2), even the containerized service is provided at a flat rate; although the fee increases as container capacity increases, it does so at a declining rate because of the lower cost to collect each additional gallon (or cubic yard) of waste. Sometimes, a flat rate is the most cost-effective way of allocating the cost among users even though it has none of the rationing benefits associated with charges scaled to the amount of consumption.

Variable- and block-rate pricing The variable rate, or two-part tariff, charges users a fixed rate (or facility charge) for the fixed costs of access to the service and a variable rate based on the volume of service used. A variation on this is a block-rate structure, in which the volume rate changes for each block as consumption changes. A block-rate structure reflects the fact that the per unit cost for overhead, capital, and operations changes as consumption changes. In some cases, as in the energy charge for wintertime use of electric power by residential consumers, the block price declines as consumption increases. In the summer, however, just the reverse occurs, and higher levels of consumption move consumers into a higher-priced block. Such a pricing strategy approximates the marginal-cost pricing model discussed below. Water rates

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Figure 5–2 Rate schedules for Denton, Texas, municipal utilities

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for summertime consumption in Figure 5–2 illustrate block-rate pricing, and the wastewater rates illustrate a two-part tariff.

Peak-period pricing Peak-period pricing determines prices according to when a service is used. In cases where a service cannot be stored, such as electric power or public transit, peak demand means that capacity must be built to satisfy peak usage. Charging the same rate for such service, regardless of time of use, means that off-peak-period users are subsidizing peak-period users. Public transit provides a good example. Fares should be higher during morning and evening rush hours to reflect the additional capacity in bus and rail service and the additional personnel required to meet demand during these peak-demand periods. Local governments are increasingly using congestion pricing, which adjusts tolls upward automatically whenever traffic increases and downward as congestion eases.7 Similar capacity costs are incurred for water, sewer, electric power, and natural gas services. Both electric and water utilities for Denton use peak-period pricing in combination with block pricing (Figure 5–2). Peak-period prices should vary according to the cycles in use of the service, such as by hour, day, or season.

Pricing by classification of users Classification of users may be according to type of user (seniors, children, disabled), location of user (resident, nonresident), or lo- cation of service (transit zones). Where costs vary by classification of user, prices should be stratified so that low-cost users do not subsidize higher-cost users. Nonresidential rates are usually higher than residential rates because of the greater distance required to deliver services to nonresidents. However, the cost of serving different classes of users is not always the overriding consideration in classifying users; for example, adults generally pay a higher admission charge for recreational services than children do, but this does not reflect actual higher costs in serving adults. In the case of utility services, consumers in Denton are generally classified as residential and commercial (Figure 5–2).

Choices in cost recovery Another policy issue that local governments must resolve is whether to price a service so that it recovers all or only a portion of its cost. The common practice, especially for nonutility services, is to recover only part of the cost through service charges, with the remainder subsidized by general revenues. The sidebar on page 112 listing services for which charges are commonly collected also identifies those services that should be priced at full (direct and indirect) cost—or at full cost for at least some users—and those services for which partial cost recovery is justified.

The various pricing strategies available to local governments are as follows:

Full-cost and return-on-investment pricing Under most circumstances, enterprise services (e.g., utilities) should be priced at full cost, including both direct and indirect costs associated with service provision. As noted above, in some cases a reasonable re- turn on investment is legally and administratively justified. Privately owned utilities earn a return on their investment, and it makes sense for government-owned utilities to earn a comparable return. State and local laws vary in the amount of return authorized.

Partial-cost pricing For merit goods and services, a partial subsidy is usually warranted. This poses two issues that local governments must resolve when setting a price: (1) when should a subsidy be provided and (2) how much of a subsidy should be provided? For merit services, partial-cost pricing is justified when any of the following conditions exists:

• Some of the benefits from the service accrue to the whole community. For example, a rabies vaccination program reduces the risk of this disease for all pet owners, not

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just for those obtaining the inoculation. A portion of the program’s costs should be funded from general revenues.

• The local government wants to stimulate demand for the service. For example, a county library provides long-term benefits to a community by enriching its quality of life. Policy makers can encourage library use by fully subsidizing its operations from general taxes or possibly by charging only a token fee for users.

• Enforcement of the charge at full cost would result in widespread evasion. For exam- ple, setting a fee for dog and cat tags at full cost may give pet owners an incentive to evade purchase of these licenses. This increases enforcement costs and creates an adversarial relationship between owners and the animal control unit. Partial-cost pricing may be justified under such circumstances.

• The service is used primarily by low-income households. For example, rental rates for public housing should be set below full cost, with the difference made up by subsidies from federal and state grants.

The second challenge for local governments is deciding how much of a subsidy is jus- tified for services with spillover benefits to the community. Often political considerations enter into this discussion,8 with the relative political influence of the users weighing heav- ily in the decision. Politically active groups, such as senior citizens or sports enthusiasts, may effectively lobby to keep a service charge lower than would otherwise be the case.

Competitive pricing A competitive pricing strategy considers the prices charged for comparable services by private or nonprofit providers or by surrounding local governments. For example, a village may set its admission price for a swimming pool to be competitive with the YMCA’s charge. In the case of utility services, decision makers give particular consideration to the prices charged by surrounding jurisdic- tions and private suppliers. In today’s deregulated environment, especially for electric power and natural gas, public utilities must keep a close eye on the pricing practices of private providers, who have an incentive to “cherry pick” (i.e., lure away the low-cost, high-revenue accounts).

Marginal-cost pricing Marginal-cost pricing sets prices to reflect the cost of produc- ing each additional unit of service. For example, higher prices for summertime electric and water rates, as shown in Figure 5–2, shift the additional cost for this marginal capac- ity to those who create that need. Economists support this approach because it leads to the most efficient allocation of resources. Since the price reflects the marginal cost, only consumers who value that additional unit will purchase it. However, this strategy poses significant administrative difficulties in determining the marginal cost of each service. It also leads to prices that do not always recover the full cost of producing a service. Some pricing structures, such as peak-period and two-part tariff pricing, may approximate marginal-cost pricing, but pure marginal-cost pricing is rarely used in either the public or the private sectors.

Provisions for a policy statement on service charges and fees

Politically and legally, a cost-of-services study or rate analysis provides a defensible basis for the price charged to users. It can buttress a government’s contention that its prices were not set arbitrarily, particularly in cases where different rates are charged to differ- ent classes of users. In the case of merit goods and services, knowing the full cost also provides the manager with an indication of the value of the subsidy going to the service. Finally, knowing the cost of providing services heightens administrators’ awareness of

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the need to control costs. It aids managers in reviewing cost trends and the effect of those trends on budget allocations.

Costs to include The objective of a cost-of-services study is to identify the cost of providing a service, but governments seldom maintain accounting information on the basis of costs (or expenses). Instead, such information is usually maintained on the basis of expenditures (the value of goods and services purchased during the budget peri- od), which must be converted into costs (the value of the inputs used to produce the particular service during the budget period). Accountants identify two types of costs: direct (those associated with the direct provision of the service, such as wages, benefits, supplies, equipment) and indirect (those associated with supporting operations, such as general management, accounting, purchasing, human resources, payroll, utilities). Direct costs include those expenses that would be eliminated if the service were discontinued. Indirect costs result from the support (or staff) services provided by one department to other government departments.

For utility services, local governments generally set rates so as to recover both direct and indirect costs. For services other than utilities—for example, park and recreation services, animal control, toll roads, public transit, and public health services—local governments almost never recover indirect costs, and even recovery of full direct costs is problematic because most of these services provide community-wide benefits.

One of the thorniest issues in cost analysis is the equitable allocation of indirect costs to each chargeable service. Support services, such as personnel or accounting, constitute indirect costs not only for line services but also for other support services. For example, the finance department provides accounting and payroll services to the water department and also to the personnel department, which is itself a support service for the water department. This complexity suggests the need for a series of simultaneous equations to determine the proper allocation ratio for the indirect costs of all government services.9 Cost studies usually use two less sophisticated procedures for allocating indirect costs: the consolidated allocation method and the step-down method.

Consolidated allocation method The consolidated allocation method involves summing the cost of all support services, including services sold for a price, and then allocating these costs to each activity using some allocation criterion, such as each activity’s share of the total budget or share of total salaries and fringe benefits. However, consolidated allocation completely ignores the interdependence of support services and thus allocates more support service costs to line activities (including chargeable services) than is justified.

Step-down method The step-down method gives some consideration to the benefits that support services derive from each other. Support services are first ranked according to the amount of service each provides to all other support services. Line activities are not ranked. The benefits of each support service are then apportioned to all support services ranked below it. At least some compensation is thereby made for the benefits that support services derive from each other before indirect costs are allocated to line activities. Properly allocating indirect costs will yield more accurate estimates of the true cost of providing services and provide a more accurate basis for pricing those services. However, the success of any allocation ratio ultimately depends on whether department heads are convinced that it is fair.

Service Charges and Regulatory Fees 121

Administering service charges and regulatory fees Many of the issues associated with the collection and enforcement of service charges parallel those associated with the property tax, and most of the recommendations for improving the collection of current and delinquent property taxes apply to service charges as well, especially those for utility services.

Collection

Service charges are collected in one of two ways: at the point of sale (such as a rental charge for the use of recreational equipment or an admission charge to an ice skating rink) or on a periodic basis for the service used (such as a monthly statement for the quantity of water consumed). While the first approach eliminates the problem of delinquency, it is usually more costly to administer relative to the amount of revenue collected. Periodic billing of users yields the largest portion of revenue from service charges, especially for utility services. However, managing these accounts receivable creates many of the same problems that a private firm encounters when it extends short-term credit to its customers.

Local governments typically piggyback several utility and related service charges onto one billing system. For example, charges for water, sewer, solid-waste (refuse) collec- tion, and electric power may be listed on one statement. While water usage is usually metered, sewerage charges are usually based on a proxy measure, such as the average volume of water used during the winter months.

Local governments should achieve at least a 95 percent collection rate on current accounts. That is, no more than 5 percent of the current charges for billed ser- vices should be delinquent. As with the property tax, achieving this collection rate depends on local economic conditions, including the unemployment level, and on the aggressiveness of the collection effort. The accompanying sidebar summarizes

Strategies for improving collection of charges and fees

Current accounts Design the utility statements to catch the attention of users and clearly com- municate the amount of payment and the due date.

Keep account records current, especially mailing addresses; consider developing a consolidated database of utility and taxpayer accounts.

Provide for web-based payment and automatic bank draft options now com- monplace with many private firms. Allow payment by credit or debit card.

Adopt penalties and interest charges that make delinquency unrewarding.

Consider the cost-effectiveness of con- tracting out collection of current and delinquent accounts.

Delinquent accounts Establish a legal basis and procedure for collecting delinquent accounts. 1. Establish liability for utility charges. 2. Specify the steps for collecting de-

linquency charges, and increase the intensity of each step in the process.

3. Use discretionary powers, such as setoff provisions in contracts and liens on the property of delinquent customers.

4. Require a deposit.

Consider contracting out collection of delinquent payments to a private law firm.

Consider developing an amnesty program to reduce the backlog of de- linquent accounts, especially for parking and traffic citations.

122 Service Charges and Regulatory Fees

the strategies for effectively administering the collection and enforcement of service charges.

Designing a policy for service charges and fees

Managers may want to propose a broad policy covering all types of charges and fees, with separate sections devoted to particular service areas, such as utility services, parks and recreation, sanitation, and health. The alternative is to adopt separate policy state- ments for each major service area. A policy statement on charges and fees should address the following issues.

Integration with the budget process Because a review of all charges and fees should be integrated into the budget preparation process, the policy statement should assign responsibility for overseeing implementation and review of this task. The respon- sibility may be assigned to the budget office, or it may be shared with units that have administrative oversight, such as internal auditing or performance management.

Schedule for cost-of-services studies The policy statement should specify the frequency with which a cost-of-services study will be undertaken and the cost-of-living index that will be used in the intervening years to adjust rates.

Levels of subsidy The policy statement should provide guidelines on the types of services that will be priced at less than full cost and the level of subsidy provided. Thornton, Colorado, classifies its park and recreation services into one of three catego- ries: self-sustaining activities, partially sustaining activities, and services for which a token fee is charged.

Collection The policy statement should provide guidelines on the collection of charges and fees. Guidelines are particularly important for utility services, where delin- quency is a problem. At a minimum, the policy should specify the amount of deposit required from new customers, the procedures for collecting delinquent charges, and the sanctions to be used against delinquent customers.

Development charges Local governments that are experiencing rapid population growth are increasingly relying on development charges and fees to finance the capital cost of additional public facilities. Traditionally, the cost of adding facilities to accommodate growing populations has been borne by all users through increased charges and taxes. However, the tax lim- itation movement and the retrenchment in federal aid have made it much more difficult for local governments to sustain this approach.

Impact fees are collected from developers, often under a local government’s reg- ulatory powers, for off-site improvements that are needed to serve the new develop- ment. Impact fees were initially used to finance off-site expansion of water and sewer treatment facilities. Their use was extended to cover the cost of expanding arterial roads serving a new development; solid-waste disposal capacity; storm drainage; beach and park acquisition; and police, fire, school, and public transit facilities. While these fees are unpopular with developers, they are understandably popular with current residents, who see them as a more equitable way of providing additional service capacity than imposing taxes and service charges on all residents.

Cities in Colorado have the longest experience with impact fees, although the fees are most widely used by cities and counties in California. Florida holds the distinction

Service Charges and Regulatory Fees 123

of having the most well developed case law on the use of impact fees, whose legality has been challenged on both statutory and constitutional grounds. State courts have generally held that impact fees do not deny due process or equal protection as long as a rational nexus exists between the need for additional capacity in public facilities and the growth from new development. To provide a clearer legal basis for local authority to assess these fees, states have shifted to granting explicit authority for the fees in statute rather than relying on local governments’ more vague regulatory powers. At least twenty states have adopted enabling legislation since Texas first did so in 1987.10

Economically, impact fees raise contentious issues about their effect on the cost of housing, especially for first-time home buyers. Opponents contend that impact fees increase the cost of housing, are potentially unfair to new residents, and provide a wind- fall in benefits to current residents. In fact, except under unusual market conditions, impact fees are capitalized into lower land values, especially in competitive markets with housing options, rather than being shifted forward to buyers (or renters) as higher prices for housing or commercial space.11

The ordinance that levies the fee should specify the types of improvements financed by the fee, the basis for determining liability, and whether rates should be stratified by the type or the location of property. It should also specify when in the development process the fee will be collected. Most governments collect it at the building permit stage along with other development-related fees. Local governments should develop accounting procedures capable of documenting that fees were used to finance projects directly benefiting those paying the fee.

Connection charges are another type of levy used to recover the cost of off-site improvements. While impact fees provide up-front financing for the expansion of public facilities, connection charges allow the developer to buy into the existing capacity of public facilities.

A third approach is to require developers to dedicate improvements—such as new streets, lighting, and drainage—as a condition for local government approval of the new subdivision. Historically, developers have been required to dedicate on-site facilities as a condition of approval. As an alternative to impact fees, local governments may extend that responsibility to include off-site improvements, such as arterial roads or expanded sewer treatment and water facilities needed to serve the new development.

Special assessments Special assessments, another form of benefits-based financing of public facilities, are levies on property owners for the increased property values attributable to a public improve- ment. For example, a city-funded street widening project increases the market value for commercial property along the improvement. (More traffic means more business, which increases the locational value of the property.) Some local governments use assessments to partially finance the installation of water and sewer lines and the construction of recreational facilities and off-street parking. Heaviest use of these levies is made by local governments west of the Mississippi River, especially those in Pacific Coast states.

Special assessments differ from other benefits-based levies, including impact fees, in that the maximum assessment is the increase in property value created by the improve- ment, regardless of the extent to which beneficiaries use the facility.

In the past twenty years, states have introduced variations on special assessments as a way to shift the financing of infrastructure to those benefiting from the improvements. For example, Texas authorizes cities to establish municipal management districts (MMDs) that

124 Service Charges and Regulatory Fees

blend the financing mechanisms of special assessments with the governance structure of tax increment financing districts. MMDs may use a combination of special assessments and impact fees on those properties that benefit from improvements in the district. Additional dedicated property taxes may be levied by the district’s governing board.

A special assessment may be applied to each property owner as a pro rata share of the cost of the project. An assessment equal to the increase in each property’s value eliminates any windfalls that these property owners would otherwise have received at other taxpayers’ expense. And by shifting part of the cost of public improvements to property owners who benefit from increased property values, special assessments promote horizontal equity.

Rarely do special assessments recover the full cost of a project. Essentially, they cap- ture the private benefits from an improvement financed in part by general revenues. But in so doing, they promote intrajurisdictional equity and also lower developers’ financing costs by giving developers access to tax-exempt debt backed by the assessments.

Authorization and implementation

Unlike impact fees, special assessments are levied under the taxing powers granted to local governments in state law. Every state grants municipalities the authority to levy assessments, and most extend the same authority to counties and, less frequently, to independent special districts such as utility districts.12

Projects financed by special assessments may be initiated by property owners (includ- ing developers) or by the local government. At a developer’s request, the local gov- ernment creates a special assessment district to obtain tax-exempt financing for public improvements in the district.13 Enabling legislation specifies the general procedures that local governments must follow to levy an assessment, the method for allocating the costs of the project, and the terms of payment for property owners affected by the project.

While impact fees are generally collected before the facility is constructed, state laws usually prohibit collection of special assessments until the project is completed, at which point property owners have the option of paying their assessments in installments over a number of years, usually at very favorable interest rates. When financing a project with assessments, a local government must finance the construction phase with general reve- nues and then reimburse itself as special assessments are collected. When impact fees are used, beneficiary financing is up front, which places less of a drain on the local govern- ment’s general revenues.

Once a feasibility study has been completed for the proposed project, a public hear- ing is held to determine property owners’ level of support for it. During this period, an assessment roll is prepared identifying the affected properties and their owners and esti- mating each property’s assessment. Property owners are notified of their assessments and given an opportunity to contest them at a public hearing. The final step is certification of the assessment roll by local government policy makers and the issuance of assessment certificates to property owners.

Allocation of costs

The aspect of special assessments that property owners contest most often is the allo- cation of construction costs. State law usually specifies the basis for allocating a proj- ect’s cost among property owners, which is almost always according to the number of feet fronting the improvement (i.e., a front-foot basis). Although by law the maximum assessment can equal the increase in value attributable to a public improvement, local governments rarely levy assessments at this level. Moreover, an appraisal study may reveal that the project’s benefits are not uniformly distributed, in which case each property

Service Charges and Regulatory Fees 125

assessment must be adjusted to reflect any differences. Costs may also be allocated on a per acre or per lot basis, especially for water and sewer installations. In some cases, a zone method may be used whereby properties closest to the improvement bear a greater portion of the cost.

Administratively, assessments are costly, particularly for improvements in residential areas, where the increases in property value are less apparent, or for projects that involve a large number of property owners. Local governments are advised to use special assess- ments only when they can gain some economies of scale by spreading administrative costs among several projects.

Conclusion Local governments should make greater use of service charges because such charges provide an equitable source of revenue (those using the service pay in proportion to the benefits they receive) and promote efficiency by discouraging wasteful use of govern- ment services. Charging for a service reduces the demand for it: the greater the price change, the greater the effect on service use. And charges to users slow the growth of local budgets by ensuring that decisions are based not on interdepartmental budgetary politics but on the relationship of service level to demand. The greatest benefit from service charges comes with regular adjustments in prices that reflect the cost of serving various types of consumers. Service charges also improve local government productivity by increasing managers’ awareness of the cost of services.

A barrier to the increased use of service charges is the political imbalance between the negligible benefits to taxpayers from a new charge and the noticeable cost to users of the service; consequently, elected lawmakers may find it politically difficult to support the imposition of a visible service charge if there are no significant benefits from a reduction in taxes.

Local governments should adopt a policy statement on service charges and fees. Such a statement should assign responsibility for annually reviewing rates as part of the budget process; specify the frequency with which a cost-of-services study will be undertaken; and provide guidelines on the types of services that will be priced at less than full cost, the level of subsidy provided, and the collection of current and delinquent charges, including the amount of deposit required from new customers.

When the cost of serving different groups of users varies, charges should be strati- fied to approximate the average cost of serving each group. A flat-rate pricing structure is the simplest to design, but it has the least effect on efficiency because users have no incentive to ration their use of the service. Moreover, it is less equitable because those using less of the service subsidize those using more. Alternative pricing structures that more efficiently and equitably allocate costs include a variable rate structure, peak- period pricing, and classification of users.

For services providing only private benefits, such as utility services, full-cost pricing (with possibly a return on investment) is appropriate. Partial-cost pricing is appropriate for services with some spillover benefits to the community or services for which local governments want to encourage demand.

A sensitive issue in the costing of services is the allocation of the indirect costs of support services, such as those associated with the manager’s office or accounting. An equitable basis should be found for allocating these costs to all activities, including those for which charges are not collected.

Development charges and fees, such as impact fees, provide an equitable alternative for financing public improvements required by new development. The critical stage in

126 Service Charges and Regulatory Fees

the process of adopting an impact fee is documenting the cost of capital improvements needed to serve new residents.

The principal objection to fees and charges for new development is that they will increase the cost of housing in the community. Although in the long term, fees are cap- italized into lower prices for undeveloped land, in the short term builders bear the fee’s cost on their existing inventory of property. To reduce this burden, local governments should phase in the fee over a two- or three-year period, giving developers and builders an opportunity to adjust their bid prices for raw land to compensate for the fee.

Special assessments and their more recent adaptations such as MMDs offer a benefits- based strategy for recouping at least part of the costs of public improvements. Successful use requires that affected property owners be involved early in the process. The local government may want to survey owners about their attitudes toward a proposed project and their willingness to pay an assessment for part of its cost. Because special assess- ments are costly to administer, there should be a sufficient volume of projects capable of being financed in part by assessments to provide some economies of scale in their administration.

Notes 1 Robert J. Kleine and John Shannon, “Characteristics

of a Balanced and Moderate State-Local Revenue System,” in Reforming State Tax Systems, ed. Steven D. Gold (Denver, Colo.: National Conference of State Legislatures, 1986), 33–34.

2 U.S. Bureau of the Census, State & Local Government Finance, Historical Data: 2002, Table 2, census.gov/ govs/estimate/historical_data_2002.html, and State & Local Government Finance, Historical Data: 2007, Table 2, census.gov/govs/estimate/historical_ data_2007.html.

3 Deborah A. Carroll and Terri Johnson, “Examining Small Town Revenues: To What Extent Are They Diversified?” Public Administration Review 70 (March/April 2010): 223–235.

4 Bernd Huber and Marco Runkel, “Tax Competition, Excludable Public Goods, and User Charges,” International Tax and Public Finance 16 (2009): 321–336.

5 Michael Cooper, “An Incinerator Becomes Harrisburg’s Money Pit,” New York Times, May 10, 2010, nytimes.com/2010/05/21/us/21harrisburg .html?_r=0 (accessed April 14, 2013).

6 Yu-Che Chen and Kurt Thurmaier, “Advancing E-Government: Financing Challenges and

Opportunities,” Public Administration Review 68 (May/June 2008): 537–548.

7 Congressional Budget Office, Using Pricing to Reduce Traffic Congestion (Washington, D.C., March 2009), cbo.gov/sites/default/files/cbofiles/ftpdocs/97xx/ doc9750/03-11-congestionpricing.pdf.

8 Michael A. Pagano, Funding and Investing in Infrastructure (Washington, D.C.: Urban Institute, December 2011).

9 Kyland Howard, “Determining Appropriate User Fees,” ICMA MIS Report 19, no. 9 (September 1987): 9.

10 Lawrence W. Libby and Carmen Carrion, “Development Impact Fees,” CDFS-1558-04 (Columbus: Ohio State University Extension Service, 2004), ohioline.osu.edu/cd-fact/1558.

11 Jennifer S. Evans-Cowley and Larry L. Lawhon, “The Effects of Impact Fees on the Price of Housing and Land: A Literature Review,” Journal of Planning Literature 17 (February 2003): 351–359.

12 Thomas P. Snyder and Michael A. Stegman, Paying for Growth: Using Development Fees to Finance Infrastructure (Washington, D.C.: Urban Land Institute, 1987), 35.

13 Ibid., 66.

Service Charges and Regulatory Fees 127

1. If a university raises graduate tuition by $50 per semester hour and the number of hours in which graduate students enroll then declines dramatically, the demand for graduate education is said to be _____________ (elastic or inelastic). Express this relationship mathematically.

2. A facility charge recovers mostly what kind of cost? A volume charge recovers mostly what kind of cost? What is meant by indirect costs? Which type of charge—facility or volume—will include indirect costs?

3. Which of the following pricing strategies best approximates the marginal cost of a service? Provide a justification for each answer. a. $18.20/thirty days for residential solid-waste service, or variable rate by container size b. Water rates that combine a facility charge, or wastewater rates based on 98 percent of volume

charge during wintertime usage c. Airport parking fees based only on length of stay, or parking fees based on length of stay by

proximity of lot to terminal d. Tuition rates that are the same for fall, spring, and summer, or tuition rates that are higher for

fall and spring than for summer

4. Which of the following services should recover full cost? Why? Which of these should use block- rate or peak-period pricing or some combination? Why? For which services is partial cost pricing justified? a. Public library b. On-demand genealogy research services offered by public library c. Public transportation (bus and rail) d. Public swimming pool e. Public water park with wave pool and slides f. Senior citizens center g. Space for senior citizens to exhibit and sell arts, crafts, and antiques h. Toll bridge i. Mosquito spraying to control West Nile virus j. Public housing k. Disaster shelter l. Large item (refrigerators, sofas) disposal in landfill m. Household hazardous-waste disposal

5. The parking office at a major university has proposed a range of double-digit increases in parking fees for each type of parking permit for the next academic year. The price of a parking permit is on a per semester or per year basis and varies depending on (1) proximity of the parking lot to campus buildings, (2) whether the parking space is reserved, and (3) type of user (employees, commuting students, resident students). a. What are the various pricing strategies that governments use for divisible goods and services,

and what are the pros and cons of each? b. What type of pricing strategy is used by this university for its parking services? What are its

pros and cons? c. Identify three goals of parking services at a university and discuss how prices can be used to

encourage each goal.

REVIEW QUESTIONS

129

c h a p t e r

Now the Israelites had been saying, “Do you see how this man keeps coming out? He comes out to defy Israel. The

king will give great wealth to the man who kills him. He will also give him his daughter in marriage and will exempt his

father’s family from taxes in Israel.”

– I Samuel 17:25

Strategic choices: Using taxes for economic and political purposes

Local and state governments invest heavily in attracting and retaining business investment. Yet the Great Recession of 2007–09 spawned a wave of municipal bankruptcies and exposed the vulnerability of local and state budgets to economic cycles. In the midst of this financial unrest, taxpayers are demanding relief and busi- nesses are shopping for the best package of incentives to relocate their operations.

Not only do taxes provide the resources needed to finance local government oper- ations, but they also have become tools in two politically powerful but potentially antithetical trends: stimulating new investment by businesses and providing tax relief for citizens. The former finds expression in the array of economic development incentives offered by local and state governments. The latter is seen in such measures as tax limita- tions, beginning with Proposition 13 in California, and targeted relief to select groups of citizens, particularly senior citizens.

This chapter examines the role of local taxing decisions in economic development and tax relief, specifically as it relates to these issues:

• What criteria do businesses use when making locational decisions?

• Do locally financed tax incentives, such as tax abatements and tax increment financ- ing, attract new business investment?

• How effective are targeted incentives—for example, for sports stadiums and arts venues?

• How has the tax limitation movement affected local government budgets? Do limitations on taxing powers stimulate an increase in household income and new job creation?

6

130 Strategic Choices: Using Taxes for Economic and Political Purposes

Taxes and economic development: Finding the balance This chapter begins where it ends: No amount of creative financing to attract busi- ness investment will compensate for poor budgeting practices. The most cost-effective economic development strategy that local governments can pursue is to maintain sound budget practices, competitive tax and utility rates, and professional leadership.

Pursuing an aggressive economic growth policy makes good political sense. A suc- cessful economic development initiative communicates to industries making locational decisions that the business environment is a favorable one. If one industry is attracted to a community, related industries are likely to follow. Economic development initiatives also express to voters that public officials are concerned about job opportunities and are making efforts to expand them.

However, a more fundamental objective underlies the effort to attract business invest- ment: to improve the local government’s revenue condition by expanding its tax base. Investment in plant facilities and equipment expands the property tax base and creates new employment opportunities. New jobs bring more workers—or at least help to retain the existing workforce—and that further expands the local tax base. If the municipality or county has access to an income tax or a sales tax, it will reap even greater budget returns from economic development as a result of increased income and consumption.

Defining a favorable business environment raises two fundamental questions: (1) how do local taxes affect business investment and (2) under what circumstances should local governments offer tax incentives? Both issues have been the focus of considerable research, and studies can be found to support almost any position on these questions: the issues are complex, and isolating the effect of local taxes or tax incentives on business locational patterns requires highly sophisticated techniques and theories. Anecdotal analyses that compare the number of jobs or the size of the business tax base before and after completion of a major business investment but that do not simultaneously control for other factors should be disregarded.

Factors affecting business locational decisions

Although business leaders often contend that different tax policies at the state or regional level have a significant bearing on their investment decisions, the research generally shows that “this effect is fairly small and easily outweighed by differences in other factors.”1 How- ever, once a firm has narrowed its locational choice to a particular region, that region’s tax burden—and particularly its property tax burden—becomes more important, even if not paramount. Firms that are otherwise indifferent to two or more possible sites may consider the effective local tax burden of the finalists in their evaluation. Thus, at the margin, a local government’s tax burden does affect business investment decisions.

However, no firm rule can be offered because a lower tax burden does not necessarily lower the cost of doing business in a jurisdiction. If lower taxes mean fewer public services, particularly those used by businesses, the operating costs may be much higher for businesses that have to absorb the cost of providing those services. Moreover, state and local taxes usu- ally represent a just small component of the cost of doing business, and those expenses are deductible for federal income tax purposes, which further lowers businesses’ marginal costs.

The inefficiencies of local tax incentives

From a political perspective, providing tax breaks to businesses is a win-win proposition. Businesses reduce their operating costs, and the local community expands employment opportunities for its citizens, augments its tax base, and promotes its reputation for hav- ing a favorable business climate.

Strategic Choices: Using Taxes for Economic and Political Purposes 131

From an economic perspective, however, local government use of tax abatements, tax credits, and tax increment financing (TIF) is inefficient for two reasons: (1) It represents government interference in the marketplace, and (2) the benefits from new job oppor- tunities that inevitably spill over into surrounding or overlapping governments are paid for by taxpayers only in the jurisdiction providing the tax incentives.

Market interference A locally financed tax abatement lowers the cost of production for qualifying firms, which makes the jurisdiction more cost competitive with another city or county. However, even in the absence of a government-provided incentive, a business will choose the location for new investment that minimizes its production costs. Energy- intensive firms search for locations with lower energy costs; labor-intensive firms seek out locations with low labor costs; and technology-dependent firms locate in areas with an ample supply of technologists. The point is that not all locations are equally desirable alternatives for firms seeking to relocate. Economic incentives interfere in the decision- making process by enhancing a community’s locational advantages beyond what they would have been without such incentives, and in so doing, these incentives may lure business investment to less than optimal locations. In other words, tax incentives reduce the neutrality of local revenue policies.

Spillover benefits People and money move unhindered across state and local bor- ders. If a city uses a tax-incentive package to attract a new business, the cost of those incentives is borne by local taxpayers while the benefits may accrue to a much broader

Summary of research on local taxes and business location

• In a firm’s initial search for possible sites, taxes have virtually no bearing on locational decision. As the number of possible sites is narrowed, however, differences in the effective tax rates of local governments increase in importance.

• Nontax factors such as labor supply and cost, energy cost, transportation networks, space availability, agglomeration economies, and educational level of the workforce are more central to a firm’s final locational choice than tax-related factors.

• The effect of local taxes on business investment decisions varies with the type of business. Firms in manufacturing and wholesale trades are more sensitive to effective property tax rates (property tax liability as a percentage of the property’s market value) than are firms in other types

of industries. Tax incentives to attract new manufacturers do increase local economic activity, especially where agglomeration economies exist.1

• Inordinately high local tax burdens may affect business investment indirectly by promoting the emigration of labor. As workers leave, so too will manufacturing firms, followed by retail and service industries, in order to be closer to the labor supply and consumers.

• In the long term, above-average property tax burdens prompt businesses and households to relocate to lower-tax areas, thereby causing property values to decline. Thus, to maintain a competitive level of public services, governments with declining property values must levy even higher tax rates, precipitating a further decline in the tax base.

1 Michael Greenstone, Richard Hornbeck, and Enrico Moretti, “Identifying Agglomeration Spillovers: Evidence from Winners and Losers of Large Plant Openings,” Journal of Political Economy 118, no. 3 (2010): 536–598.

132 Strategic Choices: Using Taxes for Economic and Political Purposes

area. For example, job creation financed by a city benefits job seekers from surrounding areas, too. No economic development initiative has ever successfully included a residency requirement for job beneficiaries.

Revenue windfalls that can accrue to overlapping governments are another type of spillover benefit. For example, locally financed tax relief enhances a firm’s profitability, resulting in increased income tax revenue for state and federal governments. State sales tax revenue also increases as businesses and households increase their consumption.

Why local governments use tax incentives

Given the inherent inefficiencies of locally financed incentives for economic growth, why do so many jurisdictions use these incentives? Local government managers must formulate decisions and make policy recommendations in the context of public percep- tions that business “pays its way” and that a tax incentive will more than “pay for itself ” in the long term as new jobs and additional business investment follow.

Research supports these perceptions. In a study of midwestern states, William Oak- land and William Testa found that, on average, businesses pay 2.4 times in taxes what they receive back in tax-supported services. The minimum ratio in their sample was 1.9, mean- ing that in the worst case, businesses pay almost $2 in taxes for every $1 in tax-supported benefits they receive.2 Tax incentives provide local governments with a mechanism for better aligning the tax burden that businesses incur with the public benefits they receive.

A second reason for the popularity of tax incentives is the need to signal a hospitable business environment. Tax incentives provide compelling evidence of a local govern- ment’s commitment to keeping existing jobs and attracting new ones.

A related reason is that businesses may pressure local leaders to offer incentives, playing one local government against another.3 Municipalities in economic decline are especially vulnerable to such pressure: they can afford neither the tax incentives nor the political consequences of refusing to offer them.

Thus, the issue for city and county leaders has become not whether to influence the locational decisions of businesses but rather how to create a favorable business environ- ment. And in this respect, interlocal competition for business investment and the mobil- ity of business capital have made tax incentives a standard tool in the local economic development toolbox.

Tax relief for business investment The fundamental purpose of tax incentives is to encourage a firm to reduce its cost of doing business by relocating to the host city or state. Incentives for business invest- ment fall into two general categories: (1) tax incentives, such as TIF, tax abatements, tax exemptions, and tax credits; and (2) nontax incentives, such as subsidized loans, industrial development bonds (IDBs), land acquisition, site preparation, preemployment training, and publicly provided infrastructure. The following discussion considers only the four types of tax incentives.

Initially, local and state governments used specifically designated federal aid to target their economic development initiatives and stimulate reinvestment in blighted areas. With the decline in that aid, those governments have increasingly broadened their use of incentives to include nonblighted areas and have sought other revenues, such as the sales tax and development and utility charges, to support economic development. Meanwhile, states have reduced their own economic development expenditures by giving local governments the financial responsibility to provide incentives on their own and the dis- cretion to determine the type and amount of incentives they will offer. This has allowed

Strategic Choices: Using Taxes for Economic and Political Purposes 133

states to avoid mandating that local governments provide such aid while knowing that interlocal competition will compel them to make concessions available.

Types of tax incentives offered by local governments

Next to IDBs, tax incentives are the most frequently used method for promoting economic growth. They are relatively easy to implement, and unlike IDBs and public financing for infrastructure, they immediately improve a business’s income statement by reducing its operating costs. Of course, if all competing firms in an industry receive the same tax incentives, competition will lower prices for the firms’ products rather than increase the firms’ profits.

Tax incentives enjoy widespread public approval when presented as aids to job creation. As mentioned earlier, most people assume that incentives more than pay for themselves. Whether this is true, however, must be determined on a case-by-case basis and only after careful analysis of the economic impact of the firm’s investment. The accompanying sidebar summarizes the range of tax incentives used by state and local governments, and the sections that follow focus on the three most popular locally pro- vided incentives: abatements, exemptions, and TIF.

Tax abatements Tax abatements, the most popular incentive and the least costly to administer, temporarily reduce the property tax burden of a business. They work in several different ways, depending on state law. One common method is to exempt all or a portion of the taxable value of the new investment in a building and equipment for a specified number of years (usually ten to fifteen), after which the property is assessed and taxed at the prevailing rate. An alternative involves freezing the tax liability at its prede- velopment level for the abatement period; in exchange, developers must make contractu- ally agreed-upon improvements in the designated area, which may include hiring from the local labor pool. Yet a third approach is to abate all tax liability but require payments in lieu of taxes (PILOTs) on the predevelopment value of the tax base. PILOTs, which would constitute a provision of the abatement agreement, are subject to negotiation.

A typology of tax incentives One way to classify tax incentives is by the component in the basic tax equation (tax base × tax rate = tax liability) that is initially targeted by the incentive. Ultimately, all incentives are intended to influence tax liability, but they differ in what component is targeted. The following typology profiles tax incentives by whether they initially alter the tax base, tax rate, or tax liability. For example, a tax exemption excludes

a portion or all of the value of a category of property, sales, or income from the tax base. A split tax roll, by contrast, creates a multitiered rate structure that levies a lower tax rate on preferred types of property, sales, or income—for example, the two- tiered property tax rate used by Michigan for public education (discussed in Chap- ter 3). A tax credit, on the other hand, is a dollar-for-dollar reduction in tax liability.

Tax base Tax rate Tax liability

Tax abatement Tax exemption Tax increment financing Tax base sharing

Split tax roll Tax rate freeze

Tax credit Tax rebate

134 Strategic Choices: Using Taxes for Economic and Political Purposes

Tax abatements were originally used for property taxes. More recently, local govern- ments have abated sales taxes, or at least a portion of them, for new retail developments such as big-box retailers. In this case, the abatement typically takes the form of a tax credit. The retailer retains a portion of the sales taxes collected rather than remitting the full amount to the local or state government.

According to state and federal reports, thirty-seven states now sanction the use of tax abatements by local governments.4 These states may also provide for the partial abate- ment of state taxes. Although states and their local governments usually pursue their economic development initiatives independently of each other, states that permit local tax abatements typically require that local governments adopt policies to guide their use of abatements. These policies specify the qualifications for an abatement, the approval process, and the terms of the abatement agreement.

Qualifying businesses Most states allow a broad range of industries to participate, especially if the abatements are targeted to blighted areas. Some states or local policies may restrict abatements to predetermined reinvestment zones where business investment is targeted to stimulate economic growth. Iowa and Illinois restrict their abatements to new firms moving into a local jurisdiction from another state or country or to an exist- ing firm expanding its production capacity by adding to an existing facility.

In stipulating the qualifications for a partial or full abatement of property or sales taxes, the local policy may specify a minimum investment that must be made in new construction or renovation, which may include new equipment; the number of new jobs to be created by the proposed investment; and the economic life of the proposed project (i.e., the number of years the facility is expected to be operational). Some poli- cies may impose even more specific criteria, especially where a municipality or county has already well-established agglomeration economies. Even if a business qualifies for an abatement, however, local governments typically have the discretion to grant such benefits on a case-by-case basis.

Approval process States typically give their municipalities or counties responsibility for approving abatements. But other overlapping local governments, such as schools and special districts, also levy property or sales taxes. Thus, for its benefits to be max- imized, the abatement should be extended to these other jurisdictions—an issue that has become the focus of considerable disagreement and litigation. Those on one side of the issue say that all local jurisdictions, including school districts, should participate in encouraging redevelopment of an area because all will enjoy the future revenue benefits from the increased property value. Those on the other side contend that maintaining or improving the urban environment is the responsibility of a municipality, not a school district. Not surprisingly, overlapping jurisdictions resist the loss of tax revenue, and states often give them the choice to participate in an abatement.

Louisiana is the only state in which the state commerce department may exempt new or expanding firms from local property taxes without the approval of the local govern- ments affected by the decision. At the other extreme, to the extent that funds are appro- priated by the state legislature, Maryland compensates local governments for up to half the lost revenue from property tax credits approved for firms locating in enterprise zones.

Terms of abatement agreements Once an abatement is approved, local governments usually enter into contractual agreements that specify the improvements or restorations that both government and business are to make as a condition for abatement. These agreements, which are typically made with the developer of the property, should specify

Strategic Choices: Using Taxes for Economic and Political Purposes 135

the amount of exemption and the method of calculating it; the improvements to be made and the time line for completion; any documentation that the property owner must provide to demonstrate compliance with the agreement; the number and types of new jobs, if any, that must be added by the project; the provisions for access and inspec- tion by city personnel; and the terms for recovering lost property tax revenue should the owner fail to honor the contract’s terms.

Tax exemptions Tax exemptions permanently exclude from the tax base particular types of transactions or property. For example, building materials used in construc- tion may be exempted from a local-option sales tax. A common form of property tax exemption—a freeport exemption—extends to inventory items, both raw materials and finished goods, that move across state borders for fabrication or sale. By targeting exemptions to businesses with inventories, local governments can stimulate significant agglomeration economies. For example, a community that serves as a transportation hub—either by highway, railroad, or airline—may use its competitive advantage to be- come a center for warehousing. Most states now extend some sort of partial exemption for goods in transit, but the parameters vary.

In Texas, for example, the freeport exemption is a local option for cities, counties, and school districts. One, two, or all three overlapping local governments may extend an exemption, which is available on all inventories brought into the state for “fabrication, assembling, manufacture, storage or processing” and then exported outside the state within 175 days. If the local governing body adopts the exemption by ordinance, Texas law provides that the exemption can never be revoked.

Of the four types of tax incentives, exemptions are the most powerful at stimulating growth. At the same time, they are the least amenable for targeting economic devel- opment efforts because they almost always exist as a blanket provision (covering all inventory or all sales of a particular type) in state law. Moreover, they deprive a local government of the discretion to target its tax incentives to industries that will provide the greatest benefits to its economic development goals. Businesses, however, generally prefer tax exemptions because those businesses that meet the provisions of state law qualify for the exemption, and the exemption, once approved, is virtually impossible to repeal.

Tax increment financing TIF is authorized in forty-eight states; only Arizona does not authorize TIF and California has terminated its use.5 Although California was the first to adopt TIF in 1952, the state disbanded all 400-plus redevelopment agencies in 2012 after a report prepared by the Legislative Analyst’s Office concluded that they had not been effective at attracting business development to California.6

Purpose and design Unlike tax abatements, which are typically awarded to busi- nesses on a case-by-case basis, TIF targets local tax incentives to an area that has lagged in development; this area is thus designated a TIF district. The design of TIF is basically the same across all states: the increased property tax revenue resulting from redevelop- ment in the TIF district is dedicated to financing the development-related costs in that district. TIF divides that tax revenue into two categories. Taxes on the predevelopment value of the tax base (the tax increment base) are kept by each taxing body, while taxes from the increased value of property after redevelopment (the tax increment) are de- posited by each jurisdiction into a tax increment fund, which is usually maintained by the city. Property owners in the TIF district incur the same property tax rate as owners outside the district. Preferential treatment is granted only in that tax revenues from the district are dedicated to financing public improvements in the district.

136 Strategic Choices: Using Taxes for Economic and Political Purposes

Typically, tax-exempt TIF bonds are sold up front to provide financing for the pur- chase and preparation of the land, including preparation for industrial, commercial, or residential development and for the installation of public infrastructure, such as streets, lights, water and sewer lines, curbs, gutters, and landscaping. Once prepared, the land is sold to developers at a price that is often below the local government’s cost of preparing the site, a technique known as a land write-down. The predevelopment costs, includ- ing write-downs, are recouped through the tax increment fund over the life of the project, and the money in the fund is usually used to repay TIF bonds.

The underlying assumptions of the TIF approach to economic development are that locally financed improvements will draw private investment into the TIF district, and that without those improvements, private investment would not occur. Whereas a tax abatement draws business investment by lowering the property (or sales) tax burden, TIF lures such investment by providing a ready-made site for construction, usually at a sub- sidized price. The up-front financing for site preparation is repaid by developers, whose property taxes on the incremental increase in property values are earmarked to repay the bonds as they mature over several years.

Responsibility for costs Although TIF is more complex and costly to administer than tax abatements, private firms generally prefer it. With TIF, the local government shares the financial risk of the TIF district’s failure with developers who invest in the district. But should the increment in property tax revenues be insufficient to meet the annual debt service costs, the city is responsible for repayment of the outstanding debt—in which case it must find some other source of funds to prevent a bond default. Local governments also use TIF to stimulate agglomeration economies in and adjacent to the redevelopment district, a strategy essential to building a sustainable local economy.7

State laws vary on whether overlapping local jurisdictions, such as counties and school districts, that levy property taxes on the TIF district must share in the cost of redevelopment by forgoing the tax revenue captured by the district. Without TIF, cities bear the full cost of redevelopment while overlapping jurisdictions reap revenue wind- falls from increased property values. Opposition to TIF comes primarily from those overlapping jurisdictions that are required to share in the costs.

Effectiveness in stimulating economic growth A number of studies have examined the effectiveness of TIF at increasing taxable property values in the TIF district as well as throughout the city or county. Unlike the mixed results of earlier studies, findings from more recent studies show increasingly consistent results. For example, one of the more rigorous analyses found that, among Illinois municipalities, increases in commercial property investment within a TIF district came at the expense of reduced investment in commercial property outside the district.8 This result was not found for industrial devel- opment, however; property values in TIF districts dedicated to industrial development were lower than they otherwise would have been in the absence of TIF. The researchers attribute this to lower demand for industrial-only TIF districts as opposed to districts where investors have more discretion in how the land is developed.

Another study, which focused on Wisconsin cities, found that while TIF stimulated the growth of property values within the TIF district, it did not change the aggregate property values for the host city.9 One explanation could be that TIF causes development to move from one part of the city to another, resulting in no net gain in total property values.10 The Wisconsin study also found evidence that, unlike commercial development, residential and manufacturing TIF districts provide no net gain in property values.

Procedures for creating a tax increment financing or redevelopment district

State laws specify the procedures that cities must observe when creating a tax increment financing (TIF) or redevelopment district.

Proposing the TIF district States typically restrict TIF to blighted areas of a city or county, such as areas with substandard housing. How- ever, laws are usually lax in their definition of blight. Once a city proposes the creation of a TIF district, all states require that it notify overlapping local jurisdic- tions and hold a public hearing where affected individ- uals and governments may weigh in on the proposal.

State laws sometimes limit the amount of a city’s property tax base that can be included in reinvestment districts. In some states, the full tax increment does not have to be committed to the tax increment fund. By agreement, overlapping local jurisdictions may retain a portion of the tax increment for their own gen- eral funds. Several states compensate school districts for revenue lost through the creation of a TIF district.

Preparing a redevelopment plan Critical to the success of a TIF district is the prepa- ration of a plan that guides the implementation of projects in the district and formally identifies the commitments made by public, nonprofit, and private sector participants. Typically the host city or county appoints a board of directors, whose primary respon- sibility is developing detailed project and financial plans for the district. The project plan should include a description of any changes in zoning, planning, or building codes required by improvements; maps of the project area; estimates of nonproject costs; and methods of relocating households or existing busi- nesses displaced by the project. The financial plan should include realistic estimates of the proposed public expenditures; the costs of site preparation, including acquisition, relocation, and demolition; and the cost of project administration.

Creating the TIF district Once public hearings have been completed and input from other local governments has been provided (if appropriate), the city must formally establish the TIF district by ordinance. This will include authorizing the creation of a fund to track associated revenues and expenditures. Once the district is established, the predevelopment value of its tax base is determined and all affected local and state agencies are notified of that value. The city council may also adopt an ordi- nance authorizing the issuance of TIF bonds.

Implementing the TIF district Funding for acquisition and preparation of land in a TIF district has historically come from TIF-backed bonds. The tax increment plus any other revenues from the sale or operation of facilities in the district may be pledged as the source of funds to repay the bonds. A common practice is for the district’s board of directors to enter into formal agreements with developers to undertake the construction of various projects in the district.

To reduce the risk that tax increment revenue will be insufficient to repay outstanding TIF bonds, the host city or county may enter into agreements in which developers in a TIF district agree to pay property taxes based on a minimum value of the development regardless of the actual value. Should revenues from the TIF district be insufficient to cover the debt service on the outstanding bonds, cities should have in place a reserve, possibly accumulated from other successful TIF district projects, to cover such exigencies.

Another issue is whether the predevelopment tax base represents a minimum for establishing revenue owed to overlapping jurisdictions. Property values in a TIF district could drop below the predevelop- ment base, so overlapping local governments would receive less tax revenue after development than before. The unresolved legal issue is whether cities have to make up the difference in lost revenue to overlapping governments.

Regular reporting of the financial activities of the TIF district should be required with an annual audit of the report. The report should include information on the amount and source of revenues in the tax incre- ment fund, the amount and purpose of expenditures from the fund, the amount of principal and interest due on outstanding TIF bonds, and the tax increment base and current appraised value of property in the district.

Terminating the TIF district Most states place a maximum life on either TIF dis- tricts or the bonds used to finance redevelopment. Illinois limits the life of redevelopment districts to twenty-three years or until all project costs are paid, whichever comes first. Wisconsin limits TIF districts to twenty years or until the city’s bond obligations have been satisfied. Texas places no constraints on the life of TIF districts but limits TIF-backed bonds to twenty years.

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138 Strategic Choices: Using Taxes for Economic and Political Purposes

Tax credits The fourth approach to tax incentives—tax credits—provides a dollar- for-dollar reduction in tax liability. From a business perspective, the appeal is the direct effect that a credit has on a company’s bottom line. From a local government perspec- tive, the appeal is that the business shares in the success of the development initiative. A common approach for sales tax abatements, for example, is to give a retailer a tax credit on sales tax receipts in exchange for the business investment. The retailer shares in the success of the venture by sharing a percentage of the sales tax revenue generated by the retail business. Property tax abatements may also be provided on a tax credit basis.11 The company receives a remittance for a predetermined percentage of the property taxes paid over the life of the agreement.

The downside of credits is that the city or county must make a cash payment to the business, and that payment often must be accounted for in the operating budget. That visibility raises the political stakes for the city or county, especially from competitors who do not receive the largesse.

Assessment of locally financed tax incentives

Tax incentives can be used to negotiate benefits for the local economy. As has been noted, tax incentive agreements commonly stipulate the number of new jobs that a firm must create and even the percentage of new hires who must reside within the city or county. Enforcing these agreements, however, has proven challenging for city adminis- trators. For example, after conducting a compliance audit of incentive agreements, the City of Fort Worth found that several firms had not met their employment require- ments. In such situations the city must decide whether to void the agreement and suffer even further reductions in its tax base, modify the agreement to reflect more realistic employment targets, or disregard the terms of the agreement.

But agreements notwithstanding, public finance experts disagree about the cost- effectiveness of tax incentives. It is indisputable that tax concessions improve the com- petitive position of a local government, but are their costs, measured in forgone revenue, worth the benefits from the business investment? Are tax incentives essential to attract- ing new business investment? The general conclusions about tax incentives can be summarized as follows:

• Tax incentives are economically most easily justified in marginal cases, where a firm is otherwise indifferent to the choice between two or more possible locations. Yet even in these instances, competing local governments tend to offer nearly compara- ble incentives that effectively cancel each other out.

• Tax incentives are politically most appropriate for state and local governments with relatively high and persistent rates of unemployment. Unfortunately, these govern- ments are the least able to bear the cost of tax incentives, particularly when compet- ing with more prosperous jurisdictions.12

• Tax incentives are also most appropriate near state or local boundaries, which is where governments often encounter the most intense competition for business investment (i.e., border-city/state effects), and especially in retail centers such as shopping malls. This is also why a number of states have curious exceptions to their tax policies, such as no state income for residents of Texarkana, Arkansas, which shares a border with Texarkana, Texas, where there is no state income tax.

• To the extent that local taxes on businesses exceed the benefits in public services that those businesses receive, tax incentives provide local governments with a mechanism for more equitably aligning the tax burden on business, particularly for mobile sectors.

Strategic Choices: Using Taxes for Economic and Political Purposes 139

Thus, tax incentives make the most sense, politically and economically, for high-tech industries and services and the least sense for retail and residential development.13

• Once a city or region establishes agglomeration economies, the necessity for tax incentives declines. However, anecdotal evidence suggests that politically it is nearly impossible to turn off the incentive spigot once it has been opened.14 And if a local economy is heavily dependent on one industry or service—for example, the enter- tainment industry in Nashville, auto manufacturing in Detroit, oil refining in Hous- ton—city and county budgets become more vulnerable to the cycles in that industry.

• Local governments with taxing powers limited to the property tax are less able to recover the cost of a tax incentive through increased revenues than those with access to an income tax or a sales tax.

• Local governments in economically linked metropolitan areas retain fewer benefits from tax incentives within their jurisdiction. For example, a tax abatement offered by a central city will produce spillover benefits in surrounding suburban communi- ties that supply some of the labor force. The smaller the geographic size of a city or county, the more the benefits of tax incentives are exported to surrounding commu- nities. The same is true for a rural community surrounded by an unincorporated area. In order to distribute the benefits of commercial and industrial development more equitably, a few metropolitan regions, such as Minneapolis/St. Paul, Minnesota, have adopted tax base–sharing plans, in which increases in the property tax base from new business development are shared with all local governments.

• Political expediency requires that local governments offer some type of tax incentive if for no other reason than to send a message that they have a “favorable business environment.” For public managers, however, the issue is more complex: they must consider what it costs in tax incentives to lure new business investment without alienating existing businesses.

Tax incentives for professional sports and the arts Professional sports stadiums and performing and visual arts centers that demand tax-supported assistance present special challenges to local governments. Even the spreading use of subsidies for outdoor displays—Cincinnati’s pigs, Dallas’s cantilever bridge—raises questions about the extent of public support for such community sym- bols. Just how long is the “arm of economic development”?

Such symbols have their origins in antiquity. The Athenians built the Parthenon and the Romans, the Coliseum—both monuments to their cultural accomplishments. But the past three decades have witnessed a significant increase in public funding in the United States for such initiatives under the guise of economic development. Of the thirty Major League Baseball teams, twenty-four play in stadiums built since 1989;15 fourteen stadiums alone were constructed between 2000 and 2012, many partially or fully funded by the host city. Between 1992 and 2012, twenty-one stadiums were constructed for teams in the National Football League (NFL), many with substantial tax subsidies, mostly sales and hotel/motel tax revenue.16 The two most recently built stadiums cost over $1 billion each. And in 2012 the Los Angeles City Council unani- mously approved building a $1.5 billion stadium for a yet-unknown team. (Los Angeles is the largest city in the United States without an NFL team.) Only two of the NFL’s thirty-two teams—the Green Bay Packers and the Chicago Bears—play in stadiums constructed before 1960, although both stadiums—Green Bay’s Lambeau Field, built in 1957, and Chicago’s Soldier Field, built in 1924—have been extensively renovated.

140 Strategic Choices: Using Taxes for Economic and Political Purposes

Performing and visual arts centers also receive dedicated tax revenue to subsidize their operations or capital improvements. Americans for the Arts, a national advocacy organization, estimates that 96 percent of the 5,000 local arts agencies in the United States partner with at least one public or community agency.17 The most common form of local tax support is a hotel/motel tax, although occasionally local governments may dedicate a portion of the property tax or sales tax for local arts and historical preserva- tion. For example, the City of Denton, Texas, dedicates 3 percent of its 7 percent hotel/ motel tax to the annual operating costs of the arts. This support is over and above the locally funded facilities that are owned by cities but leased to sports franchises or arts organizations, such as Cowboy Stadium, which the City of Arlington, Texas, owns and leases to the Dallas Cowboys for $2 million per year through 2038.

But again the question is whether these investments provide economic returns greater than their cost in public subsidies. And the resounding answer from numerous studies—particularly those analyzing the economic benefits of professional sports teams to household income and job creation—is no.18 So if they are not justified economically, what justifies such massive public investment in these facilities?

Assessing the case for government financing The case that is made for public financing of stadiums and arts venues is that these facili- ties either (1) provide public (collective) benefits or (2) contribute to the economic growth (job creation, increases in property values, growth in personal income) of the commu- nity. For true public goods, or even merit goods with substantial collective benefits, tax support is justified up to the value of the collective benefits. But professional stadiums and arts complexes, however meritorious, do not meet the criteria of nondivisibilty and nonexcludability. Admission tickets are required to their events, and nonsubscribers are excluded from enjoying any direct benefits. Thus, they do not qualify as pure public goods.

A more convincing case might be that because of the intangible public benefits they provide—a professional sports team or symphony orchestra, like a library or a museum, enriches the life and character of a community and contributes to civic pride—these facilities qualify as merit goods and so a partial subsidy is justified. In an analysis of attitudinal data for residents in the Indianapolis area, one study found that “attendance is an important element in determining pride.”19 That is, those who attend sporting and cultural events derive more pride from the event than those who do not attend. And a study of Portland, Oregon, found modest collective benefits from hosting a major league baseball team, although the value of those benefits were much smaller than the huge public subsidies that stadiums typically receive.20

In terms of the second justification for public subsidies—the impact of sports stadi- ums and arts venues on economic development—the research is conclusive: not only do the benefits to economic growth fall short of the cost of the subsidy, but these venues may even have an adverse effect on economic growth.21 Whether measured by job creation, changes in consumer spending, or revitalization of a blighted area, independent analyses consistently show that public investment in stadiums, in particular, has no effect on economic growth.22

Part of the reason is that household spending for entertainment is limited. If people buy more tickets for professional sports, they simply reduce spending for other entertain- ment purposes, and the result is no net economic gain for the region. Only 5–20 percent of the fans at professional athletic events are from outside the area.23 While some visual or performing arts events may have a strong regional draw, it is unlikely that, on average, the percentage of out-of-area patrons is any greater. Thus, apart from rare events such as the

Strategic Choices: Using Taxes for Economic and Political Purposes 141

World Series and the Super Bowl, athletic and arts events are not effective mechanisms for exporting the burden for financing stadiums and performance halls.

Finally, the benefits of professional athletics and the arts to economic development are constrained by the absence of significant multiplier effects. While the relocation of a manufacturing or technology firm may yield as much as a $2 impact on the local economy for every $1 in new investment, professional sports teams have a much lower multiplier effect.24 This is explained by their limited season, use of lower-skilled labor for services, and narrow opportunities for agglomeration economies.

Civic symbolism

Why do local government leaders acquiesce to the demands of professional sports team owners for new and increasingly more costly stadiums? Why do cities feel compelled to build and operate concert and opera halls, theaters, and art museums? In fact, cities and civic leaders, from pharaohs to presidents, have always erected monuments as a visible legacy of their leadership. What greater testimonial can there be to your tenure as a leader than to have your name on a brass plaque discreetly but visibly displayed near the main entrance of a new facility?

Seen in this historical context, sports stadiums and arts centers serve much the same function—particularly in Western culture, where benefits to the whole are valued over the immortalization of individual leaders. Beyond the civic pride, quality of life, and “bragging rights” that these venues bring to a community, they serve as permanent reminders of the community’s past accomplishments and as proclamations of anticipated achievements. Just as the arch defines St. Louis and the Eiffel Tower Paris, so too does Bass Hall symbolically herald Fort Worth’s cultural achievements and Madison Square Garden New York City’s athletic and artistic triumphs.

Regardless of what team owners and arts proponents may say, the value of stadi- ums and arts venues is symbolic, not economic. These facilities have tangible—albeit political—value, particularly for those leaders responsible for their development and construction. But Americans’ preoccupation with economic growth and general lack of historical perspective complicate the local leader’s task of rationalizing the construc- tion of new facilities. When such initiatives are presented as civic symbolism, arguments faulting their lack of value as engines for economic growth fall by the wayside. But promoting them as symbolic tributes to a community’s accomplishments poses political hurdles that the more pragmatic would prefer to avoid. Not surprisingly, when put to a vote, such initiatives result in highly contentious elections with each side making dubi- ous claims about expected benefits and costs.

Guidelines for using tax incentives Every local government has a unique set of attributes that make it a more attractive location for some types of industries than for others. When considering the use of tax incentives to enhance a community’s attractiveness for new business development, local government leaders would do well to keep the following guidelines in mind:

• Before launching an economic development program, local leaders should develop a strategic plan that identifies (1) the community’s economic strengths, weaknesses, opportunities, and threats; (2) their economic development goals, measurable objec- tives, and strategies for achieving those objectives; and (3) measurable benchmarks for assessing the progress toward achieving their goals. Local leaders should commit to annually reviewing the strategic plan and revising its elements where warranted. An

142 Strategic Choices: Using Taxes for Economic and Political Purposes

analysis of cities in Massachusetts found evidence that those cities with more growth management policies had higher credit ratings for their bonds.25

• A local government offering tax incentives should have access to at least one broad- based nonproperty tax, such as a general sales tax or an income tax, in order to capture more revenue benefits from economic growth.

• The larger the jurisdiction, the better the match between those taxpayers bearing the cost of the incentives and those benefiting from the increased economic activity; by implication, counties are better suited for providing tax incentives than are cities, towns, or villages.

• Economically declining jurisdictions are the most vulnerable to “giving away too much” when negotiating with a business that is contemplating the relocation or expansion of an existing facility.

• Incentives may be appropriate as a strategic measure to diversify the local tax base and thereby reduce a local government’s budget to the vulnerabilities of the business cycle. The greatest benefit of tax incentives comes when they are used sparingly and strategically to build agglomeration economies. For urban areas already benefiting from agglomeration economies, it is not necessary to use tax incentives to attract other firms in the same industry.

• TIF is preferred to tax abatements and tax exemptions as a more equitable approach to attracting business investment. Numerous studies have shown that tax incentives do not add to the overall taxable value of property in a city. However, they do increase the value of property within the TIF district.

• In the long term, locally financed tax incentives may prove counterproductive because they shift the cost of services to other taxpayers, who then have an incentive to move to a lower-tax jurisdiction.

For cities and counties with vibrant economies and moderately growing population, the best approach to promoting economic growth is to maintain property tax rates at competitive levels. Tax incentives are no substitute for prudent budget policies that pro- mote responsible financial management practices.

Tax relief for citizens While local governments have pursued tax relief for business through targeted tax incen- tives, citizens have grown increasingly resistant to paying more taxes, particularly property taxes. The groundswell of resistance began in 1978 when Californians ratified Propo- sition 13, rolling back property tax rates to a combined maximum of 1 percent for all overlapping local governments and limiting annual increases in taxable (assessed) values to 2 percent or to the purchase price whenever the property is sold. Tax and expendi- ture limitations (TELs) have drawn on the California approach. Although states have always imposed limitations on the taxing capabilities of local governments, the following discussion focuses on recent efforts to limit the local tax base, tax rates, and tax levies. Efforts to limit growth in local expenditures have also been undertaken; however, these have proven less attractive politically as strategies for constraining local budgets.

Tax relief for citizens has the potential to undo the gains made through tax incentives designed to attract business investment. The local manager walks a tightrope, addressing the political need to provide such relief while not unduly shifting the burden to more mobile businesses. Much of the relief has targeted taxes paid by individuals and house- holds, as summarized in the accompanying sidebar. While each state has pursued its own

Strategic Choices: Using Taxes for Economic and Political Purposes 143

approach to providing relief, their various approaches can be grouped into broad-based measures and more targeted measures.

Broad tax relief measures Four states—Colorado (1992), Missouri (1996), Nevada (1996), and Oklahoma (1992) —responded to citizens’ pleas for tax relief by adopting a requirement that tax rates could not be increased without voter approval. Colorado’s Taxpayer Bill of Rights (TABOR) not only requires voter approval for any increases in local tax rates but also restricts revenue growth in local governments to inflation plus population growth—unless voters approve otherwise. Missouri’s Hancock Amendment, one of the more sweeping local revenue limitations in the nation, requires voter approval not only of taxes but also of fees. Nineteen states limit annual increases in the taxable value of property, but the limit usually applies only to single-family residential property.26

A number of states cap tax rates, particularly for the property tax. Thirty-seven states limit property tax rates—some to a fixed percentage (as in California) and some with limits that can be overridden by a majority or supermajority of the council or of voters—and some states limit the percentage increase in the property tax rate.27 Although many states have constitutional limits on the maximum rates that particular types of local governments can impose, such as $1.50 for cities in Texas not operating with a home rule charter and $2.50 for those with a home rule charter, Proposition 13 unleashed citizen efforts to limit the combined tax rates of overlapping local gov- ernments. Massachusetts limits the overlapping tax levy to 2.5 percent of the tax base, and yields in the property tax cannot increase by more than 2.5 percent annually unless approved by at least two-thirds of the voters. Idaho and Arizona both impose a com- bined cap of 1 percent of the tax base.

Thirteen states use some variation of truth-in-taxation to hold local councils and commissioners more accountable for increases in the local property tax burden.28 Two states, Kentucky and Texas, give voters the power to overrule their local governments should their lawmakers approve an extraordinary increase in the tax revenue. The

A typology of tax relief measures for citizens As with tax incentives, tax relief measures initially target one of the factors in the ba- sic tax equation (tax base × tax rate = tax liability). Ultimately, all tax relief measures are designed to alter tax liability, but they

differ in what component is targeted. As in sidebar on page 131, the following typology profiles tax relief initiatives by whether they initially alter the tax base, tax rate, or tax liability.

Tax base Tax rate Tax liability

Cap on increases in taxable value Acquisition appraisals (Proposition 13) Tax exemption Homestead exemption Fractional assessments Sales tax holiday

Split tax roll Tax rate freeze Tax rate freeze Truth-in-taxation Voter approval

Tax credit (circuitbreaker) Tax levy freeze Tax dividend Tax rebate Tax amnesty

144 Strategic Choices: Using Taxes for Economic and Political Purposes

advantage of truth-in-taxation—particularly in states such as Florida and Utah, where a mailed notice is sent to each property owner before a final tax rate is approved—is that it elevates the visibility of the tax rate–setting process while preserving local autonomy from state fiat.

A comparative analysis of the effectiveness of TELs in Kansas made the interesting discovery that truth-in-taxation is more effective at limiting increases in per capita prop- erty taxes than the presumably more rigid tax levy limitation.29 The researchers con- clude that “these results would seem to support the notion that local officials in Kansas demonstrated a clear measure of self-imposed fiscal restraint when given greater local choice and flexibility in budgetary priorities” that comes with truth-in-taxation.30

Targeted tax relief measures

In recent years, a number of states have also pursued tax relief measures targeted to specific classes of citizens, particularly senior citizens. For example, Pennsylvania’s Act 77 freezes property assessments of senior citizens in counties levying a sales tax. As part of a sweeping tax reform initiative, Michigan adopted a two-tiered rate structure for school property taxes that was designed to reduce the burden on homeowners. In lieu of lo- cally set school taxes, the state now imposes a 6 mill tax on all primary residences and a 24 mill tax on secondary homes and businesses that fund schools. Still other states, such as Texas, freeze the school taxes of senior citizens at the amount they pay in the year that either spouse turns 65. In 2003, Texas voters amended the state constitution to give cities and counties the option to extend the senior tax freeze to their property tax levies. City and county officials have been slow to adopt the freeze because of the long-term adverse impact it has on local budgets.

The impact of tax and expenditure limitations

Proponents of TELs contend that reductions in state and local taxes will increase economic growth. Specifically, they contend that increases in per capita income will mean more consumption and investment so that more resources will shift to the private sector, and since the private sector is assumed to be more productive than the public or nonprofit sectors (an assumption that has little support from research), the increased consumption and investment will lead to greater growth in job creation and per capita income. This is a testable proposition: Do tax limitations lead to increased economic growth at the state and local levels?

A related question concerns the effect of TELs on state and local budgets. Do they lead to reduced spending by state and local governments? Do they affect states’ capacity to counter the adverse effects of recessions? These are also testable research questions that, not surprisingly, have captured the interest of public administration researchers.

Turning to the first question, if the theory underlying the tax limitation movement is accurate—that lower taxes lead to greater economic growth—then those states with the most restrictive TELs should experience the greatest economic growth. Therese McGuire and Kim Rueben specifically tested this hypothesis using data from Colorado after the state adopted its highly restrictive TABOR in 1992. While they found “some limited evidence for short-term increases to growth (in employment but not household income), these were not sustained in the long term.”31 In fact, five years after TABOR’s adoption, job growth in Colorado lagged significantly behind that in other states with comparable economies. In another study, researchers used data from 1985 to 2005 to study the effect of TELs in the forty-eight contiguous states and found that these limitations had no effect on per capita personal income or level of employment.32 In other words, there was no evidence that TELs affect job growth or household income at the state level. And in yet

Strategic Choices: Using Taxes for Economic and Political Purposes 145

another study, the more restrictive TELs were found to slow economic growth at the state level and actually lead to a decline in economic growth at the local level.33

As for the second question—the effect of TELs on state and local budgets—the evi- dence is also substantial. Limits on the use of the property tax cause local governments to shift to other resources, especially service charges and user fees. To the extent that some of those revenue sources are more volatile, they put state and local budgets on a roller-coaster, experiencing greater and greater swings in revenue yields across the busi- ness cycle.34 TELs also lead local governments, especially school districts, to depend more heavily on state aid, which increases their vulnerability to budget reductions in recessions.

Do tax limitations work? There are two general answers to this question: First, it depends on the type of tax limitation, and second, tax limitations almost never work as proponents intend and often have unintended and coun- terproductive consequences. Although no comparative analysis of tax limitation measures has been undertaken, casual observation suggests that the measures that limit increases in the tax burden most effectively are those that require voter approval to change tax (or fee) rates, followed by those that require extraordinary majorities of legislative bodies to change the rate or base.

Formal analyses of tax limitations suggest, however, that these measures have consequences that are often unanticipated and even antithetical to the proponents’ original intentions. For example, several studies of California’s Proposition 13 have found that the amendment has resulted in • Greater concentration of decision

making at the state level • A significant reduction in the fiscal

and political autonomy of local governments, particularly school districts and counties, thereby impeding the home rule capabilities of local governments and their capacity to shape their local economies

• Less accountability for local governments as they shift dependence to more indirect (hidden) taxes and to property exactions such as impact fees

• Marked increases in horizontal inequities between new buyers of property, whose property is assessed at its purchase price, and long-term residents, whose increases in property assessments are limited to 2 percent per annum (resulting in tax burdens for comparable properties that are as much as five times greater for the recent buyer)

• A significant shift in the property tax burden to homeowners and away from business owners because of the more frequent turnover of residential property

• Chronic housing shortages, especially for multifamily units, because of the punitive tax burden for new housing and thus the lower profit margins for newer developments compared with existing developments

• Competitive advantages for established retail and service industries over newer commercial businesses for the same reasons cited immediately above. As a result, retail markets in California are less competitive, which means higher prices for consumers.1

1 Gregory D. Saxton, Christopher W. Hoene, and Steven P. Erie, “Fiscal Constraints and the Loss of Home Rule: The Long-Term Impacts of California’s Post–Proposition 13 Fiscal Regime,” American Review of Public Administration 32 (December 2002): 423–454; Carol Douglas, “Proposition 13—25 Years Later,” State Tax Notes 30 (October 20, 2003): 222–226; Lenny Goldberg and David Kersten, “Huge Disparities Found in California Commercial Property Taxes,” State Tax Notes 31 (May 10, 2004): 437–457; Randall G. Holcombe, “Tax and Expenditure Limitations: Issues for Florida,” Policy Report no. 932 (April 2001); Terri A. Sexton, Steve M. Sheffrin, and Arthur O’Sullivan, “Proposition 13: Unintended Effects and Feasible Reforms,” National Tax Journal 52 (March 1999): 99–111.

Sustainable and resilient community development

Since the mid-1980s, there has been a growing sense of collective anxiety about the world’s diminishing supply of nonrenewable energy and inability to support, for the long term, the growing affluence of developed and developing nations. Sustainable economic development—providing incentives at the community level to promote ecofriendly growth by shifting production to renewable resources— has gained adherents in some cities, especially in North America.1 At its most basic level, sustainability is a resource allocation issue: “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”2 Some local governments have modified their economic development policies to attract ecofriendly industries and provide incentives for existing industries to convert to more resource-efficient technology.

Sustainable economic development uses many of the conventional tools described in this chapter but targets them for sustainable purposes. For example, sustain- able tax incentives would target new development that promotes in-filling (using vacant land within a city’s core area), the production of locally grown food, the creation of cooperative ventures, or the financing of a microen- terprise loan program. Alternatively, incentives may be used for research and development of new ecofriendly technology. Whatever approaches are taken, citizens will increasingly look to their local government to encourage innovation and experimentation through tax incentives.

Managers have recognized that in communities prone to natural or technological disasters, the goals of sustainability are closely aligned with those of disaster resiliency.3 Resiliency means the ability to anticipate, withstand, and recover from the consequences of a disaster so as to reduce its cost and the disruption to normal activity that it may cause.4

Sustainable economic development and disaster resil- iency share a common goal of adapting communities and their economies to their natural environments. In both cases, budget issues, and specifically local revenue issues, should be part of the planning and decision-making pro- cesses. Although each community’s vulnerability to natural and technological disasters is unique, including policies that promote budget resilience in a comprehensive emergency plan will mitigate the long-term effects of those events on the local economy and its capacity to return to normal.5 Like businesses, a local government needs to have a plan in place for maintaining and financing continuity of operations.

Even after their communities have been destroyed by natural or man-made forces, people have a curious habit of returning to rebuild their homes—what might be called

the “anthill phenomenon.” This pattern of redevelopment raises interesting questions for city leaders engaged in a discussion of sustainable economic development. Eco- nomic growth cannot be sustained forever. Cities reach build-out and have no further available space for expan- sion. Should they try to recreate themselves as they age? Venice, Italy, was once a glorious center of culture and trade. But no amount of investment can stop the inevi- table demise of this once glorious jewel of Europe as it slowly sinks into the Adriatic Sea. Should sustainable eco- nomic development accept the inevitability of change?

While federal and, to a lesser extent, state aid help to offset the cost of responding to and recovering from a di- saster, much of that cost goes uncompensated. A major se- ries of disasters, such as the multiple hurricanes that hit the Gulf Coast in 2005, impose long-term costs on local gov- ernments that must be absorbed locally through delayed growth and ultimately higher state and local tax burdens. Thus, when assessing the city’s or county’s disaster resiliency, the manager should consider the following questions: • Is our insurance coverage sufficient for large-scale

losses of city or county property? • What impact would the most likely types of disasters

or emergencies have on the property tax base? Sales tax base? Water and wastewater service charges? Other major revenue sources?

• What level of budget reserves is appropriate given our community’s vulnerability to particular types of disasters or emergencies?

• What protection should be available to cover debt service costs in the event of a disaster?

• What is the cost and what procedures should be followed to restore collections and enforcement of revenues in the event of a disaster?

• Do mutual aid agreements include assistance with revenue administration in the event of a disaster?

• What agreements should be in place with local nonprofits whose mission is to assist households and businesses in times of disaster?

• Under what conditions can the local government incur short-term debt to cover the operating costs associated with an emergency or disaster?

• What loans or grants are available from the state or federal government to ensure continuity in operations for the local government?

• What tax relief options should be considered for households and businesses in the event of a disaster?

1 Susan M. Opp and Jeffery L. Osgood Jr., Local Economic Development and the Environment (Boca Raton, Fla.: Taylor & Francis Group, 2013).

2 World Commission on Environment and Development, Our Common Future (New York: United Nations, April 1987). 3 Steven D. Stehr, “The Political Economy of Disaster Assistance,” Urban Affairs Review 41 (March 2006): 492–500. 4 Philip Berke and Gavin Smith, “Hazard Mitigation, Planning, and Disaster Resiliency: Challenges and Strategic Choices for

the 21st Century,” in Sustainable Development and Disaster Resiliency (Amsterdam, The Netherlands: IOS Press, 2009). 5 Shayne Kavanagh, Building a Financially Resilient Government through Long-Term Financial Planning (Chicago: Govern-

ment Finance Officers Association, circa 2011).

146 Strategic Choices: Using Taxes for Economic and Political Purposes

Strategic Choices: Using Taxes for Economic and Political Purposes 147

Accumulated evidence from several tax limitation initiatives suggests that their full impact is often delayed by several years—in the case of Proposition 13, even decades— but that their effects become cumulative and most apparent in recessions. It was during the recession of 2001 that Californians began to experience the cumulative effects and drag on economic growth from Proposition 13, effects that built up to a crisis level during the Great Recession of 2007–09. A study of the property tax cap in Illinois found that in the first few years following its adoption, the cap slowed the growth in property tax revenues for municipalities and school districts, an effect that was even more pronounced ten years later.35

Finally, tax limitations, while providing relief to some fortunate taxpayers, shift the burden to other, often less equitable and economically efficient revenue sources—in particular, more narrow-based excise taxes. Most disconcerting is their long-term impact on state and local government capacity to pursue countercyclical measures. Casual observation suggests that recessions are steeper and more protracted in states with limited tax and spending options. TELs make it more difficult for state and local governments to take preemptive action to restore economic stability and strengthen employment opportunities.

Conclusion Local government tax policy pursues two strategies: (1) providing tax incentives to busi- nesses to advance economic prosperity and (2) providing tax relief to residents to curry political favor. Both place heavy demands on local budgets in forgone revenues.

When making locational decisions, businesses are most influenced by business oppor- tunities—the cost of land and labor, the availability of transportation networks, and the presence of agglomeration economies—especially in manufacturing and warehousing. Once they have narrowed their locational choices, especially to a regional or metropol- itan area, taxes become an increasingly important factor. At the margin, a local govern- ment’s tax burden does affect business investment decisions.

And it is at the margin, where a firm is otherwise indifferent to the choice between two or more possible locations, that locally financed tax incentives, such as tax abatements and TIF, are economically most justified. Among local governments, TIF is the most widely used tax incentive; while it is more complex to administer, it creates the least ineq- uities with existing businesses. But studies on the effectiveness of tax incentives, especially TIF, show that while they may increase property values within the redevelopment district, citywide property values do not show any change that can be attributed to TIF.

Similarly, although public subsidies for professional sports and artistic venues have assumed overbearing influence in some large-city budgets, studies consistently find that these venues also add nothing to the local economy (no net increase in jobs or house- hold income). In this case, however, the subsidies are justified because these venues provide intangible benefits: civic pride, symbolic tributes to a community’s artistic and athletic accomplishments, and, not unimportantly, tributes to the elected leaders who pushed them through.

While much attention has been focused on strategically using tax incentives to promote economic growth at the state and local levels, taxpayers have intensified their demands for tax relief. Much of the relief has targeted taxes paid by individuals, partic- ularly owners of single-family residences. But because tax relief to citizens shifts more of the local burden onto businesses, it has the potential to undo any gains made through tax incentives designed to attract business investment. Thus, the local manager must find an acceptable balance between the political need to grant tax relief to households and the economic need to attract, encourage, and retain successful business ventures.

148 Strategic Choices: Using Taxes for Economic and Political Purposes

Although advocates of TELs contend that reductions in state and local taxes will increase economic growth, a number of studies have found that TELs in fact lower eco- nomic activity, especially at the local level, and that their adverse effects accumulate over time. Limits on the property tax in particular cause local governments to shift to other resources and lead to greater dependence on state aid, increasing their vulnerability to budget reductions in recessions.

For cities and counties with vibrant economies and a stable to moderately growing population, the best approach to promoting economic development strategy is to maintain their property tax and utility rates at competitive levels. Tax incentives are no substitute for prudent budget policies that promote responsible financial management practices.

Notes 1 Daphne A. Kenyon, Adam H. Langley, and Bethany P.

Paquin, Rethinking Property Tax Incentives for Business (Cambridge, Mass.: Lincoln Institute of Land Policy, 2012), 29, lincolninst.edu/pubs/dl/2024_1423_ Rethinking%20Property%20Tax%20Incentives%20 for%20Business.pdf.

2 William H. Oakland and William A. Testa, “The Benefit Principle as a Preferred Approach to Taxing Business in the Midwest,” Economic Development Quarterly 14 (May 2000): 154–164.

3 Ronald C. Fisher, State & Local Public Finance, 3rd ed. (Mason, Ohio: Thomson South-Western, 2007), 664–665.

4 Kenyon, Langley, and Paquin, Rethinking Property Tax Incentives, 5.

5 Ibid., 5.

6 Ibid., 37.

7 Gerald A. Carlino, “Three Keys to the City: Resources, Agglomeration Economies, and Sorting,” Business Review (2011): 1–13, philadelphiafed.org/research- and-data/publications/business-review/2011/q3/ brq311_three-keys-to-the-city.pdf.

8 Rachel Weber, Saurav Dev Bhatta, and David Merriman, “Does Tax Increment Financing Raise Urban Industrial Property Values?,” Urban Studies 40 (September 2003): 2001–2021.

9 David F. Merriman, Mark L. Skidmore, and Russ D. Kashian, “Do Tax Increment Finance Districts Stimulate Growth in Real Estate Values?,” Real Estate Economics 39 (2011): 221–250.

10 Richard F. Dye and David F. Merriman, “Tax Increment Financing: A Tool for Economic Development,” Land Lines 18 (2006): 2–7, lincolninst .edu/pubs/1078_Tax-Increment-Financing.

11 Robert W. Wassmer, “Property Tax Abatement as a Means of Promoting State and Local Economic Activity,” in Erosion of the Property Tax Base: Trends, Causes, and Consequences, ed. Nancy Y. Augustine et al. (Cambridge, Mass.: Lincoln Institute of Land Policy, 2009): 237.

12 Kenyon, Langley, and Paquin, Rethinking Property Tax Incentives, 12.

13 Ibid., 8.

14 Gary Sands and Laura A. Reese, Money for Nothing: Industrial Tax Abatements and Economic Development (Lanham, Md.: Lexington Books, 2012).

15 “List of Major League Baseball Stadiums,” MLB.com. 16 “List of Current National Football League

Stadiums,” NFL.com. 17 Americans for the Arts, Local Arts Agency Programs

(2012), artsusa.org/pdf/get_involved/advocacy/ research/2012/localartsagencies12.pdf.

18 Geoffrey Propheter, “Are Basketball Arenas Catalysts of Economic Development?,” Journal of Urban Affairs 34 (2012): 441–459; Andrew Zimbalist, May the Best Team Win: Baseball Economics and Public Policy (Washington, D.C.: Brookings Institution Press: 2003); David Swindell and Mark S. Rosentraub, “Who Benefits from the Presence of Professional Sports Teams? The Implications for Public Funding of Stadiums and Arenas,” Public Administration Review 58 (January/February 1998): 11–20; Judith Grant Long, Public/Private Partnerships for Major League Sports Facilities (New York: Routledge, 2013).

19 Swindell and Rosentraub, “Who Benefits from the Presence of Professional Sports Teams?,” 16.

20 Charles A. Santo, “Beyond the Economic Catalyst Debate: Can Public Consumption Benefits Justify a Municipal Stadium Investment?,” Journal of Urban Affairs 29 (2007): 455–479.

21 Zimbalist, May the Best Team Win, 125. 22 See, e.g., Gerald A. Carlino and N. Edward

Coulson, “Should Cities Be Ready for Some Football? Assessing the Social Benefits of Hosting an NFL Team,” Business Review (2004): 7–17; Santo, “Beyond the Economic Catalyst Debate”; Zimbalist, May the Best Team Win.

23 Zimbalist, May the Best Team Win, 126. 24 Carlino and Coulson, “Should Cities Be Ready for

Some Football?” 25 Skip Krueger, Christopher V. Hawkins, and Robert

W. Walker, “The Cost of Boosterism: Development, Growth Management, and Municipal Bond Ratings,” Municipal Finance Journal 31 (2010): 51–75.

26 Bing Yuan et al., “Tax Expenditure Limits and Their Effects on Local Public Finances” (technical report, The George Washington University, August 30, 2007), 10–11, gwu.edu/~gwipp/lincoln/Yuan_ Cordes_Brunori_Bell.pdf.

27 Ibid. 28 Robert L. Bland and Phanit Laosirirat, “Tax

Limitations to Reduce Municipal Property Taxes:

Strategic Choices: Using Taxes for Economic and Political Purposes 149

Truth in Taxation in Texas,” Journal of Urban Affairs 19 (Spring 1997): 47.

29 Job D. Springer et al., “An Evaluation of Alternative Tax and Expenditure Policies on Kansas Local Governments,” Public Budgeting & Finance 29 (Summer 2009): 48–70.

30 Ibid., 68. 31 Therese J. McGuire and Kim S. Rueben, “The

Colorado Revenue Limit: The Economic Effects of TABOR,” Economic Policy Institute Briefing Paper (March 21, 2006): 2, urban.org/ uploadedpdf/1000940_TABOR.pdf.

32 Suho Bae, Seong-gin Moon, and Changhoon Jung, “Economic Effects of State-Level Tax and Expenditure Limitations,” Public Administration Review 72 (September/October 2012): 649–658.

33 Steven Deller, Judith I. Stallmann, and Lindsay Amiel, “The Impact of State and Local Tax and Expenditure Limitations on State Economic Growth,” Growth and Change 43 (March 2012): 56–84.

34 Mathew D. McCubbins and Ellen Moule, “Making Mountains of Debt out of Molehills: The Pro- Cyclical Implications of Tax and Expenditure Limitations,” National Tax Journal 63 (September 2010): 603–622; Travis St. Clair, “The Effect of Tax and Expenditure Limitations on Revenue Volatility: Evidence from Colorado,” Public Budgeting & Finance 32 (Fall 2012): 61–78.

35 Richard F. Dye, Therese J. McGuire, and Daniel P. McMillen, “Are Property Tax Limitations More Binding over Time?” National Tax Journal 58 (June 2005): 215–225.

150 Strategic Choices: Using Taxes for Economic and Political Purposes

1. The continued constriction of local government budgets has prompted a number of cities around the country to look at their tax expenditures—the exemptions or other tax relief measures provided to businesses, individuals, and nonprofits. What is the justification for exempting nonprofits from paying local property taxes? From paying state and local sales taxes? What are the long-term effects to the property tax base of exempting nonprofits from the property tax? Several local governments have begun demanding payments in lieu of taxes (PILOTs) from large private universities and hospitals. Should all nonprofits be required to pay PILOTs? Why or why not?

2. Another tax expenditure receiving increased scrutiny is tax incentives to businesses. When are tax incentives justified? What are the most common sources of problems (political and economic) that arise from local governments’ use of tax incentives? What measures should public administrators take to minimize the occurrence of these problems?

3. A number of local governments have taken an aggressive approach to the use of tax incentives to promote economic development. Not surprisingly, the use of these incentives has been accompanied by considerable debate among managers, local and state lawmakers, and taxpayers as to their efficacy, especially in rapidly growing regions of the country. a. What effect do tax incentives, such as tax abatements and tax increment financing, have on

equity? On tax neutrality? b. According to the research, what effect do tax incentives have on economic development at

the local level? Under what circumstances should tax incentives be used? c. Briefly summarize the policies and procedures that a local government should have in place

before using tax incentives.

4. All of the following are evidence of intergovernmental tax competition except a. Offering tax incentives to attract business investment b. Locking in voter approval on general obligation bonds before overlapping local governments

have the opportunity to do so c. Tax exportation d. Agglomeration economies e. Tax base sharing.

5. The border-city/border-county/border-state effect a. Occurs in a federal system of government b. Reduces tax neutrality c. Occurs as tax rates vary across jurisdictions d. Adds to the administrative cost of collection and enforcement. e. All of the above. f. All but D.

6. Tax incentives offered by local governments make the most sense a. For commercial and residential development b. For industrial and technology development c. When agglomeration economies are present d. For relatively small jurisdictions in metropolitan areas.

REVIEW QUESTIONS

PART II: PREPARING AND APPROVING THE LOCAL BUDGET

153

c h a p t e r

One cannot speak of “better budgeting” without considering who benefits and who loses

or demonstrating that no one loses.

– Aaron Wildavsky

Budget choices: Principles to guide the manager

No other aspect of public administration has undergone as much reform or been the focus of as much attention from political leaders—from city and county managers to presidents—as the budget. As was noted at the beginning of Chapter 1, the budget document is foremost a tool for maintaining financial accountability, and its preparation has evolved into a forum for establishing strategic goals and perfor- mance expectations.

The quality of budget decisions made and policies formulated, however, depends fundamentally on the quality of information fed into the budgeting process, and that process tends to produce far more information than is used in decision making. Thus, as the chief budget officer for the organization, the chief executive must identify the cen- tral issues to be resolved in the budget process and the essential information needed to resolve them. As Edward Lehan, former finance director for the city of Rochester, New York, observed: “Formats are important. People tend to think about what is put in front of them. Budget classifications tend to define reality for budget makers and reviewers, channeling their attention and thought.”1

A thoughtfully designed and strategically oriented budget process results in more complete and accurate documentation. Not insignificantly, it also reduces resentment toward budget preparation among those department heads who bear the burden of compiling and presenting information. The views debated throughout the budget pro- cess and the interpretation of the data generated from that process shape the allocation of resources. Managers know that this process is the one common thread that links the

7

154 Budget Choices: Principles to Guide the Manager

parts of the organization together and steers them toward common goals. The budget is the rudder for any public organization.

A common misperception is that governmental budgeting is like budgeting in the private sector and so most of the innovations developed in the business sector can be easily transferred to the public arena with the same laudable results. All that is needed to improve government productivity is to import the financial management innovations developed in the private sector. As the accompanying sidebar makes clear, however, this is a false equivalency.

Public sector budgeting versus private sector budgeting As with most administrative practices, budgeting fulfills fundamentally different purposes in the public sector than it does in the private sector. In the private sector, it fulfills a limited internal man- agement function: providing targets for a firm’s sales volume. Often businesses create responsibility centers and charge them with preparing a budget based on both the cost of production and the ex- pected revenue from sales. These center budgets are then compiled into a single document, which becomes a statement of the firm’s sales and profit targets by each month or quarter for the year.

Governmental budgeting, by con- trast, is more than a process of costing out public services and then setting a tax rate. It involves building consensus among citizens on what services govern- ment should provide and at what level of effort; finding compromises among powerful interest groups over their relative share of taxation; and recon- ciling the public will with what leaders in the budget process perceive as the long-term public interest. Governmental budgeting also differs from private sec- tor budgeting because of the nature of services provided (public and merit) and the need to provide them equitably.

Even accounting practices reflect differences in the way the two sectors track and report their financial affairs. Whereas businesses track their financial transactions by treating the organization as a single, unified entity, virtually all governments in the United States use fund accounting, which breaks transac- tions into separate funds, each with its own revenues, expenditures, and finan-

cial reports. Unlike businesses, which have a single bottom line for the whole company, governments must contend with multiple bottom lines, one for each fund.

Rigid and sometimes excessive controls have been compounded at the local level by mandates—requirements from the state and federal governments that specify which services local govern- ments must provide and at what level. Mandates typically contain regulations with which local governments must comply, often at great expense. Some of the requirements reflect the effective- ness of lobbying groups that find it more efficient to deal with a state government than with multiple local governments.

Ultimately, however, comparing public and private sector performance is pointless because the two sectors produce fundamentally different types of goods. Government produces goods for which there is no profit incentive and/or that address political or social concerns for fairness. This greatly complicates the public manager’s task of managing and budgeting. Moreover, unlike the private sector manager, the public manager cannot make budget decisions solely to maximize the organization’s profit; while efficiency is important, it is not the only consideration. And further complicating the public manager’s task is the fact that decision making in government is much more open to outside influence than it is in the private sector. This means that the public budgeting process will be more riddled with conflict, requiring public managers to possess superb negotiating skills if they are to be effective leaders.

Budget Choices: Principles to Guide the Manager 155

A century of budget innovations Budgeting in the twentieth century was characterized by a series of innovations that parallel many of the innovations in management practices. Modern budgeting began in New York City in 1906, when the city’s Bureau of Municipal Research called for all city agencies to use a budget. Since then, what began as an accounting function has become an executive tool for implementing strategic plans and promoting entrepreneurial gov- ernment. Particularly at the local level, the tendency has been to retain those elements of an innovation that work well and to discard those that are less suitable. The result is that local budgeting practices are often layered with elements of various innovations that, much like an archaeological dig, reveal successive stages in budget development.

Budget reforms fall into one of two general categories: (1) innovations designed to improve budget data—that is, the content and presentation of budget information (bud- get focus), and (2) innovations designed to improve the budget process (budget locus) (Figure 7–1).2 In practice, these categories overlap.

In his classic 1966 article, “The Road to PPB: The Stages of Budget Reform,” Allen Schick traced the evolution of the budgeting function from (1) imposing control to (2) improving the management of operations to (3) improving the prioritization of programs.3 With the transformation in budget focus came an increased reliance on more and different kinds of data, particularly data that help top management and lawmakers better connect the impact of their spending decisions to conditions in their community; this has led in turn to changes in the organizational location of the budget function to accommodate new informational needs. Thus, the budget has evolved from being a tool for accounting and financial management to being a tool for strategically and logistically positioning a community to capitalize on historical strengths and emerging opportunities.

Line-item budgeting

The line-item (object-of-expenditure) budget, the format most often associated with budgeting, originated in the late nineteenth century in response to the excesses of the political machines that controlled many state and local governments. This format shifted power away from political bosses to legislative bodies, which were more account- able to voters. It is still the most widely used budget format.

The line-item budget collects and reports information on inputs (resources) used in the production of government goods and services (Figure 7–2). It lists the goods or services to be purchased—labor, supplies, utilities, capital items, and miscellaneous. Its

Budget locus Accounting Finance

Independent budget office

Chief executive’s office

Budget focus

• Line-item budgeting

• Zero-base budgeting

• Target-base budgeting

• Performance budgeting

• Management by objectives

• Program budgeting

• Entrepreneurial budgeting

• Balanced scorecard

• Budgeting for outcomes

Figure 7–1 The evolving locus and focus of budgeting

156 Budget Choices: Principles to Guide the Manager

focus is the objects of expenditure allowed for each department or agency; once the council appropriates the funds (i.e., approves the proposed budget), department heads can acquire the objects authorized in the line-item budget. The locus of budgeting is the accounting office, where the detailed line-item information is collected and made readily available.

It is clear why a line-item budget format is associated with a control-oriented budget process: the line items correspond to the accounts in the accounting system and make it easy for budget overseers to compare budgeted amounts with actual levels of spending. The more detailed the objects of expenditure, the greater the governing body’s control over administrative agencies.

Zero-base budgeting In response to pressure to limit government spending, zero-base budgeting (ZBB) emerged in the 1970s as an adaptation of the line-item

Figure 7–2 FY 2013 operating budget, Syracuse, New York

Source: Budget for the City of Syracuse for the Period of July 1, 2012–June 30, 2013, 139, syracuse.ny.us/ uploadedFiles/Departments/Budget/Content/Budget_Documents/Final%20%202012-13%20Budget.pdf.

Budget Choices: Principles to Guide the Manager 157

budget. Initially developed in the private sector by Texas Instruments, ZBB quickly spread to local and state governments. Much of its popularity was due to the fact that it relies on existing accounting information and is simple to understand and implement. Although many local governments had moved budgeting out of the accounting department by the 1970s, ZBB reasserted the value of accounting information to budget deliberations.

ZBB focuses on budget inputs (i.e., the resources used by local governments to produce goods and services), organizing them into decision packages that reflect various levels of effort and cost. In theory, each department (or decision unit, which is the lowest level in the organization at which budgetary decisions are made) prepares at least three packages: a base-level package, which meets only the most basic service needs (hence, the term zero base); a current services package, which ensures delivery of services at the current level; and an enhanced package, which allows the decision unit to extend its services to currently unmet needs. Decision units can prepare more than one enhanced package, each representing a different level of expanded effort. Packages from all the decision units are then ranked according to the perceived need for the package; rankings are based on the subjective judgment of decision makers, who annually evalu- ate each program’s purpose and priority, weighing the program against all other spend- ing possibilities.

As a consequence of this evaluation, decision makers may decide not to renew fund- ing for an existing program, choosing instead to fund an enhanced spending package for another decision unit or even to provide base-level funding for an entirely new initiative. In fact, however, such reallocation rarely occurs.4 Chief executives quickly found that department heads were unwilling to provide them with estimates of the base package because, as the department heads argued, the estimates were already at the minimum level and any further reductions would make it difficult to continue provid- ing service. Thus, the base-level (or minimum) package has all but disappeared from the scene. But vestiges of ZBB still persist in many local governments, particularly in the use of enhancement packages, which receive separate and more thorough scrutiny from top administrators and lawmakers.

Target-base budgeting Target-base budgeting (TBB), which entered the pic- ture in the 1980s, reversed the trend toward increasingly complex budget innovations. It was intended to simplify budget preparation, mitigate interdepartmental conflict, and reduce gamesmanship in the preparation of budget requests. Under the simplest form of TBB, the budget office gives each department a maximum dollar figure for its budget request,5 basing its targets for each department on revenue estimates for the coming fiscal year and on any changes in policy makers’ priorities (e.g., more for public safety, less for park maintenance).

The more complex part of TBB involves estimating each department’s current ser- vices budget, which is defined according to rules that are sometimes rather elaborate. Generally, the current services budget is the department’s appropriation for the current year unless it happens to contain funding for one-time purchases or for a position that was filled well into the fiscal year. Once the current services budget is established, the target is typically set at some percentage of that level—for example, 95 percent if the program has a lower priority in the current year or 105 percent if it has a higher priority. Although TBB includes some elements of ZBB, it greatly reduces the level of conflict and the role of subjective judgment found in ZBB: departments know from the outset what their likely level of funding will be for the coming year.

158 Budget Choices: Principles to Guide the Manager

Performance budgeting While line-item budgets are effective at controlling expenditures, they provide no in- formation on outputs (how much work gets accomplished) or level of efficiency (how much input is required to produce each unit of output). Local governments had already begun experimenting with performance budgeting in the 1950s, when the approach gained popularity after the second Hoover Commission issued a report that recom- mended collecting and reporting output measures in the federal budget as a tool for controlling costs.6 They began to use performance measures to monitor the use of funds and to identify ways to improve productivity and the management of public programs.

In the 1990s, performance budgeting experienced a resurgence in interest as a result of the national performance review undertaken by the Clinton administration. In both its original and more recent incarnation, performance budgeting is designed to improve program efficiency, evaluate the outcomes of program operations, and provide decision makers and the public with better information on what they are getting for their tax dollars. Budgets not only report information at the line-item level but also indicate what is to be accomplished with those funds.

Budgeting has thus become a financial management tool (Figure 7–1), and local governments increasingly locate the budget function where they can ensure that the necessary information on performance and outcomes (actual results achieved) is being provided in a form appropriate to the organization’s needs. The trend has been to move budgeting out of the accounting area and align it with other finance functions that share a broader management focus.

Management by objectives (MBO), an innovation of the legendary management scholar Peter Drucker, had a short-lived courtship with budgeting in the 1960s and early 1970s. MBO is a top-down process: each level in the organization develops perfor- mance objectives for the coming year. Employees negotiate a performance agreement with their supervisors, which becomes the basis for evaluating the employee’s year-end job performance. The intent is for all employees to have a clear understanding of both the organization’s priorities for the fiscal year and its expectations for their individual contributions to meeting those priorities. MBO is more of a personnel management tool than a budgeting tool, but the budget process provided a suitable forum for negoti- ating the performance agreements.

Program budgeting Performance budgets focus attention on outputs, but they do not address more funda- mental policy questions, such as whether a program is necessary at all or how best to allocate limited resources among competing purposes. The quest to add a policy focus to budgeting gained momentum in the 1960s with the introduction of planning, programming, budgeting systems (PPBS), or program budgeting for short.

Program budgeting organizes government activities into programs—activities or ser- vices with a common goal—and identifies alternatives for achieving each goal, determines the costs and benefits of each alternative, and selects the alternative that maximizes net benefits. In short, it seeks to interject policy analysis into fundamental budgetary deci- sion making—that is, to determine how much to allocate to activity A as opposed to activity B.7

To accommodate this new analytical focus, the budgeting function grew independent of accounting and even of finance, and the independent budget office emerged, reporting directly to the city or county manager or to an assistant manager over administrative services. The newfound autonomy of the budgeting function opened up opportunities

Budget Choices: Principles to Guide the Manager 159

for more independent analysis to guide budget deliberations. The merger of budgeting with management was now complete organizationally (locus) and functionally (focus).

While a few local governments continue to build their budgets using the program format, most have abandoned that format, at least as it was originally designed. Like other budget reforms, program budgeting has morphed into other approaches, one of which is total quality management (TQM).

Entrepreneurial budgeting

As strategic planning gained widespread acceptance among local governments as an ef- fective tool for harnessing and channeling the energy of their organizations as well as for containing their growing costs, managers began to cast about for ways to use the process to prioritize programs and reallocate funds to those priorities. Attention quickly turned to the budget process as the vehicle for merging strategic planning with the indicators of demand provided by a competitive market. The cutting edge in budget innovation over the past decade has been the attempt to transform local governments into entrepreneur- ial enterprises (Figure 7–1); this effort has introduced competition into the process for setting spending priorities—an area where a competitive market does not exist. At the same time, governments have added a community value perspective to budgeting: how do spending proposals achieve the strategic priorities of the city or county to the satis- faction of customers? (Note the transition of residents from “citizens” to “customers of government services.”) Given the new information and management needs, some budget personnel are now finding their duties mingled with those of the chief executive’s office.

Two different approaches to entrepreneurial budgeting have gained attention in the past few years: the balanced scorecard and budgeting for outcomes. Although the two methods are very different, they both introduce a kind of competition into budgeting and management.

Balanced scorecard Robert Kaplan and David Norton, two Harvard management experts, developed the balanced scorecard as a tool for translating an organization’s mission into a series of action plans that link together financing, customer satisfaction, internal operations, and the learning and growth of employees.8

In a fully operational balanced scorecard approach, a local government begins by developing a mission statement that clearly articulates the organization’s purpose and values. Then it carefully assesses the expectations and needs of its customers (citizens and businesses, presumably) and develops a strategic plan (goals, objectives, and strategies), while the administrator prepares a budget that allocates funds to the strategic priori- ties. In accordance with its mission and strategic plan, the local government leadership develops ten to fifteen key measures of success that the organization will pursue, and each department develops performance measures that show how it will contribute to the expected outcomes.

Since the balanced scorecard was designed for private business, customer satisfaction is a key indicator of success. To fully develop the scorecard concept, a local government must know how a change in performance—for example, the fire service reducing its average response time to top-priority fire alarms by ten seconds—will affect citizen satisfaction. The organization is expected to learn from its experiences and improve its internal processes in order to achieve its key measures of success. One local government that has implemented the balanced scorecard is Charlotte, North Carolina, and Fig- ure 7–3 is an excerpt from the city’s balanced scorecard report for two of its corporate objectives.

160 Budget Choices: Principles to Guide the Manager

Budgeting for outcomes Budgeting for outcomes, also called priority-based budgeting,9 is a relatively recent adaptation of several previous budget reforms. The goal is to provide better information that helps council members make better decisions, provide better procedures to increase the accountability of local governments to their citizens, and thereby increase the efficiency and effectiveness of government. Budgeting for outcomes relies on competition among city departments as well as with businesses and nonprofits outside government to bid on the provision of city services.

Budgeting for outcomes begins with the council articulating the community-wide outcomes, or priorities, that it wants to focus on in the coming year.10 The city council of Fort Collins, Colorado, for example, developed seven such outcomes to which all budget requests are anchored: improve economic health; improve environmental health; improve neighborhood quality; improve community safety; improve cultural, recreational, and educational opportunities; improve transportation; and create a high-performing entrepreneurial city government.11

The next step involves determining the “price of city government.” This is the percentage of personal income in the city that should go to pay for city services. In

Appendix C- CRC-Balanced Scorecard Report Reporting Period: July 1, 2010 to November 30, 2010

Corporate Objective KBU Initiative

(* indicates Focus Area Initiative)

Measure Prior Year

Actual

Lead or

Lag

Performance Data Comments/Explanation

(To be completed at mid-year and year-end reporting))

Target YTD Status $

* in KBU initiative column indicates Focus Area initiative

Se rv

e th

e C

us to

m er

C1. Strengthen Neighborhoods

Investigate housing discrimination

Number of fair housing cases investigated.

Percentage of new fair housing cases closed

within 100 days

48

52%

Lag

Lead

50

65% - 100 days

18

69%

Prevent housing discrimination

Number of fair housing trainings

Number of persons educated on fair

housing practices and protections

52

906

Lead

Lag

50

800

19

249

R un

th e

B us

in es

s

B1. Develop Collaborative Solutions

Increase service capacity through leveraged city tax

dollars

Increase service capacity through leveraged city tax

dollars

Number of volunteer hours

(CRC members and volunteer mediators)

1697.5 Lag 2000 849

Number of dollars saved through

volunteer’s service ($20.85)

34,374 Lag 35,000 $17,701.65

Amount of public & private revenue

secured

221,291 Lead 200,000 $

Total taxpayer dollars saved (CJS + Volunteers)

208,974 Lag 210,000 $100,101.65

Figure 7–3 Excerpt from the balanced scorecard report of Charlotte, North Carolina

Source: City of Charlotte, North Carolina, “Balanced Scorecard,” charmeck.org/city/charlotte/CRC/Scorecard%20 Updates/11_2010_Nov.pdf.

Budget Choices: Principles to Guide the Manager 161

Fort Collins, the city collects about 5 percent of residents’ personal income in taxes and charges to support city operations. The council tries to hold that percentage constant over time. Revenue projections for the biennium are prepared, and that revenue target becomes the spending limit for the budget period. The projected funding is then allo- cated to the seven outcomes based on the council’s priorities.

At this point in the process, city departments and, where relevant, businesses outside the city government prepare bids or requests for results (RFRs) to meet the council’s prior- ities and deliver the targeted results. Most spending requests in a city’s budget have to be part of a bid offer, and each offer has to include quantifiable measures of the results to be delivered. Much like the decision packages in ZBB, RFRs form the city’s budget building blocks. Department and program managers are recast as “sellers” in this budget construct.

Bidders compete with each other on the basis of their RFRs. They may also form partnerships with other units, inside or outside government, to prepare an RFR for a particular service need. If a bidder does not cost out its RFR accurately, it may not meet its performance requirements. The RFRs are then ranked by the budget office and manager, and the manager uses them to prepare a budget for submission to the council based on the revenue target established at the outset. Those proposals above the revenue target cutoff line receive funding; those below the line do not—a process analogous to ZBB’s ranking of decision packages.

Budgeting in the twenty-first century represents a rich blend of all these innovations. Especially at the local level, where budget format and process are substantially shaped by the chief executive’s management philosophy, the budget is likely to contain some combination of line items, performance measures, and even enhancement packages for new spending initiatives, and departments are likely to be given target funding levels at the outset of budget preparation.

Discovering budget linkages Budgeting involves converting data and information on community needs and wishes into an action plan with resources. Economically, the budget process converts the factors of production—labor and capital (money, fixed assets, technology)—into goods and services. The process of preparing a budget is about discovering the linkages between budget inputs and outcomes. For example,

• Does an increase in police officers reduce crime and make our city safer?

• How will a reduction in park or recreational services affect the livability of our community?

• Does an increase in the number of code enforcement officers improve property values?

• Will a mosquito spraying program reduce the incidence of West Nile virus?

Divining the link between budget inputs and the impact on the community is the key budget problem that leaders at all levels of government must wrestle with as they sort out various spending requests.

Inputs, outputs, and outcomes The “probable linkages” in a particular city, town, or county are determined by the community’s unique mix of economic, social, political, cultural, and historical events. For example, changes in spending for law enforcement have an impact on outcomes (response times, crime rates, recovery of stolen property rates), but that impact will be unique for every city or county. Through the budget process, community leaders learn what works effectively in their communities and what does not.

162 Budget Choices: Principles to Guide the Manager

The budget process is not only about understanding the linkage between inputs and outcomes, but also about reducing unintended effects. Every budget decision has unintended consequences, and budget deliberations help community leaders ferret out a better, albeit still imperfect, understanding of both the intended and unintended conse- quences of their choices. It is through this learning process and the conflict inherent in budget deliberations that budget data are converted into budget decisions.

The true cause-and-effect links between spending and outcomes—budget “truth”— are never known with certainty. As leaders, public administrators and elected officials make informed decisions about what will work. But they don’t really know; nor does anyone else. It is, as characterized by Charles Lindblom more than fifty years ago, man- agement by “muddling through.”12 Good leaders continuously search for more data and better interpretations of those data. They intuitively know that the better the informa- tion, the better the decisions that will follow.

The role of the budget analyst In this context, the budget process is the public sector’s commodity exchange, and budget analysts are its commodity brokers. But their brokerage skills entail providing an independent assessment of the linkage between proposed appropriations and antici- pated results. Governments (and in many cases nonprofit boards) use the budget process to sort out their collective values, determine the quantity of services to produce, and set prices for those services. Rather than being traded in a few centralized commodity exchanges in the financial centers of America, public-produced commodities are val- ued, priced, and authorized in thousands of decentralized exchanges in cities, counties, special districts, and states across the nation. The cumulative impact of these annual or biennial budget processes determines the mix of services produced by government.

As brokers, budget analysts and those responsible for overall budget preparation collect data, interpret it, and compile it into the budget document that becomes the focus of legislative deliberations. Unfortunately, the budget analyst works in a world of incomplete information. First, as noted above, the organizational locus of the budget office shapes the focus of subsequent deliberations. A budget prepared by an accounting office will have a much different focus than one prepared by the strategic management division in the city manager’s office. Each locus has its preferences for the type of data collected, analyzed, and reported.

Second, while department heads grapple with converting budget inputs—labor and capital—into outputs, it is the budget office and ultimately the chief executive who must reconcile inputs and outputs with outcomes. The budget analyst must formulate answers using limited data and an imperfect knowledge of the causal linkages among inputs and outputs and the more critical inputs and outcomes. These are the relation- ships that command the attention of legislators, the media, and community activists. Will a household hazardous-waste collection program reduce illicit dumping and encourage conservation? More fundamentally, will such a program significantly help protect the environment? Is the cost of such a program worth the benefits? And what will be the unintended consequences? A manager who is successful at helping the community dis- cover its budget linkages will be more successful in his or her professional career.

Third, the analyst works in a world where discovering comparable standards of per- formance has been difficult. Budgets report a manager’s best guess as to the optimal mix of labor and capital at a particular time. Because each community has a unique production function—the combination of inputs that gives rise to outputs—comparing performance across jurisdictions becomes problematic. The spatial location of fire stations, building

Budget Choices: Principles to Guide the Manager 163

density, and age of vehicles can readily explain why a fire department has a slower (or faster) response time than its neighbor across the river. Budget innovations are import- ant if for no other reason than trying to acquire better data and subjecting it to more exhaustive analysis.

Budgeting is, in essence, social science inquiry.

Lessons for budgeting Several implications for budget theory and practice emanate from this discussion:

• The quality of the data and information coming into the budget dialogue is critical to the successful discovery of a community’s budget linkages. The manager performs a pivotal role in authenticating information and providing budget participants with credible sources.

• The fewer the resources available to a community, the less room the community has for error in discovering budget linkages.

• Comparisons of performance across cities and counties are fraught with problems. The uniqueness of every community makes it improbable that the link between inputs and outputs or between inputs and outcomes will be the same for any two communi- ties. The most defensible comparison is historical trends within a city or county.

• The search for the linkage among inputs, outputs, and outcomes is iterative and unending. As communities age, the relationships among the three factors also change. Budgets reflect a community leadership’s best guess as to what those relationships are at a particular point in time.

• While businesses can measure with some degree of accuracy their production func- tion (the relationship between labor and capital and their profitability), the complex interaction among public services suggests that local governments face a greater challenge when measuring their performance.

The budget office For the most part, budget offices provide accurate, timely, and comprehensive budget analyses. Where those analyses fail to accurately or fully anticipate the costs, benefits, or collateral effects of a proposal, it is usually because of poor or incomplete data, insuffi- cient time, a lack of expertise, or a lack of knowledge about the causal linkages among the inputs, expected outputs, and the desired outcomes. In those relatively rare instances where the failure is the result of human error, the cause is often traceable to under- staffing or to insufficient training and investment in technical support for analysts. And, of course, political spinning may alter budget estimates or at least foster a tendency to cherry-pick those estimates that most closely align with an advocate’s political agenda, creating the potential for good analyses to be misrepresented.

Budget accuracy also suffers because of the unpredictability of economic cycles. Accurately forecasting the turning points of a recession, not to mention the recession’s depth or length, is nearly impossible. Forecasting the yields for the more elastic revenue sources—income and consumption taxes—is particularly problematic for analysts. And each local and state economy reacts differently to economic cycles.

Seeking truth in budgeting

In the 1960s, the Advisory Commission on Intergovernmental Relations promoted a reform dubbed “truth-in-taxation,” which was designed to make the property tax more

164 Budget Choices: Principles to Guide the Manager

transparent and accountable to taxpayers. Although imperfect, the idea behind truth-in- taxation was laudable, and the policy is used today in various forms by thirteen states. It may now be time for governments to embrace truth in budgeting: an organizational culture that ensures that the budget office is a dependable and credible source of analyses.

What measures can managers take to pursue an organizational culture that promotes truth in budgeting? First, the budget office must be protected from political influence. While it is naïve to expect complete insulation, there must be a clear boundary around the budget office to ensure that its analyses are completed independent of any political agenda. Man-

Budget lessons from recessions Financial crises, such as the Great Reces- sion of 2007–09, drive home the lesson that recessions have widely varying effects on state and local budgets. The collateral damage of a recession, like that of an earthquake, reverberates long after the initial shock wave. And aftershocks con- tinue for many months thereafter, striking unsuspecting communities and states. Our lack of knowledge about budget causality makes it nearly impossible to gauge with precision the impact of a re- cession on any one government’s budget. But local governments do control their budget processes, and they can adopt recession-resistant policies that mitigate the financial impact of recessions.

The 2007–09 recession exposed the disconnect between the political forces calling for more and better government services and the political will to finance those services over the long term. Budget analysts provide the key to reconciling these two opposing forces by bringing truth to budgeting estimates. What are the long-term costs of the proposed new program or service? Will the long-term revenue base provide sufficient resources to meet this new commitment? Do the benefits of the new service outweigh the costs? Truth in budgeting means providing public officials and citizens with the full budgetary impact of a proposal and the revenue requirements needed to support it over the long term. It means accurately assessing the impact of the proposal on the current operating and capital budgets and knowing up front what revenues will be needed to support the initiative in prosperous as well as less prosperous times.

Because recessions make state and federal aid highly vulnerable to reduc- tion or elimination, they expose the peril of depending on that aid to balance local budgets. Those local governments most dependent on state and federal aid are also the most vulnerable to its elimination. State revenue structures are not capable of financing both state and local operations.

Recessions reveal that delaying difficult budget decisions only narrows the options available in subsequent years and elevates the magnitude of the adjustments needed to bring about budgetary balance. In the absence of credible analyses and a commitment to truth in budgeting, it becomes politi- cally expedient to defer making difficult spending and taxing decisions and leave them to the next administration. The 2007–09 recession shortened the time line and elevated the urgency to resolve political impasses involving past budget decisions on issues such as federal and state entitlements, unfunded pension li- abilities, and programs that have fulfilled their mission.

Democracies depend on making quality information available to citizens. The key to better financial decision making is better analyses up front of the short- and long-term budgetary effects of new or expanded initiatives. It means investing in analysts who can provide rig- orous analyses of the budgetary effects of proposals and promoting an organi- zational culture that advocates for truth in budgeting. It means pursuing budget policies and procedures that make local budgets more recession resistant.

Budget Choices: Principles to Guide the Manager 165

agers will likely be uneasy about giving the budget office too much independence because of its central role in managing operations. One possibility is to create a quasi-independent research unit made up of analysts drawn from inside and outside the organization.

Second, progress has been made in evaluating and rating budget information and documentation. A next step may be to evaluate the quality of work performed by bud- get offices, particularly their analyses of policy and administrative issues. Just as criteria have been developed to evaluate budget documentation, criteria would be needed to guide external evaluators of budget analyses.

The key to good budgeting is recruiting good people and providing them with the technology to support their work. Qualified analysts bring an array of analytical and intuitive skills to their tasks, and they must have access to the data and the methodolo- gies needed to accomplish those tasks.

Finally, every local economy is unique, and the mix of revenues and expenditures responds differently to economic cycles. With experience, the budget office accrues institutional expertise in understanding the interaction among the economic factors that influence its budget and is better able to predict how its budget will respond to eco- nomic cycles. That experience must be nurtured and rewarded if the organization is to achieve a reputation for accurate and thorough analyses.

Organizing the budget office

When budgeting first became an accepted financial management tool of government in the late nineteenth century, it typically entailed a clerk in the accounting department who was responsible for preparing a list of expenditures by department; this list was pre- sented directly to the legislature for review and approval. Budget preparation involved tabulating requests and required only a few weeks of attention. As has been described, however, the role of budgeting has since expanded, and responsibility for it has shifted from a subunit in accounting and finance to, in some cases, an independent executive- level agency with a budget director reporting to the chief executive. At the same time, the focus of the budget process has expanded as well—from controlling spending (e.g., by means of a line-item budget) to implementing the strategic plan.

Location, values, and functions The most fundamental issue for the manager is the organizational placement of the budget function. Once again, locus shapes focus, and the budget office’s locus has undergone considerable transformation over the past cen- tury. Figure 7–4 shows the different organizational placements commonly used by local governments today; each has its merits and advocates.

A budget office located in an accounting or finance department focuses on financial controls, reporting, and line-item expenditures; its core values are controlled spending and financial accountability for the use of funds. In smaller local governments, budget- ing responsibility may be assigned to an accountant who, for most of the year, records and reconciles transactions, and for the rest of the time prepares the budget, including a revenue forecast.

An alternative model, more often found in mid-sized cities and counties, places the budget office in an administrative services department that brings together a number of other support services, such as purchasing, risk management, tax administration, finance, and information technology. In this organizational scenario, the budget office is a unit on a par with finance, internal auditing, and other finance-related activities. The core value is now productivity improvement: budgeting is seen as an opportunity to improve management performance by optimizing outputs relative to inputs.

166 Budget Choices: Principles to Guide the Manager

A variation on the administrative services model is the independent budget depart- ment, whose head reports to the city or county manager or assistant manager. As an independent unit, the budget office has the most latitude to shape its agenda and can add responsiveness to community priorities as a core value along with productivity improvement. Its budget analysts assume a wider range of duties: measuring and mon- itoring program performance, assessing citizen preferences and satisfaction with public services, determining community needs and their relative priority, and finding ways to better link program and agency goals to addressing those needs.

Some governments opt to locate the budget office in the chief executive’s office. (A quick way to assess a chief executive’s priorities is to examine an organizational chart to see what activities report directly to the city or county manager.) In this setup, it is quite common to find the budget office’s focus on big-picture issues of strategic planning, mission, and vision. Budget analysts may be more directly involved in policy analysis, particularly in those areas that hold political importance for the governing board. Not surprisingly, the budget function in this environment will have a more political focus than it would in a unit located further down in the organization.

In a few rare cases, primary responsibility for budget preparation lies with an elected council or board rather than with the manager; in such cases, a comptroller may assist in preparing the proposed budget. A few governments, most notably at the state level, rely on a legislature-initiated rather than an executive-initiated budget proposal and have a separate legislative budget office with its own analysts.13 Where dual budget offices exist— one that assists the executive and the other, the legislature—they usually work closely with each other, at least through the budget preparation phase. However, the norm in the United States is for a single budget office that is located in the executive branch.

Organizational location

Accounting department

Finance department

Administrative services

department Budgeting

department Chief executive’s

office

Supervisor

Budgeting office

Chief executive’s office

Director of administration or assistant city manager

City manager or deputy city manager

City manager

Core values

Controlled spending

Financial accountability

Productivity improvement

Program evaluation and responsiveness

Policy development

Focus

Revenue forecast

Budget preparation

Budget compliance

Long-range forecasting

Interim budget reports and projections

Financial impact analysis

Cost of services

Performance measures

Performance monitoring and reporting

Policy research

Improved organization

Citizen satisfaction

Community needs

Program goals and effectiveness

Strategic planning

Policy analysis

Figure 7–4 Impact of budget location on core values and focus

Budget Choices: Principles to Guide the Manager 167

The focus of the budget office depends not only on the location of the office but also, to some extent, on the size of its staff. Where the budget office consists of just one person, it usually does not carry out any functions other than budgeting—not even finance functions, such as accounting, treasury, purchasing, or internal auditing. If it employs several analysts, it may include some program and performance evalua- tion functions. In larger governments, the budget office typically employs a larger staff, many of whom hold graduate degrees in public administration. Each staff member may specialize in a particular area of the budgeting process—for example, long-term financial forecasting, revenue estimation, grants administration, or capital planning and budgeting.

Larger governments also have budget analysts to help provide objective assessments of departmental performance and capabilities; these analysts advise departments on policy issues, review their requests for the next budget period, and help them tighten their spending requests. A particular budget analyst may be responsible for several depart- ments. In larger governments, the departments will also have their own budget special- ists, who represent the department head on budget matters and who interact closely with their assigned analyst in the budget office.

Principal duties Regardless of its location or size, the budget office has traditionally collected spending requests from departments and, with the advice of the chief execu- tive, trimmed those requests to meet expected revenue levels. Even though the focus of the budget office has expanded over the years, its main duties remain constant: estimat- ing revenues, preparing a budget calendar, reviewing and compiling budget requests into a proposal, ensuring that total requests do not exceed estimated revenues, monitoring compliance with the budget during implementation, and periodically preparing a status report comparing actual revenues and expenditures with what was budgeted.

In carrying out these duties, the budget office typically assumes a number of roles: it educates participants about the budget process, adjudicates among participants both within and outside government, manages data processing, promotes accuracy and integ- rity in budget requests, provides information to budget participants, and reports on how well the approved budget plan is being followed.

When the primary function of the budget office is monitoring departmental budget requests, conflict between it and the various departments is inevitable: departments advocate for more resources, but as guardian of the treasury, the budget office scans budget requests for waste and excess. In the past, the budget office’s denial of requests prompted department heads to devise strategies—padding the budget, making partial- year requests, seeking a state mandate or regulatory requirement—in order to outma- neuver the budget office and ensure that their departments got the resources needed to meet the expectations of the community, its elected representatives, and the chief executive. This budget gamesmanship created an adversarial relationship between budget analysts and department heads.

To reduce this conflict, administrators introduced TBB and variations of ZBB to let department heads know up front the boundaries of their budget requests. At the begin- ning of the budget cycle, the budget office gives each department a target that its pro- posed budget cannot exceed. New initiatives that exceed the target may be proposed as separate requests for the budget office to consider on a case-by-case basis. TBB enables the budget office to limit total budget requests to expected revenue levels while giving department heads an opportunity to make a case for extraordinary needs.

The budget office of the twenty-first century seeks a collaborative relationship with departments that promotes and models good management throughout the organization.

168 Budget Choices: Principles to Guide the Manager

A clearer division of labor has lessened antagonism, and the budget office provides tech- nical expertise to departments on such matters as strategic planning, developing perfor- mance measures, analyzing policy choices, and even identifying entrepreneurial options for raising needed revenue.

The budget cycle The system of checks and balances between the executive and legislative branches of government that has emerged in most Western democracies is evident in the four phases of the budget process (Figure 7–5). The seesaw relationship begins with the executive proposing expenditures and the legislative branch then empowering the executive to enter into financial commitments; it culminates with the council verifying the execu- tive’s compliance with its wishes. The four-phased cycle—characterized by the acronym PLEA—is nearly universal among state and local governments regardless of size or the organizational location of the budget function:

1. Preparation. A proposed spending and operational plan for the coming budget period is drafted, usually under the guidance of the manager or elected chief executive.

2. Legislative approval. The council or governing board approves the spending plan through an appropriation act.

3. Executive implementation. The executive branch implements the approved spend- ing plan by approving contracts, purchase orders, and other agreements that legally commit the government to the disbursement of funds once goods and services are delivered.

4. Accounting and auditing. All transactions, both expenditures and revenues, are tracked, tallied continually, and summarized into financial reports. At the end of the fiscal year, a CAFR of all city activities is prepared and audited for accuracy.

The next three chapters discuss the elements of these four phases in detail; prepa- ration and legislative approval, which occur in tandem, are topic of discussion in the Chapter 8. Chapter 9 then turns to the third phase of the budget cycle, executive imple- mentation, and Chapter 10 examines the final phase, accounting and auditing.

Phase Product Key participants Time frame

Preparation Executive's proposed budget

Budget director; chief executive, department heads

3 to 6 months before FY begins

Legislative adoption Appropriation act Council; governing board 2 to 3 months before FY begins

Executive implementation

Encumbrance and disbursement of funds

Department heads; budget office

The fiscal year (12 months)

Accounting and auditing

Comprehensive annual financial report

Accounting office; comptroller

Fiscal year plus 3 to 6 months after year ends to complete audit

Figure 7–5 Phases of the budget cycle

Budget Choices: Principles to Guide the Manager 169

Conclusion Elected leaders, often those newly elected to public office, incur considerable frustra- tion as they try to remake governmental budgeting to look more like the processes and methods used by businesses. In a representative democracy, governmental budgeting performs the essential social functions of building consensus among citizens on what services government should provide and at what level of effort; formulating compromises among powerful interest groups; and reconciling the public will with what leaders in the budget process perceive as the long-term public interest.

Since 1906, when New York City’s Bureau of Municipal Research required all city agencies to use a budget, innovations have changed both the focus and locus of budget- ing. Line-item budgeting remains the focus of municipal budgeting, and the accounting unit remains the primary locus of budget decisions. However, as the focus of the budget has expanded to include performance measures, policy analysis, and even entrepreneur- ial approaches, the budget has increasingly become the responsibility of an independent department that reports directly to the manager, or of a unit in the manager’s office that brings together strategic planning and performance monitoring.

One of the most important decisions that a manager can make is the placement of the budget function within the organization. That decision shapes the core values that will guide the unit as well as the way in which the unit defines and carries out its duties. The budget function has become the locus of arbitration between the government and those it serves.

The budget cycle consists of four distinct phases that involve an interplay of checks and balances between the executive and legislative branches: preparation, legislative approval, executive implementation, and accounting and auditing. The next three chap- ters examine these phases in greater detail.

Notes 1 Edward Anthony Lehan, Simplified Governmental

Budgeting (Chicago: Government Finance Officers Association [GFOA], 1981), 2.

2 The use of locus and focus in local government budgeting is adapted from Nicholas Henry, who used the dichotomy to trace the development of the study of public administration through five successive paradigms; see Nicholas Henry, Public Administration and Public Affairs, 8th ed. (Upper Saddle River, N.J.: Prentice Hall, 2001), 27.

3 Allen Schick, “The Road to PPB: The Stages of Budget Reform,” Public Administration Review 26 (December 1966): 245-256.

4 Thomas P. Lauth, “Zero-Base Budgeting in Georgia State Government: Myth and Reality,” Public Administration Review 38 (September-October 1978): 420–430.

5 Irene S. Rubin, “Budgeting for Our Times: Target Base Budgeting,” Public Budgeting & Finance 11 (Fall 1991): 5–14.

6 Geert Bouckaert, “The History of the Productivity Movement,” Public Productivity & Management Review 14 (Fall 1990): 53–89.

7 Verne B. Lewis, “Toward a Theory of Budgeting,” Public Administration Review 12 (Winter 1952): 42–54.

8 Robert S. Kaplan and David Norton, The Balanced Scorecard: Translating Strategy into Action (Cambridge, Mass.: Harvard Business School Publishing, 1996).

9 Shayne C. Kavanagh, Jon Johnson, and Chris Fabian, Anatomy of a Priority-Driven Budget Process (Chicago: GFOA, March 2011).

10 Michael J. Mucha, “Budgeting for Outcomes, Key Findings from GFOA Research,” Government Finance Review 28 (October 2012); Eva Elmer and Christopher Morrill, “Budgeting for Outcomes in Savannah,” Government Finance Review 26 (April 2010).

11 City of Fort Collins, Colorado, “Budgeting for Outcomes,” fcgov.com/bfo/index.php.

12 Charles E. Lindblom, “The Science of ‘Muddling Through,’” Public Administration Review 19 (Spring 1959): 79–88.

13 Corina L. Eckl, Legislative Authority over the Enacted Budget (Denver, Colo.: National Conference of State Legislatures, July 1992).

170 Budget Choices: Principles to Guide the Manager

1. In what ways does budgeting in the public sector differ from budgeting in business? Discuss the implications of these differences for the argument that “government can’t be run like a business.”

2. This chapter has discussed the search for budget linkages—an understanding of the relationship among inputs, outputs, and outcomes. Using the evolution of budget innovations, discuss the linkages that each of the following innovations seeks to understand. The first one is done as an example. a. Line-item budget: Links proposed with actual spending; enables comparisons of relative bud-

get shares over time by departments and programs. b. Zero-base budget c. Target-base budget d. Performance budget e. Program budget f. Balanced scorecard g. Budgeting for outcomes

3. Discuss how you would organize the budget process (both operating and capital) if you were chief executive of a public or nonprofit organization. Include in your discussion how you would (1) organize the budget office, (2) involve the public (or stakeholders) in budget deliberations, (3) integrate performance measures into budget deliberations, and (4) involve your governing board in the budget process—and when. Be specific.

4. Budget processes reflect the political values of their times. The current emphasis on entrepreneurial budgeting—budgeting for outcomes, balanced scorecard—epitomizes that relationship. In an essay, discuss a. The current political values that are shaping the budget process b. The pros and cons of using an entrepreneurial approach to budget decision making c. The effect, if any, on budget decisions that can be expected from entrepreneurial budgeting.

5. No other aspect of public management has been the target of reform more than the budget process. Discuss the historical progression of innovations in the budget process. How have these developments been shaped by changes in the broader thinking about public administration? While many budgeting practices have changed over the past century, actual practices in budgeting have remained remarkably stable. Explain why this is the case.

REVIEW QUESTIONS

171

c h a p t e r

There is always something to upset the most careful of human calculations.

– Ihara Saikaku, Japanese poet

The budget cycle: Preparation and legislative approval

8

The top priority in the preparation and legislative approval phases of the budget cycle is to create a process that produces information and, ultimately, decisions that reflect the priorities of elected representatives while also advancing the long-term interests of the community. Close behind this priority is the need to ensure that budget deliberations proceed constructively, efficiently, and prudently. As noted in the previous chapter, part of the challenge is ensuring that the budget staff has adequate information with which to evaluate options objectively and provide a credible assessment of the link between budgetary inputs and the most likely outputs and outcomes. The key to good budgeting is making certain that the process provides a forum for vetting responsible ideas and building consensus on the best course of action.

This chapter covers in depth the first two phases of the budget cycle: budget prepara- tion and legislative approval. Because conflict is endemic to budget deliberations, partic- ularly during these first two phases, this chapter also examines the sources of conflict and the importance of well-crafted budget policies in helping managers deal with conflict.

Preparation phase Budget preparation begins well before the start of the new fiscal year. For example, if the fiscal year begins on October 1, larger governments begin preparing the proposed budget as early as the preceding January; smaller ones, in early summer. State law or local charter may specify the time frame, but the timing for launching budget preparation is more commonly dictated by historical precedent.

172 The Budget Cycle: Preparation and Legislative Approval

The preparation of a budget requires these critical tasks, most of which originate with the budget office:

• Publish a calendar identifying deadlines for tasks and the individuals responsible for meeting those deadlines.

• Prepare and update revenue projections.

• Develop budget instructions and targets if applicable.

• Design and revise a budget manual with instructions and forms.

• Update web-based templates and macros for departments to use when submitting budget requests online.

• Review departmental requests for accuracy and consistency with guidelines.

• Conduct budget hearings first with analysts and then with the executive team.

• Prepare the final executive budget request, and make it available on the website.

Budget calendar

Although budget preparation is never popular with department heads because it takes them away from running their departments, the budget calendar provides a roadmap to the preparation and adoption of the budget for the next fiscal year. It establishes dead- lines for key activities in the process and names those responsible for completing the tasks.

Departments commonly make their initial requests for funding, especially requests that exceed their target base, to a team of budget analysts and the budget director in an informal meeting. The budget calendar specifies the date and time for making these requests; due dates are typically staggered to create a more uniform workload for budget personnel during this peak period and to give departments with more complex budgets a longer time to compile their requests. The budget office may respond with a set of questions that require further research and analysis by the department.

The next step may be more formal hearings before the city or county manager and a team of senior executives. Usually the budget director will join these hearings, and the department will be expected to address the questions that were raised in the earlier meeting. The formal hearings provide a forum for resolving any lingering con- flicts between the recommendations of the budget office and a department’s spending requests. They are included in the budget calendar to give participants sufficient notice to clear their schedules and prepare for them.

Revenue projections

Without exception, revenue forecasting is the most important task in budget prepara- tion. Because, as discussed in the accompanying sidebar, most state and local govern- ments have some type of balanced budget requirement, available revenues determine the level of spending for the fiscal year or biennium.

The beginning point in budget deliberations is the available revenues for the coming year. If revenues have dropped, the governing board, with the manager’s advice, must immediately look for ways to reduce spending levels. If revenues have risen, the board typically looks for ways to approve tax cuts while also accommodating modest spend- ing increases. State and local governments sometimes have no choice but to seek new revenues, such as a tax or fee increase, or to try to shift the cost of services to another government or to consumers—for example, through higher tuition for a state or local university. Tax revenues can be increased by broadening the tax base or increasing tax

The Budget Cycle: Preparation and Legislative Approval 173

Defining budget balance The issue of a balanced budget—one in which current revenues cover current expenditures—has been at the fore of public debate for several decades as a result of the continuing deficits incurred by the federal government. Those annual budget deficits must be funded somehow, and the federal government chooses to fund them with debt—that is, by borrowing through the issuance of Treasury bills, notes, and bonds. (The Bureau of the Public Debt’s website, publicdebt.treas.gov, contains details on the amount of debt and who owns it.) Local governments, however, are usually required to adopt a balanced budget. There have been numerous calls for an amendment to the U.S. Constitution requiring the same discipline from the president and Congress.

There are several points in the life of a budget where it can be balanced (see figure below). But a balanced budget is elusive. For example, the manager may be required to propose a balanced bud- get, but the council may have the lati- tude to approve an unbalanced one. Or state or local law may require that both the proposed and approved budgets balance but allow deficits at year-end to be carried over to the next year. (Coun- cils typically amend the budget during

the fiscal year and approve supplemental appropriations, but a local government may still conclude the fiscal year with a deficit.) The most stringent balanced bud- get condition specifies that the budget must be in balance when it is proposed, when it is adopted, and at year-end.

Because there are no uniform and en- forceable standards for budgets as there are for financial reports, budgets are much more amenable to manipulation.1 Local governments facing a budget crisis may resort to financial sleight of hand to temporarily achieve budget- ary balance: they may approve overly optimistic revenue forecasts, shift the last payday of the fiscal year to the next fiscal year (thus saving one pay period in the current budget), accelerate the due date on taxes, defer payments for pensions or other obligations, book the sale of assets as revenue before the sale actually oc- curs, defer maintenance expenditures, or borrow against a future revenue source.2 These actions may temporarily balance the budget. However, budget shenan- igans have consequences. Unless the local government changes its budget practices, the imbalance will return with a vengeance, leaving local leaders with fewer options and increasingly more costly remedies.

Preparation phase Legislative phase Executive implementation

Accounting and auditing

1. Chief executive must submit a balanced budget.

2. Budget approved by council must be balanced.

3. Budget signed by elected chief executive, after any vetoes, must be balanced.

4. Budget amendments and supplemental appropriations must include offsetting revenue sources.

5. Fiscal year must end with a balanced budget.

1 Yilin Hou and Daniel L. Smith, “A Framework for Understanding State Balanced Budget Requirement Systems: Reexamining Distinctive Features and an Operational Definition,” Public Budgeting & Finance 26 (Fall 2006): 22–45.

2 Karl Nollenberger, Evaluating Financial Condition, A Handbook for Local Government (Washington, D.C.: ICMA, 2003), 149–152.

174 The Budget Cycle: Preparation and Legislative Approval

rates. Occasionally governments will reduce or remove a tax break—perhaps by reducing a homestead exemption on the property tax or by eliminating a tax exemption.

Well before the budget preparation is officially under way, the budget office begins compiling estimates of yields from the major sources of revenue (property and sales taxes for most cities and counties). These estimates are regularly updated throughout the budget preparation and legislative approval phases and into executive implementation. The budget office also solicits estimates of expected yields from departments that collect revenue—for example, investment income (from the treasurer), park and recreation fees, library fines, airport fees, municipal court fines, utility charges (water, wastewater, storm drainage, electric, and in some cities natural gas).

For some revenue, a range of forecasts may be appropriate. The amount of rainfall anticipated in the coming year, for example, affects the forecast for water use. Thus the water department may prepare three scenarios for revenue yields: one for above-average rainfall, another for below-average rainfall, and a third for an average year. This gives budget planners a better idea of the sensitivity of revenue yields to changes in external conditions.

Revenue forecasting involves a variety of measures, which are described in the accompanying sidebar. Some measures, such as econometric modeling, involve sophis- ticated statistical methodologies; others, such as informed judgment, are more intuitive. Typically the budget office will use two or more techniques in combination to estimate the major revenue sources. Sales (and income) taxes pose the greatest challenge to revenue forecasters because of the difficulty of predicting changes in the local economy, especially downturns.

While the budget office has administrative responsibility for preparing and updating revenue projections, these projections can become political issues, especially if revenues are falling. Should that be the case, the safest approach for the budget office is to keep revenue projections conservative—that is, somewhat below what it actually anticipates receiving. On the other hand, sometimes the city or county administrator and council prefer more optimistic revenue forecasts—projections that assume more favorable eco- nomic conditions—because an optimistic revenue forecast makes it easier for them to balance the budget.

The chief executive plays a key role in bringing integrity to revenue forecasts and discouraging their manipulation, which can become counterproductive. In the long term, the manager’s most prudent course is to insist on accuracy in all revenue forecasts and to stand firm against their manipulation, whether it is done to protect the budget office or to promote the council’s agenda. In revenue forecasting, your sins find you out, and they do have a cost.

Budget preparation instructions and manual

To help departments develop their budget requests, the budget office, in consultation with the top management team, develops detailed guidelines for preparing requests. These guidelines present general information on the budget environment: the expected changes in demand for services, trends in the major revenue sources, unemployment trends, major projects affecting the operating (or capital) budget, and any shift in em- phasis on community-wide goals. They also include instructions on preparing a base budget request, supplemental (or enhancement) requests, revenue estimates for depart- ments with revenue-generating activities, and performance indicators and other program measures, as well as instructions on entering budget data into an online database. In addition, they provide contact information for specific types of questions.

Revenue forecasting techniques Local government expenditures are revenue driven– that is, the total amount of available revenue frames budget deliberations throughout the preparation and legislation phases. For this reason, estimating the amount of revenue available for the budget year is one of the first steps in budget preparation. Typically, a revenue forecast is prepared for each major revenue source, such as the property or sales tax and each utility service. For smaller revenue sources, such as license or recreation fees, a forecast is prepared for the combined totals, often based on historical trends.

Because local governments collect revenue from dozens, even hundreds, of sources, they often prepare a revenue manual that provides detailed information on each source: its legal basis, collection and rate his- tory for the past five years, principal payers, and the entity in local government responsible for collection and enforcement.

The methods used to project revenues can be classified into four generic types: informed judgment (professional guess); deterministic, or formula-based, projections; time series, or trend, analysis; and econo- metric, or causal, modeling. Most budget offices use several methodologies in combination, depending on the type of revenue source.

Informed (professional) judgment comes with experience and careful observation and is essential to preparing defensible estimates regardless of what other methodology is used. Even the most elaborate statistical projections require the discerning eye of an experienced budget director. Budget directors and local government managers who have been caught short in the past learn to watch for changes in the local economy or in state and federal laws that could affect revenue yields. In addition, a panel of local experts and business leaders can be recruited to assess the busi- ness environment for the coming budget period and predict its likely effect on local employment and capital investment decisions. The budget office may recon- vene the panel periodically during the year to update projections for the current and future fiscal years. For certain types of revenue, such as from the sale of elec- tric power or water, a local government may tap the expertise of a consultant whose experience provides a better basis for making an informed judgment of the expected revenue for the budget period.

Deterministic (formula-based) revenue projection relies on a simple mathematical formula to provide an estimate of expected revenue. The property tax, which is usually the most important source of general revenue for local governments, is calculated on a for- mula basis (total assessed value x tax rate = tax yield). The assessed value represents the taxable value of all property—both real and personal—in the taxing juris- diction. Typically, the property tax rate is set concurrent with the council’s adoption of the budget at a level that will generate sufficient tax revenue (yield) to balance the operating budget. Sometimes collection rates fall or estimates of assessed valuation are off because of

delinquencies or bankruptcies, in which case the fore- cast must be adjusted.

Utility charges are also forecast using the determin- istic method (volume of consumption x rates = revenue yield), although forecasting the volume of consump- tion, such as the demand for water or electric power, requires more sophisticated forecasting methods.

Time series (trend) analysis involves looking for trends from prior years’ data. It provides a useful and accurate estimate for some revenue sources, especially those that are less elastic with respect to economic growth–that is, those for which yield does not change much whether the economy is growing or shrinking. For example, license fees and certain excise taxes, such as those on cigarettes and alcoholic beverages, are relatively stable; thus, because they may depend roughly on population size, a simple trend analysis provides reliable estimates.

For revenue sources that produce more volatile yields but that grow at a reasonably constant rate, a common approach is to average several recent years together to project the next year’s yield. By taking the average of recent years, the budget forecaster smooths out the peaks and troughs and thereby reduces the chance of over- or underestimating revenue yields.

Econometric (causal) modeling is a more sophis- ticated statistical method that can help anticipate turning points in the local or state economy, some- thing that time series methods cannot do. Econo- metric models assume that the yield from a particular revenue source is affected by a number of underlying determinants, such as per capita income, inflation, and population change. Econometric modeling does not work perfectly, but a statistical model can be helpful in showing how the local economy and the tax revenues that come from that economy respond in comparison to a state or regional economy.

The larger and more complicated the economy of a state or local government and the more complicated its revenue sources, the more useful econometric models become. The Texas state comptroller, who is consti- tutionally charged with preparing revenue estimates for the state’s biennial budget, has developed a highly sophisticated series of simultaneous equations whereby one model’s prediction becomes a predictor for another. The comptroller’s forecasts have proven remarkably accurate, strengthening their credibility and influence in the budget preparation process. Modeling can be done at many levels of sophistication, from the simplest correlations to complex multistage models.

In practice, budget forecasters use a variety of techniques concurrently. They combine their expertise and professional judgment with simple or more complex trend analysis. Striving for accuracy, they have a strong incentive to keep their forecasts conservative. It is far bet- ter politically to bring good news midyear of additional revenues coming into the treasury than to have to report that revenues were overestimated and that emergency budget actions will be needed to reduce spending.

The Budget Cycle: Preparation and Legislative Approval 175

176 The Budget Cycle: Preparation and Legislative Approval

Along with the budget guidelines, departments receive their target allocation for the budget period and a reestimate of their current year’s level of expenditures and revenues. This midyear reestimate reflects changes in the local economy that may alter the budget conditions not only for the current year but also for the coming one.

The budget calendar and budget guidelines, as well as forms to be used, are compiled into a document called the budget manual. For department heads and their staffs, the manual provides information needed to prepare and justify budget requests. Budget manuals vary widely in their content and level of detail. Smaller local governments rely on minimal documentation—the basic forms and instructions needed for submitting requests and a narrative from departments explaining any deviations from their historical budget base. Larger governments require more detailed documentation.

Budget offices tend to ask for more information than they need because, in the uncertain environment in which budget decisions are made, data and information are key to the quality of decisions. But at some point, additional information has dimin- ishing value to decision making, and its cost is borne by the departments, which have a limited amount of staff time to devote to budget preparation. An open dialogue among the budget office, department heads, and the chief executive office reduces the risk that the budget office will ask for obsolete or redundant information.

The flip side of the coin is the tendency for budget offices to shower departments with endless reams of data, making it difficult for those responsible for preparing budgets to know what is essential to the process. Again, the information distributed to departments must be clearly linked to the documentation that departments must submit.

A new department head unfamiliar with the jurisdiction’s budget procedures must invest considerable time learning the mechanics of budget preparation. While some elements of the process are fairly common across governments, enough variation exists, especially in data entry and processing, to require significant time and energy from someone learning a new system. Similarly, when a new city or county administrator introduces major changes in the process and documentation, department leaders must spend time learning the new material. Ultimately, the department head skilled in data analysis and written communications will have a competitive edge.

Department budget requests

Once the budget manual is prepared, the budget office typically begins the preparation process with a kickoff event, a somewhat celebratory occasion that brings together department heads, budget analysts, and top management. Participants are briefed on the budget calendar, guidelines, and budget manual; they may also be briefed on targets, either for each spending category in the department’s budget or for the department’s budget request overall. In larger governments, budget analysts are introduced and their departmental assignments announced if different from past years; the number of de- partments that an analyst serves will vary, depending on the size and complexity of the departmental budget.

The kickoff event may be followed by a training session that lasts anywhere from part of a day to two or three days, depending on the extent of changes in the budget process. For example, if a new information management system is being introduced, the training may extend for several days as users become familiar with its features. With new executive leadership often comes new approaches to budget deliberations; these may have catchy titles, such as the “balanced scorecard” approach or “responsibility-centered management” or “budgeting for outcomes.” Wholesale changes in the documentation required from departments and the criteria used to evaluate departmental proposals will

The Budget Cycle: Preparation and Legislative Approval 177

require extensive retooling of the administrative staff, whose task will be to collect and analyze the data and prepare the documentation needed for budget deliberations.

As departments begin to prepare their requests, a number of concerns will surface, some of which may require consultation with the departments’ assigned budget ana- lysts. For example, given the trend toward a more expansive role for budgeting, budget analysts and department administrators must collect and analyze a wider array of data, including performance measures, citizen attitudes, consumer satisfaction levels, and outcome measures. If the government uses a unified budget, departments must prepare capital spending requests alongside operating requests. Further complicating the pro- cess are spending requests that are funded from federal or state grants and that typically require separate documentation, justification, and hearings. Departments inevitably have questions about collecting and reporting all these types of information.

Departmental budget requests must also include information on salary savings—the savings in unpaid salaries that result whenever positions remain unfilled for part of a year because of personnel changes. Some governments estimate salary savings for each depart- ment using historical data and exclude that portion of the salary expenditures from their budget base for the coming year. Others record salary savings only as they occur during the fiscal year and allocate them to a separate account that can be used to fund supple- mental requests or to supplement salary offers where the budgeted salary is below market rates. And still other governments allow departments to keep salary savings, placing limits on how they may be used—for example, to fund a temporary position for an MPA intern.

Another issue involves the use of unused budget authority. In most cases, budget authority lapses at the end of the fiscal year, creating an incentive for year-end spending. City councils consider money carried over as evidence of budget padding and generally reduce the department’s budget for the next year, especially if funding is tight.

As department heads agonize over their budget proposals, they will carefully scruti- nize the numbers and justification, looking for ways to link each spending initiative to a strategic goal or priority articulated by the council. In some cases, union agreements require the addition of personnel or equipment. In most cases, however, department heads must defend each new spending initiative as well as their current levels of spend- ing. Generally, they must also supply performance measures as part of the justification for spending requests.

Departmental requests vary widely in form and content. The submission require- ments for the City of Plano, Texas, however, are representative of the documentation usually submitted at the end of the preparation phase:

• A transmittal letter to the city manager

• A report on forecasted expenditures for the cost center

• A report on forecasted revenues by cost center (if applicable)

• Budget detail sheets (information on base budget, detailed expenditures)

• Decision packages

• Priority list of supplemental decision packages

• A program-of-services form, covering mission, goals, accomplishments, significant budget changes, performance measures, and more detailed information on full-time equivalent (FTE) positions1

As the budget progresses through the winnowing forks of the legislative approval process, department heads may be called upon to provide additional data or an explana- tion of requests. However, most of the data collection and reporting is now complete.

178 The Budget Cycle: Preparation and Legislative Approval

Assembling the executive budget

To smooth the workload for budget analysts, mid-size and larger governments stagger the due dates for departmental budget submissions. Usually smaller departments’ requests are due first, followed by larger departments’ requests. As requests filter in, budget ana- lysts verify that all the required information has been submitted, that the estimated costs conform to the guidelines specified in the budget manual, and that measures of perfor- mance and other indicators of accomplishments are appropriate to the departments’ missions and goals. The budget office may verify that mandated costs are included in a department’s request and that the full cost of projects or new staff is also included.

The budget analyst’s initial review usually results in a follow-up with the department for clarification, correction, or further documentation, especially on requests for new initiatives. Often the department is asked to describe the consequences of not funding the proposed initiative. There may also be questions about performance and outcome measures. The budget office will typically push for measures that better reflect the depart- ment’s mission and that provide top management and council members with a better understanding of how the department’s programs address the priorities of the council.

As it refines its revenue forecast for the coming budget year, the budget office merges the forecasts prepared by revenue-producing departments. These forecasts have been organized by fund and type of revenue source, grouped into larger categories, such as property tax, sales tax, other local taxes, general service charges, license and permit fees, fines and forfeitures, investment income, revenue from other governments, and other revenue.

The budget office also begins compiling expenditure data for continuing activities and preparing a prioritized list of proposed new initiatives or of possible areas targeted for reallocation of existing funds. Its staff pays particular attention to the priorities devel- oped by the council, whether that was done through a strategic planning process, citizen focus groups, or some other method. The goal is to fit department-centered information into a framework that responds to the priorities of the legislative oversight body and the citizens it serves.

The budget analyst typically makes field visits throughout the year to observe the department’s activities and the quality of its performance. If an analyst is assigned to a particular department year after year, he or she becomes familiar with that department’s budget and history of requests and thus becomes a critical adviser to the executive on the merits of that department’s requests.

Executive budget hearings The final step in assembling the executive budget is a series of executive-level hearings involving each department head, the budget office, and a team of top managers. Depart- ment heads meet one-on-one with the budget director, with the manager, or more com- monly with a budget committee comprising representatives from the chief executive’s leadership team (city manager, assistant city manager(s), budget director, human resource director, and finance director). These hearings are not open to the public, and there is no public record of the proceedings. Given the stakes involved, departments expend con- siderable effort developing PowerPoint presentations, honing their speaking points, and justifying their spending priorities. Some department heads role-play the presentation with their staffs, trying to anticipate questions that the budget committee may ask.

Executive budget hearings typically proceed over several days, depending on the size of the organization. Each department has a fixed amount of time to make its presen- tation, describe new initiatives, justify any extraordinary changes in spending requests,

The Budget Cycle: Preparation and Legislative Approval 179

explain new funding options, and answer questions. Larger departments may be allocated more time given the complexity of their operations. The finance director may also be allotted extra time to explain debt service payments or new state or federal legislation that is expected to affect spending choices.

During the question-and-answer period, the committee typically focuses on the more controversial proposals, especially those that involve increased spending. It may again ask about the consequences of not funding a particular item. Department heads with a reputation for fiscal prudence and an innovative management style have an advantage at this point because they tend to be given the benefit of the doubt when it comes to funding a new initiative or reallocating existing spending. Departments that have developed defensible measures of the impact of their programs on community priorities also have an advantage, as do departments that can document an increase in efficiency, have enhanced responsiveness to citizens, or have otherwise improved the delivery of public services. And finally, those departments that are known to have strong support among community groups will also have a competitive advantage even at this stage of the budget process.

Once the executive budget hearings are completed, the executive budget committee makes its recommendations to the city or county manager. Some committees use elabo- rate rating schemes to rank new spending proposals. Others use a simple voting process to identify new initiatives to be included in the budget request, initiatives recommended for possible inclusion should sufficient funds become available, and initiatives not rec- ommended for funding in the current year.

The budget office then prepares a draft of the recommended executive budget and distributes it to each department head. At this point, if the department feels that its proposal was not fully understood or if additional information has become available that would have a bearing on the recommendation, the department head may be allowed to appeal to the chief executive to restore a deleted item or increase its priority. The department head should carefully weigh the wisdom of making such an appeal, however: failure to succeed may lower the department’s standing among its peers, while success may lay the department open to accusations of making an “end run”—circumventing the normal chain of command to gain support for its agenda. The opportunity for appeal is usually reserved for truly extraordinary matters. If the budget office and budget com- mittee have effectively screened the requests coming from departments, only the most controversial items will be passed on to the manager for resolution.

The budget document

The culmination of the preparation phase is the executive budget, which represents the chief executive’s proposed spending plan for the coming year. The initial version may be posted on the web or circulated internally for departments to review. Depending on the council’s preferences, the final version may also be posted on the web for council review, or it may be printed and distributed for council members to mark up and make personal notes as they prepare for the next phase: legislative approval.

After reviewing and revising the executive’s proposal, the legislature adopts the bud- get into law by passing an appropriation, a legally binding act that sets the spending limits for each government department and agency, including those in the legislative and judicial branches, for the coming fiscal year.

Administrators responsible for budget implementation then enter into contracts and issue purchase orders that create encumbrances to each department’s appropriation. The accounting department is responsible for recording encumbrances and approving

180 The Budget Cycle: Preparation and Legislative Approval

the subsequent disbursement of funds once the contracted service is completed. As a fiscal year unfolds, unexpected events—for example, a recession or the loss of a major taxpayer—often require alteration of the approved spending plan; this is sometimes done through a formal amendment by the council, a supplemental appropriation, or a revision of revenue projections. And in today’s world, the increased frequency of disasters and the ever-present threat of terrorist attacks complicate budget planning and compel even greater flexibility and creativity from public servants at the forefront of preserving social order.

On completion of the fiscal year, the chief accountant prepares a comprehensive annual financial report (CAFR) that, among other things, compares the appropri- ation for each department, as amended, with the actual amount of expenditures. An independent auditor reviews the CAFR and reports to the council on its accuracy and on the local government’s compliance with federal, state, and local laws.

For most local governments, the budget consists of two documents: the operating budget and the capital budget. An operating budget reports the spending plan for a government’s ongoing services, such as police and fire protection, parks and recreation, water, and sewer service. It typically organizes information by departments and provides details on such line items as personnel, supplies, contract services, travel, utilities, and smaller capital items (e.g., office equipment). Money for the operating budget comes from current revenues, such as property, sales, and income taxes; service charges; fees and fines; and grants.

The capital budget (the preparation of which is discussed in Chapter 11) represents a spending plan for the acquisition of fixed assets, such as highway and building con- struction, water and sewer line installation, and park development. This budget is usually part of a more comprehensive capital improvement plan (CIP) that projects major construction and acquisition needs for a five- to eight-year period. Funding for the capital budget usually comes from the sale of bonds or other long-term obligations, supplemented by funds from grants and current revenues. Information contained in the capital budget is usually organized by projects.

These budgets may be prepared as part of two distinct processes during the fiscal year, each resulting in a separate appropriation, or they may be prepared concurrently, as is done in Dallas, Texas (see Figure 8–1).

Legislative approval Home rule charters generally stipulate a date by which the city or county manager must submit a proposed budget. For example, the charter for the City of Fort Worth, Texas, requires that “on or before August 15 each year, the City Manager must submit to the City Council a proposed budget that provides a complete financial plan for all city funds and activities for the ensuing year.”2 General law local governments and those that operate without a home rule charter follow the time line spelled out in state law. Some states specify detailed timetables; others have relatively few requirements other than that the local government annually adopt and publicize a comprehensive spending plan before the fiscal year begins.

In state governments and in larger local governments, the budget document sub- mitted to the legislature provides a summary compiled from the budget database. This document typically includes

• An organizational chart for the city, county, or state

• A message from the city or county manager or governor summarizing the major policy issues

The Budget Cycle: Preparation and Legislative Approval 181

• Background information, such as budget procedures, a summary of citizen surveys or other public perceptions, financial management policies, strategic goals, a summary of the long-range financial forecast, and a statement of the economic outlook for the city, county, or state

• A section summarizing the key issues considered in the current budget proposal and the chief executive’s recommendations

• A series of tables summarizing revenues by source, expenditures by fund and department, FTE positions by fund and department, and proposed changes in FTE positions

• More detailed information by department on spending requests (sometimes aggre- gated into broad categories, such as personal services, supplies, contractual services, and capital items to be funded through the operating budget); departmental goals, objectives, and performance measures; and FTE positions by rank

• A separate section on debt service obligations for the budget year

• Additional sections on enterprise activities, such as water and wastewater manage- ment, the municipal golf course, the airport, and other fee-for-service ventures

Figure 8–1 Total budget overview, Dallas, Texas

Source: City of Dallas, Texas, Annual Budget for Fiscal Year 2012–2013 (September 19, 2012), 22, dallascityhall.com/ Budget/adopted_1213/FY13-AdoptedBudgetBook.pdf.

182 The Budget Cycle: Preparation and Legislative Approval

• Detailed spending proposals for internal service activities, such as data processing, the motor vehicles pool, and office supplies

• A separate section on expenditures for trust funds, such as employee pensions, insur- ance, workers’ compensation, and pending litigation

• A separate section or volume containing detailed information on the proposed cap- ital spending plan for the year (if the capital budget is prepared concurrent with the operating budget).

Council members often have particular areas of interest and will devote more time to those areas, scrutinizing the information and making certain that they understand the implications of proposed changes. Rarely will a council “rubber stamp” the manager’s proposed budget. The manager and budget office will be called on during the legisla- tive approval phase to explain requests, clarify justifications, and prepare at the council’s request documentation on alternative spending scenarios.

Legislative deliberations

Up to this point, deliberations on the budget have been largely outside the purview of public scrutiny. Council involvement in the early stages of budget preparation also varies, depending on the manager’s leadership philosophy and on precedent in that city or county. For example, before the budget kickoff meeting, some managers poll their councils to determine their spending priorities for the coming budget year. Others hold a leadership retreat for the council and city staff before departmental budgets are pre- pared so that they can review economic conditions, strategic priorities, and the results of the most recent citizen survey. Council and staff might use this retreat to update the government’s strategic plan, developing new priorities that will guide departments as they prepare their budget requests and the executive budget team as it chooses the new initiatives to include in the proposed executive budget.

The process has now come full circle as the council reenters the dialogue to assess how well the executive branch has responded to its priorities. If there has been little legislative involvement up to this point, the proposed executive budget may contain surprises for members of the council—never a good idea. Thus, the astute manager will have prepared the council for new initiatives or other spending and revenue issues well before the budget is released, thereby avoiding the need to educate council members on the details in the spending plan in order to “sell” the budget. Although council mem- bers should be prepared in advance for requests for new revenue sources or proposed increases in taxes or fees, open and frank discussions of the proposed changes and increases should be expected and encouraged.

Some councils prefer to work through committees. The executive budget may go to a budget and finance committee that first reviews the spending plan and the accom- panying proposed revenue requirements. Other councils work as a committee of the whole, and all members of the legislative body participate in all aspects of the adoption process.

Local governments have experimented with citizen budget advisory committees with varying degrees of success. Such committees, composed of council- or board- appointed representatives, provide legislators with a citizen’s perspective on the pro- posed spending plan. However, if the citizen committee is no more representative of the community than the council itself or the department heads who submitted the original requests, it may unnecessarily complicate budget deliberations and ultimately add little value to the final product. Citizen committees tend to work best and add

The Budget Cycle: Preparation and Legislative Approval 183

the most value when there is continuity of membership from year to year so that they gain some understanding of the economic issues, budget processes and procedures, and performance measures. Ensuring that the committee composition is diverse and rep- resents a true cross section of the community also can make the process more valuable to councils.

Shortly after delivery of the executive budget, the council begins holding a series of budget work sessions in which members of the budget office and the manager’s office walk the council through the proposed budget page by page. These sessions are open to the public, and state or local law may require public notification, including posting or publishing a summary of the proposed budget. Public notice of tax or fee changes may also be required, which the city secretary or county clerk posts in the appropriate venue (local newspaper, city website, city hall bulletin board) and for the appropriate time period (e.g., at least fourteen days in advance of the council’s expected action). A continuing challenge for local governments at this stage is to generate broad citizen interest and participation in the budget process.

As the legislative body works through the budget, the requirement for a balanced budget means that most of the discussion will usually center around activities and ser- vices funded from taxes. For local governments, adjusting the property tax rate provides the means to bring revenues into balance with planned expenditures. For the vast majority of local governments in the United States that levy a property tax, adoption of the budget is accompanied by adoption of a property tax ordinance that sets the tax rate at a level sufficient to fund operations (not necessarily capital) for the coming year or biennium. Sometimes growth in the tax base (assessed value) is more than sufficient to cover increases in expenditures. As it works through the spending options, the council keeps an eye on the impact of proposals on the property tax rate and often consults with the budget office on the effect of proposed initiatives on that rate.

Councils usually devote much less attention to the budgets for utilities and other government-sponsored enterprises and for internal services (the proprietary group of activities) unless those budgets include a significant fee increase. Unlike the tax-supported operations in the general fund, proprietary fund activities, including internal services, are usually self-supporting; their level of activity is determined by market forces, not the political process. Proprietary activities fund their expenditures with user charges, so outlays fluctuate with consumption. The ordinance approving their budgets typi- cally limits expenditures to the purpose of the enterprise activity and sets a maximum appropriation for the fiscal year. Figure 8–2 shows a sample budget ordinance from Durham, North Carolina, that combines adoption of the budget with approval of the tax rate.

Councils must also approve the budget for debt service—the annual payment of principal and interest on borrowed funds. Sometimes debt service is funded through a transfer from the general fund to the debt service fund. In other cases, a separate dedi- cated tax levy—usually a portion of the property tax—is collected and deposited directly into the appropriate debt service fund. Again, there is little discussion by council on this appropriation since it represents a legally binding commitment that no govern- ment that wants to retain its credit rating will renege on.

The debt service funds account for only the general obligation (GO) debt, which is used to finance capital improvements that support the general operations of govern- ment. Most of this debt service is funded through general revenues, such as property and sales taxes. Estimating the amount of annual debt service is a fairly straightforward task for the budget office in that few policy issues are involved.

184 The Budget Cycle: Preparation and Legislative Approval

Figure 8–2 Budget ordinance, Durham, North Carolina

Source: Durham, North Carolina, “Annual Budget Process,” XIII-2, durhamnc.gov/ich/as/bms/Documents/ 2012-2013_final_budget/Section%20XIII%20combined%20final%207%203%2012.pdf.

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The appropriation bill

Since adoption of the budget and accompanying taxes or fees constitutes a legal action, specific procedures apply. In the case of the appropriation—the act adopting a budget and granting authority to the executive branch to enter into agreements that will result in the future disbursement of funds—a council may be required to have a first and second reading of the proposed ordinance. The first reading puts the proposed bill on the table for council action; the second, and final, reading enacts the budget. If there is opposition to the spending (or taxing) plan, it most likely will be voiced at the second reading. Prior to one or both readings, the council sets aside time for a public hearing. Sometimes separate hearings are held for the budget and tax proposals; at other times the two are considered at one hearing. Again, state law usually defines the parameters for what local governments can do.

As an aid to council deliberations, the manager’s message introducing the proposed bud- get typically discusses the major initiatives and the cost and changes in personnel for each, organized by strategic area. If economic development is one of the strategic priorities, the manager’s message will discuss each of the new initiatives in the proposed budget designed to help promote that priority. The budget office may prepare a similar document summa- rizing the council’s changes to the executive’s budget proposal, and the reasons for those changes, to give department heads and other budget preparers insight into the council’s thinking so that proposals not funded this time around can be reworked over the next year.

Most local governments adopt one appropriation bill that covers all operating expenditures for the year. If a biennial budget is used, the appropriation bill contains separate amounts for each year in the biennium, or, less commonly, two separate appro- priation bills may be approved. If a separate capital budget is prepared, usually a separate appropriation ordinance is drafted and approved for capital expenditures. (The U.S. Con- gress, which uses a unified budget, adopts thirteen separate appropriation bills, one for each subcommittee of the House and Senate Appropriations Committees.)

As the council deliberates on the budget ordinance, members may offer amendments to the proposal modifying the level of funding for a particular area. Each amendment is voted on, and those that receive a majority vote become part of the amended budget ordinance. After all the amendments have been acted upon, the final amended budget is approved and becomes the legally binding spending plan for the fiscal year.

Councils that use a work session prior to council approval may rely on a more informal process to make changes to the manager’s proposed budget. These changes are discussed during the work session and, if supported by the majority of the council, are used to modify the final budget. The council then approves the revised budget when it is taken up at the regular council meeting.

If a long-term financial forecast is prepared—a three- to five-year projection of trends in the major revenue sources and expenditures and of their effect on the city’s or county’s budget balance—the council may give the manager and budget office direction on spending and revenue options when the forecast comes up for discussion, which is usually at the outset of budget preparation. (The council will review the forecast but take no formal action since the forecast serves as an internal planning tool.) In this case, most of the controversial issues will have been resolved well before the budget is pre- sented to the council for action.

Final budget approval

In the system of checks and balances that characterizes American government, the exec- utive usually possesses some veto power over legislative actions. This is also the case with

186 The Budget Cycle: Preparation and Legislative Approval

appropriation bills. State governors wield varying degrees of veto power, from line- item veto power to no veto power (North Carolina).3 There are no known cases where an appointed city or county administrator can exercise veto power over a council action. However, mayors in some council-manager and in most mayor-council governments typically possess veto power, including line-item veto of appropriation bills. Councils in these governments can override any vetoes, typically with an extraordinary majority.

Should a local government fail to adopt a budget before the beginning of the fiscal year, state and local laws may provide recourse. In some cases, local charters lay out the way to proceed; in some Texas cities, the city charters dictate that the manager’s budget de facto becomes the legally authorized appropriation. In some states, such as New Jersey, a state agency must approve certain local budgets before they become effective. In cases of extreme fiscal distress, states have taken over the financial operations of a local government, including budget preparation and adoption.

As the fiscal year progresses, major events, such as a sudden drop in revenues or a natural disaster, may require the executive to request amendments to the budget to authorize new expenditures. Most amendments, however, address smaller issues: an unexpected need or a misestimate of the cost of a piece of equipment. In some cases, the council may intentionally underfund an activity or acquisition and ask that the agency return later in the fiscal year for a supplemental appropriation. Governmental accounting rules require that the annual financial report disclose both the original bud- get as approved and the final budget as amended.

Conflict in budget deliberations To the average citizen, conflict appears endemic to the budget process, whether at the national, state, or local level. Media coverage of legislative budget deliberations conveys an impression of unending battles. But conflict is inevitable in budget deliberations. It becomes destructive and unproductive only when it is unmanaged. The key is to develop and maintain policies to guide all phases of the budget cycle, and particularly those for budget preparation and legislative adoption.

Budget policies provide a framework for anchoring budget deliberations to the core values that define a city, county, or state. Some governments adopt a written budget policy statement; this statement establishes boundaries for budget deliberations that protect the government from actions that might compromise its financial well-being. Thus it may specify the amount and type of budget reserves, regulate the transfer of money across accounts or funds, and impose limits on the amount of debt that the government can incur.

In state and local governments, where most constitutions or statutes require that expenditures not exceed available revenues, the overriding struggle is to curtail proposed spending levels to the level of forecasted revenues. Increases in revenue are considered only after all opportunities for reducing spending and manipulating the accounting system have been exhausted.

The local government manager’s task is not to rid the process of conflict, for to do so would strip the budget process of its essential democratic function of airing commu- nity concerns and building consensus on government’s role in meeting perceived public needs. Rather, the manager’s task is to manage conflict so that everyone with a stake in the budget has an opportunity to present information and question recommendations. Figure 8–3 depicts some of the conflicting interests that must be managed. The follow- ing discussion examines the sources of conflict commonly encountered during budget preparation, legislative enactment, and executive implementation.

The Budget Cycle: Preparation and Legislative Approval 187

Advocates versus conservers

Within government, and especially during the executive preparation phase of the bud- get, the conflict between advocates and conservers, or guardians, accounts for much of the debate.4

Among the advocates are department heads, who generally request more funding than they know will be approved in the hope of gaining at least some increase in their budget base to meet growing service demands. Other advocates include clients or interest groups who benefit from the department’s services, and legislative committees that oversee the agency. Together these three groups form what political scientists call an “iron triangle”—the mutually reinforcing relationship that exists among an agency, its clients or beneficiaries, and the legislative committee exercising oversight.5 Each group in the triangle needs the other, and they all benefit from increased funding, especially if the costs are borne by a broad-based tax. Members of a library board, in partnership with the patrons of the library, have a vested interest in promoting the public library system, and together they use their influence with the full council to pressure for more funding or even a dedicated source of revenue.

Conservers, on the other hand, are the neck in the hourglass when it comes to spend- ing proposals. The budget office must defend budgetary limits, which are defined by available revenues, and this places them at odds with departmental advocates. In particular, departments funded from general tax sources such as property, general sales, and income taxes have little incentive to consider revenue availability. The budget office must bear the onus of that task. In essence, the conflict between conservers and advocates involves those who are responsible for the whole versus those who are responsible for a part.6

One strategy that executives use to moderate this conflict is to inform departments early in the budget preparation phase about the government’s forecasted revenue con- dition and its implications for each department. Some executives specify a target budget for each department. But for an enterprise fund agency such as a water department, the operating budget is determined by level of consumer demand for the service; thus, allo- cation of funding is driven more by market considerations than by the political criteria

Advocates vs. conservers

Accuracy vs. political expediency

Special interests vs. collective interests

Bureaucracy vs. democracy

The budget of�ce vs. departments

Public will vs. public welfare

Chief executive mediator

Figure 8–3 Sources of conflict in the budget process

188 The Budget Cycle: Preparation and Legislative Approval

that determine the public goods and services that general fund agencies produce. For these producers of private goods and services, the interests of conservers and advocates converge, and conflict is less apparent.

The budget office versus departments

Another source of conflict is information. A budget analyst must have accurate and timely documentation in order to make fair and responsible budget recommendations. Thus, the budget office constantly scans for information on departmental operations, especially their efficiency and effectiveness. But the more information a department discloses to the budget office, the more control the budget office can exert over the department, especially during budget implementation, so department heads vigilantly scrutinize information leaving the organization to ensure that it conveys a positive pic- ture of the department and its operations.

This struggle over information is one reason why zero-base budgeting (ZBB) declined in popularity. ZBB requires that departments (or their decision units) submit at least three spending packages: one that provides for minimum services (only the depart- ment’s most urgent needs), one that continues spending at current levels, and one that provides for enhanced services. If funding falls below the minimum level, the program or agency will not be able to continue operating. Understandably, department heads resist disclosing a package of minimum services: to do so gives the budget office valuable information should spending need to be reduced. Department heads typically contend that their departments are already at the minimum level and that any further reduction in funding would be catastrophic.

Finally, as noted in the previous chapter, the cost of requests for additional informa- tion is largely borne by departments that have to devote additional staff time to com- plete the analysis.

To moderate this conflict, the chief executive should

• Make clear what information is essential to decision making

• Recruit a professional staff of budget examiners who have good interpersonal as well as analytical skills

• Promote automation of the budget preparation process

• Annually examine the instructions and forms contained in the budget manual for redundancy and obsolescence.

In short, the chief executive should recognize that the budget office tends to ask for more information than it needs and that departments tend to resist disclosing more than they must.

Accuracy versus political expediency

The quest for budget accuracy can also find itself at odds with political expediency. Public administrators’ preoccupation with budget realities and exactitude often clashes with politicians’ attention to image and concern that the budget picture be positive. In the case of revenue forecasts, budget offices generally provide conservative estimates, while legislators pressure forecasters to raise their estimates in order to ease the task of balancing the budget. An imbalance in either direction can be disastrous.

Overly optimistic revenue forecasts contribute significantly to local governments’ financial crises, especially in large central cities that are facing long-term economic decline. Lawmakers will often authorize an accelerated payment of taxes in order to increase revenues for the coming year. Conversely, they may defer payments to another

The Budget Cycle: Preparation and Legislative Approval 189

year—for example, rolling ahead the last pay period to the next fiscal year—in order to reduce spending for the current fiscal year. Accounting sleight of hand is used all too often to balance expenditures with revenues, especially when revenues are scarce. At one point, after trying vainly to resolve a budget imbalance, the Texas legislature

Budget stalemates and government shutdowns Partisan brawling in Congress routinely erupts over the federal government’s annual budget. Unfortunately, the involuntary pawns in these exercises of brinkmanship have been federal civilian employees and contractors, who face repeated threats of being furloughed or having their contracts suspended be- cause funding has not been approved.

Under the U.S. Constitution, Con- gress is responsible for funding govern- ment operations through appropriation legislation: “No money shall be drawn from the Treasury, but in consequence of appropriations made by law” (Article I, Section 9). Congress annually appro- priates budget authority to all three branches of government. Subsequent statutes have established the role of the president in preparing an annual budget and of Congress in reviewing the proposed budget and passing appropriation bills before the start of the fiscal year on October 1. Without an appropriation, agencies cannot enter into obligations and federal operations cease—at least in theory.

The Constitution also empowers Congress to borrow funds, which legisla- tors do by setting the maximum amount of debt that the U.S. Treasury may issue. As that debt ceiling is approached, Con- gress must enact legislation to raise that ceiling—now in excess of $15 trillion—or risk defaulting on its debt service obli- gations.

Congress has rarely been able to com- plete work on all elements of the budget before the start of the fiscal year, necessi- tating passage each year of a continuing resolution to grant temporary budget authority while it completes work on the appropriation bills. Occasionally agencies

have had to operate for the full fiscal year on a continuing resolution.

The Antideficiency Act of 1982 gov- erns how the president must respond to funding gaps. In the absence of the timely adoption of an appropriation or its substitute (a continuing resolution), the act requires the furloughing of all federal employees except • Those performing emergency work

affecting the safety of human life or the protection of property

• The president, members of Congress, presidential appointees, and certain appointees of Congress

• Federal employees paid from restricted sources not subject to the annual appropriation (e.g., U.S. Postal Service, Federal Reserve, Tennessee Valley Authority, and Amtrak).

The law gives the president, working through the Office of Management and Budget, some latitude in defining “ex- cepted” employees. Some estimates put the number as high as one-quarter of the current federal workforce of 2.8 million civilian employees. In the past, Congress has retroactively paid all employees— excepted and nonexcepted—for the fur- loughed days, and evidence from these experiences shows no salary savings from a government shutdown.

Nevertheless, federal employees, whether in uniform or not, are victims when they are held hostage to conflicts in the budget process. We as a nation depend on these fellow citizens—experts in their fields—for protection, security, commerce, justice, and economic stability. Our elected leaders would do well to display the same level of professionalism that we have come to rely on from these public servants.

Source: Information for this sidebar is drawn from Clinton T. Brass, Shutdown of the Federal Government: Causes, Processes, and Effects, RL34680 (Washington, D.C.: Congressional Research Service, April 13, 2013), fas.org/sgp/crs/misc/RL34680.pdf.

190 The Budget Cycle: Preparation and Legislative Approval

authorized the state comptroller to temporarily transfer more than $1 billion from various special funds to the general fund on the last day of the fiscal year; this allowed the comptroller to certify that the proposed budget for the next fiscal year was indeed balanced—at least on the first day of the new year. The money then reverted to the funds of origin on the following day.

During the past three decades the conflict between accuracy and political expedi- ency has been particularly apparent at the national level, where both the president and Congress have been frustrated by an inability to control the size of the budget deficit except for a brief time between 1998 and 2001. As the deficit has grown, so too has the pressure on both branches of government to adopt a balanced budget. To make the deficit appear less egregious, they have resorted to manipulating budget totals through interfund borrowing from the Social Security Trust Fund, making overly optimistic economic forecasts, and accelerating tax collections, among other things.

Pressure to avoid tax increases or to make difficult spending reductions tempts legis- lators to use these deceptive measures. Although state and local governments generally lack the option of incurring deficits in successive years, they, too, have succumbed to budget manipulation. With few exceptions, however, such measures can be used only once. The chief executive must serve as the conscience of the organization and ensure that budget accuracy is not sacrificed for the benefit of short-term political expediency.

Bureaucracy versus democracy

At a more philosophical level, the budget process features conflict between the goals of democracy (equality and accountability) and those of bureaucracy (centralization of power and control). Since the earliest days of democracy in ancient Greece, political theorists have sought to devise strategies to keep the bureaucratic (the executive branch) accountable to the democratic (the people and their elected representatives).7 The intro- duction of governmental budgeting in the United States in 1906, when New York City became the first major government in the country to adopt a formal budget process, represented a significant innovation in this quest for democratic control of the bureau- cracy. Jesse Burkhead, a leading scholar in the field, observed that

the budget was conceived as a major weapon for instilling responsibility in the govern- mental structure: the budget system rests on popular control; the budget will publicize what government is doing and make for an informed and alert citizenry; the budget will destroy the rule of invisible government—the party bosses who are responsible to no one.8

By the mid-1920s, most major cities in the United States had established budgeting systems. States also began developing formal budget procedures, Wisconsin being one of the pioneers. Although a formal budget process had been proposed more than a decade earlier, it was not until 1921 that Congress passed the Budget and Accounting Act giving the president responsibility for preparing an executive budget—a document that presents the chief executive’s spending proposals for review and action by Congress. The act established a Bureau of the Budget in the Treasury Department to assist the president in budget preparation, and it created the General Accounting Office (now the Govern- ment Accountability Office, or GAO) as an investigative arm of Congress charged with auditing the financial reports and management performance of each agency. Thus, in the first two decades of the last century, the budget became the premier tool for achieving accountability to those being governed and, with it, greater control over the bureaucracy.

This quest to elevate democracy through greater citizen involvement in government has since proceeded unabated. Outsourcing, privatization, the National Performance

The Budget Cycle: Preparation and Legislative Approval 191

Review, budgeting for outcomes, and priority-based budgeting have all become com- mon parlance in budget deliberations as managers seek innovative ways to demonstrate accountability to councils and citizens.

The Internet has given public managers another venue for creatively engaging citizens in budget decision making. For example, Austin, Texas, has developed a “budget in a box” exercise that uses facilitated small groups of citizens to role-play their preferences for spending on each of eight service areas.9 Boulder, Colorado, invites citizens to share their cost-saving suggestions as part of its priority-based budget process.10 Citizen satisfaction surveys, focus groups, and input from citizen groups and advisory boards are other meth- ods that local governments use to obtain a valid measure of citizens’ budgetary preferences.

Special interests versus collective interests

Budgeting also places special interests at odds with the community as a whole. Interest groups both within and outside government try to garner funding for their particular causes, whether a city’s recreation program, state highway construction, or military hard- ware. Because spending decisions for the general fund agencies are not linked with reve- nue decisions, interest groups rarely see their requests in terms of cost to the community.

Politically, it is difficult for members of a council or governing board to refuse the requests of special interests, especially well-organized groups. If funding comes from the general fund, the costs for a group’s proposal are borne by all taxpayers (the collective interest) at a negligible and presumably unnoticeable cost to any one taxpayer. If legis- lators oppose the group’s request, they risk losing the group’s support or, worse, incur- ring its opposition in the next election. On the other hand, because of the negligible cost to the nonvocal and usually unorganized collective interest, that sector’s support is uncertain if legislators oppose the interest group’s request. Thus, in a democracy, budgets characteristically contain an ever-widening variety of programs and services as legisla- tors seek to appease the wishes of interest groups—or at least reduce the risk of kindling their opposition.

Occasionally, taxpayers who are politically uninvolved and generally indifferent become sufficiently irritated that they revolt, precipitating tax limitation actions like Proposition 13 in California and the Taxpayer Bill of Rights in Colorado. Onerous and visible taxes such as the property tax provide a focal point for rallying the collective interest into action. Most research indicates that these revolts are more a reaction to perceived government inefficiency than a demand for fewer services, with the possible exception of welfare services.

Public will versus public welfare

Budget conflict may also involve perceptions of public will versus public welfare—a struggle between what the public wants and what is in its long-term best interest. On the one hand, administrators and lawmakers must be attuned to public opinion and the will of the majority. Effective leadership depends on the manager’s ability to accurately read public attitudes on sensitive issues facing the government.

Yet the long-term well-being of the community may not be served by what opinion polls indicate to be the public will. Chief executives and other administrators have access to information on the ramifications of a policy that may suggest a detrimental effect to the community’s long-term economic and social welfare. For example, public opinion may favor a county government extending a tax abatement for a local manufac- turer to expand its existing facilities, but it may be in the county’s best interest to use the abatement to attract other types of industries and thus diversify the local economy.

192 The Budget Cycle: Preparation and Legislative Approval

Public managers are educators. Nowhere is that more apparent than in the budgeting process. As leaders, managers must educate lawmakers, the media, department heads, and citizens about what they perceive as being in the public interest. And they must be willing to be educated themselves about what others perceive as being in the public interest. In the budget process, effective management of the conflict between public will and public welfare means being able to both lead and follow while never being too far ahead of or too far behind public opinion.

Managing conflict through a budget policy How can managers balance the ever-present tensions inherent in the budget cycle and keep deliberations from being sidetracked into endless maneuvering and one-upmanship? As noted above, a budget policy statement provides one mechanism for institutionalizing responsible dialogue within a government’s decision-making framework as it establishes the financial standards that guide budget deliberations for both the executive and legis- lative branches.

In fact, every government has some type of budget policy, although often it is unwritten and thus more vulnerable to being compromised. Past precedent largely frames governmental budget policy, whether written or unwritten. The principal benefit of a written policy is that it provides a standard of budgetary performance that both branches of government have endorsed. If, as a matter of policy, a government will not incur a GO debt burden that exceeds 15 percent of its assessed value of property, then any proposal to exceed that limit places the burden of proof on those making the proposal. The written policy becomes the conscience of the organization by reducing, although never eliminating, the incentives for making imprudent financial decisions in the interest of political expediency. The more specific the policy statement, the more effective it will be in promoting financially responsible budget actions.

A formal statement also provides continuity in budget decision making. It reinforces the core financial values of the organization and preserves them for successive legislatures and administrations. Of course, future legislatures and executives may choose to amend those policies as community needs or standards of financial prudence change. However, any amendment requires deliberation by the leadership on its merits before it becomes effective.

A budget policy may also reduce the number of issues open to debate during budget preparation and adoption. In so doing, it will expedite budget deliberations, a prospect that is normally greeted warmly by anyone who has ever prepared a budget. Noted budgeting scholar Michael White has observed that “budget policy becomes a means for managing participation in the budget process and moving that process along its calendar. Questions not debated mean participants not needed.”11

A budget policy may have as its overarching goal the preservation of a claim to distinction. For example, the board of supervisors for Fairfax County, Virginia, relies on “Ten Principles of Sound Financial Management” that are “designed to contribute to the County’s fiscal management and maintain the County’s ‘triple A’ bond rating.”12 A number of local governments, such as Salt Lake City, now use the balanced scorecard that ties citywide goals to departmental performance measures. As described in the previous chapter, Fort Collins, Colorado, has taken an even more radical approach— budgeting for outcomes—that “focuses on results and priorities, not on cost. The budget process shifts from paying for costs to buying results.”13 This approach has radically altered the ways in which the city evaluates departmental budgets and spending plans are presented to the city council.

The Budget Cycle: Preparation and Legislative Approval 193

A virtually sacrosanct assumption about tax rates or bond ratings often develops within a community’s psyche and holds sway over budget deliberations. A number of local governments that have received an Aaa/AAA bond rating from Moody’s, Standard and Poor’s, and/or Fitch’s—Salt Lake City, for example—take great pains not to make any tax or expenditure decisions that could tarnish their exemplary credit ratings.14 Managers in fiscally conservative regions of the country may have to undertake budget preparations in a city or county where the property tax rate has remained constant for decades, and no manager wants to be the one to break such a record. An even more conservative position is that revenue received from the tax will not increase, so that any increase in the assessed value of taxable property (the tax base) will be offset by a reduc- tion in the tax rate in order to hold revenue yield constant.

Budget deliberations are sometimes tempered by the need to preserve a particular strength of the community. States hard hit by a recession may give special consideration in budget deliberations to preserving a favorable business environment. A city with a rep- utation for excellence in its recreation and park services may protect these services from budget cuts during tight fiscal periods. These underlying assumptions can become so deeply ingrained in a government that they assume a mystique of their own. Challeng- ing them often ends in failure and in the challenger’s loss of credibility in the organiza- tion. Only a major crisis will budge the organization from these unwritten but deeply cherished marks of distinction.

The following four sections provide recommendations on policies for the operating budget, revenues, budget implementation, and debt. The accompanying sidebar summa- rizes the items that a policy statement on the budget should address.

Operating budget policies Operating policies address the basic philosophical questions of the budget’s scope and preparation. Whereas a policy statement should not include a detailed description of the budget cycle, operating policies should address the key issues in budget preparation, including

• How comprehensive is the budget (budget coverage or scope)?

• What constitutes a balanced budget?

• What types of budget reserves should be maintained?

• What general guidelines should govern budget preparation and amendment?

• Who is responsible for budget preparation, and what are their duties?

Budget coverage The comprehensiveness of the operating budget has been debated since the inception of the formal budgeting process in government. The issue is twofold: to what extent should the operating and capital budgets be integrated, and what activities should be reported in the operating budget? Activities or projects not included in either budget constitute off-budget transactions: they are evaluated on a case-by-case basis and are not subject to the usual scrutiny given to spending proposals in the regular budget cycle. Off-budget transactions can occur any time after budget adoption. Some govern- ments routinely defer decisions on new initiatives to a midyear budget review to ensure that revenues will be sufficient to cover the continuing services already in the budget.

Coordinating operating and capital budgets Municipalities and counties usually prepare an operating budget separate from the capital budget because the planning and financing sources for each are different. First, capital projects require a much longer planning period because of their large, up-front investment and because any errors in

194 The Budget Cycle: Preparation and Legislative Approval

design are costly to correct once construction has begun. Second, although practice var- ies among governments, capital improvements are usually financed with long-term debt from the sale of GO or revenue bonds, whereas operating budgets are financed from current taxes, grants, and service charges.

Although the operating and capital budgets are usually prepared as two separate documents, it is quite common for governments to prepare them concurrently. One benefit of this is that the manager can better assess the impact of a capital improvement on annual operating costs. For example, the acquisition of new computer hardware may

Elements of a budget policy statement As part of the criteria used in recognizing governments with distinguished bud- gets, the National Advisory Council on State and Local Budgeting recommends that “a government should develop a comprehensive set of financial policies. [These] policies should be consistent with the broad government goals and should be the outcome of sound analy- sis.”1 A policy statement on the budget should address the following elements: 1. Operating budget policies

a. Is the budget document compre- hensive? Does it include all oper- ating and capital expenditures? What funds should be included in the operating budget? Should the operating and capital budgets be prepared concurrently or separately?

b. What constitutes a balanced budget?

c. What kinds of budget reserves should be maintained? How much money should be maintained in each? Under what conditions should money be withdrawn?

d. What guidelines should govern budget preparation?

e. Who is responsible for budget preparation, and what are the critical tasks for which they are responsible?

2. Revenue policies a. How much change in the property tax

rate is acceptable in a given year?

b. How will one-time revenues, such as grants or tax windfalls, be used?

c. How frequently should service charges and fees be reviewed? Should they recover indirect costs?

d. What policies should govern collection of delinquent taxes and charges?

3. Budget implementation policies a. What policies should govern the

transfer of money across accounts or funds?

b. Under what conditions should governments authorize interfund borrowing or interfund payments in lieu of taxes?

c. When should the chief executive be empowered to encumber bud- get authority?

d. Who should be held responsible for expenditures exceeding appro- priated amounts?

e. What standards should govern ac- counting, financial reporting, and auditing?

4. Debt policies a. What is the maximum long-term

debt burden that the government will incur?

b. What mix of long-term debt and current revenues, if any, will be the basis for financing capital improve- ments?

c. How will bond proceeds be used? d. Under what conditions will short-

term debt be issued?

1 National Advisory Council on State and Local Budgeting, Recommended Budget Practices: A Framework for Improved State and Local Government Budgeting (Chicago: Government Finance Officers Association, 1998), 74–75, gfoa.org/services/dfl/budget/ RecommendedBudgetPractices.pdf.

The Budget Cycle: Preparation and Legislative Approval 195

reduce operating costs to the extent that they increase worker productivity or decrease the need for personnel; however, the addition of a fire station or a new library will increase operating costs as additional personnel and utilities are needed to staff the new facilities. A second benefit is that concurrent preparation concentrates budget delib- erations. Budget preparation is time-consuming and stressful, and no one likes to do it—least of all department heads. Concentrating the budget debate helps keeps tempers under control and discussion focused on the issues at hand.

Other local governments, however, choose to separate deliberations by first preparing an operating budget and later preparing the capital budget. The primary advantage of this approach is that it reduces the workload by spreading budget deliberations out over a longer period. More careful deliberation may reduce errors in judgment and provide a better opportunity to educate participants on the merits of each proposal.

The operating budget policy should specify whether the two budget cycles will pro- ceed concurrently or separately and should briefly explain the reasons for the choice.

Funds to include An operating budget policy should specify the types of funds in- cluded in the operating and capital budgets. As discussed further in Chapter 10, govern- ments account for their money in one of eleven types of funds:

• Governmental: General fund, special revenue funds, debt service funds, capital proj- ects funds, and permanent funds

• Proprietary (or business-type): Enterprise funds and internal service funds

• Fiduciary: Investment funds, private-purpose funds, pension funds, and agency funds.

Governmental funds are generally supported by tax or grant revenues that go to the delivery of public goods and services. Proprietary funds account for the sale of private goods and services, such as water or parking, so they function more typically like business- type ventures of a local government. Fiduciary funds are used by local governments to hold money in trust for other governments (agency funds) or persons (pensions, private-purpose funds). These funds are the least likely to be included in the budget because their activities are typically defined by contract or by state or federal law.

For purposes of understanding the issues in budget coverage, the operating budget covers the recurring expenditures and revenues in all three categories of funds. Capital budgets, however, usually cover projects accounted for in capital projects funds and, to a lesser extent, in special revenue funds and the general fund.

Preferably, the budget policy should call for a comprehensive inclusion of all fund types in the annual budget process. Some governments, such as Birmingham, Alabama, limit the budget coverage to transactions in the general fund; capital expenditures are approved on a project-by-project basis and are not part of a consolidated capital bud- get.15 In its budget policy statement, Olympia, Washington, provides a detailed list of each of the city’s funds and indicates whether the fund is included in the annual appro- priation.16 Except for such fiduciary funds as the Firemen’s Pension, Municipal Court Trust Fund, and a trust fund for an interlocal law enforcement records management system, most of the city’s funds are included in the annual budget and are subject to an annual appropriation.

At a minimum, the operating budget should include all general fund activities. The issue of budget coverage centers on whether special revenue, debt service, enterprise, and trust funds should also be included. Excluding these funds from the budget plan- ning process may be politically expedient because it gives the appearance of a smaller government. But spending that is not subject to the scrutiny of lawmakers and the rigor

196 The Budget Cycle: Preparation and Legislative Approval

of comparative analysis with other spending options undermines accountability and government leaders’ control over spending. As a matter of policy, budget scholars advise that all spending be covered in the operating and capital budgets.

One other issue concerns how governments budget for internal services. Govern- ments set up internal service funds as a tool to control costs. For example, a motor vehicles pool may be accounted for as an internal service fund, in which case each department (internal user) is charged for the use of city or county vehicles. From a budgeting perspective, the question is how to budget for this internal service: as a line- item expenditure for each department, or as a lump-sum appropriation to the motor vehicles department that is then allocated to each departmental user? The first method is much preferred. Each department has an incentive to ration its use of the internal service in accordance with the funds it has available for the activity. Occasionally, an internal service may require a subsidy from the operating budget because usage does not provide the level of funding needed to sustain the desired quality of service. For example, the motor vehicles department may not have a sufficient volume of activity to cover its annual direct and indirect operating costs, in which case a subsidy will be needed if the jurisdiction decides to retain the service rather than outsource it to a private provider.

Pension obligations Pension liabilities have become a major issue for many local governments, particularly those that have failed to adequately fund their obligations as they are incurred. Failure to include pension obligations in the operating budget shifts the liability to future taxpayers and creates what accountants call an unfunded bene- fit. The Governmental Accounting Standards Board (GASB) has issued guidelines for reporting pension obligations as well as for the failure to fully fund those obligations as the liability is incurred.17 Local governments typically extend health care benefits to their retirees—what accountants have labeled other post-employment benefits (OPEB). In the past, local governments typically did not include funding for these liabilities in their operating budgets and are now having to pay for past OPEB from current revenues while also setting aside funds for future retirees. The GASB has issued guidelines as well for reporting OPEB.18

Budgetary balance At first glance, the definition of a balanced budget may appear obvious. If current revenues equal current expenditures, the budget is balanced; thus, a deficit budget occurs when revenues fall short of expenditures, which requires the government to borrow money or draw on fund balances carried over from previous years in order to cover current expenditures. But as noted earlier in the chapter, polit- ical gamesmanship has made even something as simple as defining a balanced budget enormously complex. Questions arise over whether the balance test applies to only the executive’s proposed budget or also to the budget adopted by the legislature or to the year-end balance remaining in the budget. There is also the question of how the balance should be measured—on a cash basis or an accrual basis? (These terms are defined and discussed in Chapter 10).

Occasionally, a local government will want to draw down its fund balance—the accumulated year-end surpluses available for reappropriation. In this case, it will inten- tionally adopt a budget in which estimated current revenues are less than appropriations, with the difference made up by drawing down the fund balance:

Estimated revenues + fund balance = appropriations.

The Budget Cycle: Preparation and Legislative Approval 197

The budget policy should specify the expectation for a balanced budget and the amount of money to be retained in the fund balance as a reserve for contingencies. Figure 8–4, a summary of all funds from the Cambridge, Massachusetts, budget comparing total revenues with expenditures, shows not only a balanced budget but also the budget’s comprehensiveness.

Budget reserves Although policies on budget coverage and a balanced budget are not always clearly articulated, many governments have adopted explicit policy guidelines for budget reserves. To accumulate money for future purposes or unforeseen events, governments establish reserve accounts in various funds and then earmark the money for that purpose. The more common types of reserves are for

• Cash flow requirements

• Revenue stabilization (or rainy day funds)

• Unforeseen contingencies

• Equipment replacement and building improvements

• Debt service.

Cash flow requirements Because revenue inflow never coincides with the outflow of payments, governments must maintain sufficient cash on hand to satisfy cash flow needs. The amount of reserve for this purpose—sometimes called operating reserves— depends on the timing of tax and utility payments. For example, most cities in Texas begin their fiscal year on October 1, yet property taxes are not due until the following

Figure 8–4 FY 2013 adopted budget summary, Cambridge, Massachusetts

Source: City of Cambridge, Massachusetts, Annual Budget 2012–2013, I-5, cambridgema.gov/budget/fy12 submittedbudget.aspx.

198 The Budget Cycle: Preparation and Legislative Approval

January 31. Sufficient cash must be reserved in a fund balance to cover disbursements during that period.

For general fund services, one rule of thumb is that there should be enough cash on hand to cover disbursements for sixty days. A government should first examine its cash flow needs and the margin of protection required, and then specify in its budget policy the size of cash flow reserve it wishes to maintain. Some funds may require higher levels of operating reserves than others because of the cyclicality of their revenue stream. For example, enterprise funds such as a water fund may require a higher operating reserve because of the uneven flow of revenues, which peak during the dry summer months.

Revenue stabilization Following the bitter impact of recessions over the past two decades, many state and local governments established revenue stabilization reserves, or rainy day accounts, usually maintained in the general fund, to provide resources when revenues decline because of an economic slowdown. While the timing of slowdowns and even recessions can be anticipated somewhat accurately, their severity and length are much more difficult to forecast. And their impact on local communities varies widely, depending on their cause and on the local economy’s link to the broader economic cycle. Consequently, state and local governments risk misestimating revenues whenever their assumptions about the economy’s future are inaccurate.19 A 1987 study of revenue forecasting by the State of California showed that half of its forecasting error was due to inaccurate assumptions about the course of the state’s economy and half was due to random statistical error inherent in revenue models.20

While revenues fluctuate with the economy, expenditures usually display a counter- cyclical trend. During economic downturns, demand for government services such as unemployment compensation, education, and police protection may increase. A revenue stabilization reserve enables governments to insulate their spending and taxing policies from the vagaries of the economy.

Two policy issues that a government must resolve when creating a revenue stabili- zation reserve are the size of the reserve and the way in which it can be tapped. One approach is to set the reserve equal to a percentage of the operating expenditures; another is to set it according to the maximum change in the property tax rate that the government is willing to adopt. In the final analysis, the appropriate size of the reserve depends on the stability of a government’s revenue stream and on its political resolve to protect against budget instability.

Most budget policies leave the question of when to tap the reserve to the discretion of the council on the recommendation of the chief executive. Some governments, such as Milwaukee, Wisconsin, require an extraordinary (three-fourths) majority of the coun- cil before money can be transferred from the reserve to the operating budget. An alter- native approach pegs accessing the reserve to an economic indicator, such as a decline in the gross state product or an increase in the regional unemployment rate. Whatever mechanism is used, the budget policy should specify the benchmark measure, or “trigger point,” for accessing the reserve.

Unforeseen contingencies State and local governments also establish contingency reserves to provide funding in case of unforeseen emergencies or disasters. Article X, Section 20, of the Colorado Constitution requires all cities to maintain a restricted reserve in all city funds, which can be tapped only for declared emergencies.21 A con- tingency reserve provides a readily available pool of funding to ensure continuation of city operations during an emergency, and it buys time while the city or county assesses the impact of the emergency. Many governments establish a separate contingency reserve

The Budget Cycle: Preparation and Legislative Approval 199

in each major fund, such as one for each enterprise fund (water, sewer, sanitation, etc.). In cases where the disaster has a long-term impact, however, as has occurred with Hurricanes Katrina and Sandy, no amount of local contingency funding can provide adequate preparation.

Equipment replacement and building improvements Two other types of reserve that state and local governments use occasionally are for equipment replacement and building improvements. The advantage of an equipment replacement reserve is that money is available for purchasing operating equipment and vehicles as those on hand become obsolete or unusable. Some governments, such as Fort Collins set up a revolving fund that departments can borrow from to replace equipment before the next funding cycle or before the next lease-purchase agreement is approved. Sometimes governments establish a separate reserve that accumulates funds for deferred maintenance, renovations, and repairs to government-owned facilities. Funding for both types of reserve usually comes from surcharges assessed to each department on the basis of its pro rata share of equipment used or building space occupied.

Local governments that pursue a pay-as-you-go policy for capital improvements (dis- cussed in Chapter 11) will likely set up a similar reserve fund to finance new construc- tion, particularly construction for general government activities. Contributions to the reserve may be an annual fee assessed on all general fund activities, a fixed percentage of the annual operating budget, or some combination. Unfortunately, governments that fund their activities using this strategy rarely accumulate sufficient reserves to keep pace with new or replacement construction.

Debt service Lastly, governments establish reserves for debt service payments, usu- ally as a condition of their bond agreements with private investors. Debt service is the annual or semiannual payment of principal and interest that governments must make on outstanding indebtedness. For GO bonds, a debt service fund is created to account for the taxes levied and payments made to service this type of debt. For revenue bonds, separate accounts are created in an enterprise fund to track revenues and payments for debt service. In the case of revenue bonds, reserves of 10–25 percent of the annual debt service payment may be required by a rate covenant in the bond ordinance that protects bondholders against default. The size of the reserve varies, depending on the instability of the revenue stream from the project financed by the bonds. Less frequently, govern- ments may establish a small reserve for their GO payments, but this is usually done more for cash flow purposes than to fulfill a requirement of the bond covenant.

Budget preparation and amendment A budget policy statement should make clear certain critical aspects of budget preparation: the duration of appropriations, the process for amending the budget during the fiscal year, the type and frequency of budget performance reports, and what funds, if any, will be self-supporting.

Duration of appropriation authority For the operating budget, appropriation authority usually lapses at the end of the fiscal year (or biennium for governments on a two-year cycle). Such requirements are often specified in law. Any unspent or un- encumbered balances remaining at the end of the year lapse into the fund balance and become available for reappropriation for the next fiscal year. Obviously, department heads have a powerful incentive to spend their full appropriation as they risk having their budgets reduced the next year by an amount equal to the unspent balance. Excep- tions to year-end lapsing of authority include appropriations for capital projects, which

200 The Budget Cycle: Preparation and Legislative Approval

usually do not lapse until the project is completed, and state and federal grants, which lapse once the grant expires or the grant-funded project is completed.

Amending the budget A budget policy statement should specify the procedures for amending the budget during the fiscal year. Because revenue forecasts must be devel- oped several months before the fiscal year begins, revenue collections may deviate sub- stantially from those on which the budget is based, and the operating budget may need to be amended. In Georgia, as in many state and local governments, revenue forecasts are conservative, leading to a surplus of revenue available for appropriation by the fiscal year’s midpoint. Each year the Georgia legislature passes a midyear supplemental appro- priation that allocates any revenue surplus to state agencies.22

A policy should specify the circumstances under which the legislative body may amend the budget. For example, Fort Collins amends the budget (1) to pay for encum- brances (purchase orders) carried over from the preceding fiscal year; (2) to allocate unanticipated revenues, such as a grant or bond issue; or (3) to allocate reserves where the balances are greater than required by budget policy or where an emergency or unusual circumstance has occurred.23 Legislatures also amend budgets to transfer money across funds or to retroactively approve a transfer made by the chief executive. Such amend- ments align the operating budget with the actual levels of spending that are occurring.

Budget status reports A government’s budget policy should specify the types of budget status reports to be prepared and their frequency. Governments prepare interim financial reports that compare budgeted with actual amounts of revenues and expendi- tures to date. These reports, now available in real time with web-based financial manage- ment systems, provide decision makers with an important early warning of impending overruns in expenditures or shortfalls in revenues. For governments that rely on legacy data management systems, reports should be prepared quarterly or preferably monthly.

Self-supporting funds Finally, the policy statement for the operating budget should specify which enterprise funds will be self-supporting. In general, enterprise and inter- nal service funds should be self-supporting if (1) the benefits largely accrue to users of the service, (2) collecting a fee from users is administratively feasible, and (3) pricing the service at its full cost will not result in users acting in ways that end up to be more costly than the revenue raised from the charge. For example, charging full cost for residential use of a landfill may increase illegal dumping of trash along roads and in vacant lots. In such cases, subsidizing the service with general tax revenues is more efficient than trying to make it self-supporting.

Fort Collins has the following policy with respect to this issue. The city currently has five enterprise funds: golf, light and power, wastewater, storm drainage, and water. The goal is for all these funds to be self-sufficient—that is, to recover 100 percent of their costs. As a matter of policy, if an activity is unable to adjust its fees over a five-year period so as to achieve self-sufficiency, it will no longer be considered an enterprise fund but will instead be accounted for as part of the general fund.24

A related issue concerns the recovery of indirect as well as direct costs by enterprise funds. Indirect costs (or overhead) are the cost of services that are provided to all units of a government, such as the budget office or human resources, but that are not set up as internal service funds. Full cost recovery requires that enterprise funds bear a pro rata share of the cost of these support services. San Luis Obispo, California, states in its policy that its enterprise funds will “fully cover the total direct and indirect costs—including operations, capital outlay, and debt service” of its water, sewer, and parking enterprises.25

The Budget Cycle: Preparation and Legislative Approval 201

Assigned responsibilities in the budget process A budget policy should specify the broad outlines of key duties in budget preparation and adoption. For example, it should specify the officer responsible for budget preparation—either the finance officer or, if a separate budget office exists, the budget officer. It should describe in general terms the duties of this officer, such as his or her authority to standardize budget documenta- tion, prepare the budget calendar, and review departmental budget requests for accuracy and conformance to budget guidelines. It should also specify who is responsible for preparing revenue forecasts and the frequency with which such forecasts should be pre- pared. Finally, the policy should clearly assign responsibility for overseeing the budget’s implementation to the chief budget officer. The duties in this phase include preparing and reviewing budget status reports, monitoring revenues, reviewing agency expendi- ture requests for conformance with the budget, authorizing transfers across accounts or departments, and reviewing requests for supplementary appropriations.

Revenue policies

As with policies governing the operating budget, a revenue policy provides continuity in the procedures and assumptions guiding the funding decisions of government. It also in- creases the efficiency of deliberations on taxes and service charges by establishing a basis for addressing these sensitive political issues. And such a policy discourages exceptions by making those seeking an exception explain why it should be granted.

Governments typically prepare revenue manuals that provide extensive detail on the legal basis, administration, and yield history of every source of revenue they collect. However, the policies of concern here are those that directly affect funding of the oper- ating and capital budgets: stability of tax rates, use of one-time revenue sources, review of service charges and fees, and collection of delinquent revenues.

Tax rate stability Local leaders can promote revenue stability through a diversified revenue structure. With respect to fluctuations in the property tax rate, a common policy among local governments that have discretion in the property tax rate being levied is to limit increases in the annual levy to the rate of inflation. Since GO bonds are usually repaid with property taxes, local governments often have to increase tax rates to meet annual debt service requirements. In those states that require voter approval to issue GO bonds, governments look to growth in the tax base for the revenue to repay the bonds while holding tax rates constant. Research has found a substitution effect between prop- erty taxes levied to repay debt and those levied to fund general government operations, which suggests that as the property taxes dedicated to debt service go up, the latitude for increasing the tax rate for operating purposes goes down.

Use of one-time or temporary revenue Political leaders can easily become lulled into thinking that a temporary revenue windfall, such as a block grant, will continue into the future, and they then use the money for ongoing programs and services. To protect against developing a dependency on one-time or temporary revenue, some governments have a policy of using windfall revenues to finance the purchase of capital assets (equipment, buildings, land) or other nonrecurring purchases. This, too, poses risks if governments defer much-needed capital projects in anticipation of receiving a grant. An alternative strategy is to earmark windfall revenues for deposit in the revenue stabilization account. But in fact it is impossible not to develop some dependency on such resources. If the capital item is needed and the one-time revenue windfall is not present, other resources will be used. Ideally, a policy should target transitory revenues to purposes that will minimize the risk of dependency.

202 The Budget Cycle: Preparation and Legislative Approval

Review of service charges and fees As local governments have reduced their dependence on the property tax over the past decade, and as both state and local gov- ernments have scrambled to find new sources of funding, their dependence on service charges and fees has significantly increased. However, the tendency has been to review and update these levies only in the event of a budgetary crisis precipitated by a shortfall in taxes. Characteristically, state legislatures review university tuition rates only when other state revenues are tight.

As governments depend more on charges and fees, they must review rates annually and adjust them to reflect the cost of service delivery. A number of governments have formal- ized this practice into their budget policies. For example, San Luis Obispo’s extensive pol- icy on user fees classifies the city’s recreational services into three categories based on the percentage of cost recovered through the charge: (1) high-range cost recovery activities (60–100 percent of cost recovered), (2) midrange cost recovery activities (30–60 percent of cost recovered), and (3) low-range cost recovery activities (0–30 percent of cost recov- ered).26 The policy then lists the recreational programs in each category. Part of the budget preparation process includes examining each program for compliance with the fee policy.

Collection of delinquent revenues While a budget policy statement is not the ap- propriate forum for a full explication of delinquent revenue collection policies, it should include the level of performance that the government seeks to achieve. For instance, it may prescribe that delinquencies will not exceed 5 percent of the levy for the year and provide that, if they do, management will increase the productivity of the unit responsible for delinquent accounts receivable.

Budget implementation policies

The budget policy should cover issues pertaining to budget implementation, including procedures for transferring money across accounts or funds, interfund borrowing or payments, budget impoundments, and assignment of responsibility for expenditures. While these are all discussed in more detail in Chapter 9, the following discussion covers the more salient issues for inclusion in a budget policy statement.

Transferring money After the council has adopted the budget through an appro- priation ordinance (or an act at the state level), department heads enter into obligations through the approval of contracts and purchase orders that result in the expenditure of money once the goods or services have been delivered. When departments’ spending needs change, the manager may authorize the transfer of budget authority from one department or fund to another in order to bring the budget into line with the depart- ments’ actual spending needs. The budget policy should specify the types of budget transfers that can be made and the authorization required to make them. The policy of Olympia, Washington, is characteristic of those used by local governments:

1. Budget transfers across accounts within a department or agency require only the city manager’s authorization.

2. Budget transfers across departments but within the same fund require the city man- ager’s recommendation and the city council’s approval. Such transfers may be made only in the last three months of the fiscal year.

3. Budget transfers across funds (e.g., from the general fund to a capital projects fund) require city council approval.27

In addition, legislative approval is almost always required to transfer appropriations between capital project funds and sometimes even across accounts within these funds.

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Interfund borrowing and payments A related issue concerns interfund bor- rowing and interfund payments in lieu of taxes (PILOTs or, alternatively, PILTs). Trans- fers of these types are usually governed by legislation that requires, for example, an enterprise fund to annually make a payment to the general fund for property taxes that otherwise would have been received had the service been provided by a private firm. In Fort Collins, the water, wastewater, and light and power funds transfer 6 percent of their operating revenue each year to the general fund as a PILOT. Occasionally these transfers are characterized as returns on investment or as overhead charges assessed to the enterprise activity for the indirect costs incurred by the general fund in administer- ing the activity.

By contrast, interfund borrowing occurs when a temporary revenue shortfall in one fund is offset by a surplus in another. Such borrowing often occurs during the budget year as a cash management measure. However, governments also use interfund bor- rowing to balance operating budgets across fiscal years, as the federal government does when it borrows from the Social Security Trust Fund to lessen the deficit.

Impoundments Another issue that should be addressed in a budget policy is im- poundments. If revenues fail to keep pace with spending or if budgeted expenditures are no longer needed, the chief executive should have the authority to impound or restrict spending. At the federal level, the Congressional Budget and Impoundment Control Act of 1974 clarified the president’s impoundment authority by creating two categories: a deferral, whereby the president recommends delaying spending on a pro- gram for a period of time, and a recision, whereby the president recommends cancella- tion of budget authority for a particular program or line item.

While the impoundment authority of governors and the president is often specified in statute, local governments may grant this power through a policy statement. Fort Collins gives the city manager authority to direct “budget reductions,” but the council must be informed. This policy also obviates the issue of an appointed executive acting without the express approval of an elected council by providing that “while this admin- istrative action does not lower the appropriations within a fund, expenditures from the fund shall not exceed the amount recommended by the City Manager.”28

Responsibility for expenditures A related issue concerns responsibility for expen- ditures that exceed appropriations. An appropriation represents a legal limit on commit- ments in spending that the executive may incur for the fiscal period. Control is further exercised by the budget office through a process of apportioning the appropriation over the fiscal year and by the line-item detail provided in the budget document, which limits the amount of spending that each department head can incur and implicitly holds those with authority to spend money accountable for not exceeding the appropriated amounts. Fiscal prudence would suggest that this implicit authority should be formalized as part of the budget policy. Such a policy should state that each department or agency head is liable for expenditures exceeding those appropriated to the department and is responsible for keeping spending within appropriated amounts.

Debt policies

A fourth area typically included in a budget policy concerns debt issuance and adminis- tration. Provisions addressing these issues specify the maximum long-term debt burden the government will incur, the mix of debt with current revenues in financing capital improvements, the use of bond proceeds, and the conditions under which short-term debt will be issued.

204 The Budget Cycle: Preparation and Legislative Approval

Long-term debt burden One of the most common provisions in a budget policy statement places limits on the amount of debt a government can incur. Such limitations are on both the percentage of operating revenue spent for debt service and the amount of outstanding direct debt as a percentage of the full value of assessed property. For example, Scottsdale, Arizona’s policy provides for a ceiling on annual debt service of 25 percent of general operating revenue; San Luis Obispo limits debt service to 10 percent of general fund revenues. State law in Utah limits GO debt to 4 percent of a city’s adjusted taxable property value.29 Percentages will vary among governments depending on the composi- tion of their property tax base and the rate of growth in population. More rapidly growing communities that have a larger proportion of residential property set higher limits.

Capital improvement financing San Luis Obispo stipulates that capital improve- ments will be financed with a maximum of 60 percent debt and a minimum of 40 percent current revenues. The benefit of such a policy is the fiscal discipline it imposes on govern- ments to accumulate enough money—possibly in a building or equipment replacement fund—and then to carefully prioritize capital projects before construction begins.

Use of bond proceeds Another common provision in budget policy statements is a stipulation on how bond proceeds can be used. For example, San Luis Obispo uses debt “only for one-time capital improvement projects and only under the following circum- stances:

a. When the project’s useful life will exceed the term of the financing.

b. When project revenues or specific resources will be sufficient to service the long- term debt.”30

Short-term debt A final issue concerns the use of short-term debt. For example, governments may limit such debt to bond anticipation notes, or they may allow the issuance of notes for a broader range of purposes, such as to meet cash flow needs. Olym- pia, Washington’s policy states that tax anticipation notes, issued to cover short-term cash flow needs, cannot exceed 60 percent of expected appropriations and must mature during the current fiscal year.31 Governments that issue short-term debt should carefully assess their needs and then develop a policy that protects them from abuse of short-term debt without undermining their ability to meet cash flow needs.

Conclusion Preparation of the executive budget engages department heads in intense and time- consuming deliberations over their departments’ activities, their role in the government’s overall strategic plan, and the measures being used to assess their progress toward achiev- ing goals and objectives. Regular updates of revenue forecasts from the budget office are a key feature of budget preparation and adoption. The final step in this phase is the executive-level hearings, out of which comes the manager’s proposed spending plan for the next fiscal year or biennium.

The locus of deliberations then moves to the legislative branch, where the council reviews and modifies the proposed spending plan. Most of the legislature’s deliberations usually center on the tax-supported as opposed to fee-supported activities found in the enterprise funds.

Both the preparation and legislative approval phases are infused with conflict. Conflict, the product of opposing needs and goals, is most likely to arise between advocates and conservers, the budget office and departments, accuracy and political expediency, bureau-

The Budget Cycle: Preparation and Legislative Approval 205

1 City of Plano, Texas, 2012–13 Budget Preparation Manual, 15–19, plano.gov/DocumentCenter/ View/1869.

2 City of Fort Worth, Texas, FY 2013 Adopted Annual Budget and Program Objectives, D-7, fortworthtexas .gov/uploadedFiles/Budget_and_Management_ Services/FY2013/FY2013_final.pdf.

3 Glenn Abney and Thomas P. Lauth, “Gubernatorial Use of the Item Veto for Narrative Deletion,” Public Administration Review 62 (July/August 2002): 492–501.

4 Anthony Downs, Inside Bureaucracy (Boston: Little, Brown, 1967), 96–103.

5 Robert B. Denhardt and Janet V. Denhardt, Public Administration: An Action Orientation, 5th ed. (Belmont, Calif.: Thomson Wadsworth, 2006), 53.

6 Lance T. LeLoup, “From Microbudgeting to Macrobudgeting: Evolution in Theory and Practice,” in New Directions in Budget Theory, ed. Irene S. Rubin (Albany: State University of New York Press, 1988), 33.

7 Dwight Waldo, The Enterprise of Public Administration (Novato, Calif.: Chandler and Sharp, 1980), 81–98.

8 Jesse Burkhead, Government Budgeting (New York: John Wiley & Sons, 1956), 14.

9 City of Austin, Texas, “Budget in a Box” (April 2013), austintexas.gov/biab.

10 City of Boulder, Colorado, “Priority-based Budgeting” (May 2013), bouldercolorado.gov/ index.php?option=com_content&view= article&id=12883&Itemid=4403.

11 Michael J. White, “Budget Policy: Where Does It Begin and End?” Government Finance 7 (August 1978).

12 Fairfax County, Virginia, “Ten Principles of Sound Financial Management,” fairfaxcounty.gov/dmb/ 10_principles_sound_financial_management.htm.

13 City of Fort Collins, Colorado, “Budgeting for Outcomes” (2012), fcgov.com/bfo/index.php.

14 City of Salt Lake City, Utah, “Financial Policies,” FY 2012–13 Mayor’s Recommended Budget, C-2, slcdocs .com/budget/mayor2013.pdf.

15 City of Birmingham, Alabama, Finance Department, at birminghamal.gov/budget.aspx.

16 City of Olympia, Washington, “Policies and Guidelines,” 2012 Adopted Operating Budget, 33–35, olympiawa.gov/city-government/budget-financial- reports.

17 Governmental Accounting Standards Board (GASB), Statement No. 5 Disclosure of Pension Information by Public Employee Retirement Systems and State and Local Governmental Employers (Norwalk, Conn.: GASB, November 1986).

18 GASB, Summary of Statement No. 45 Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions (Norwalk, Conn.: GASB, June 2004).

19 Jon David Vasche and Brad Williams, “Optimal Governmental Budgeting Contingency Reserve Funds,” Public Budgeting & Finance 17 (Spring 1987): 74.

20 Ibid., 75.

21 City of Fort Collins, “Financial Management Policies” (2006), 120, fcgov.com/citymanager/ pdf/04-05financial-mgmt-pol.pdf.

22 Thomas P. Lauth, “Mid-Year Appropriations in Georgia: Allocating the ‘Surplus,”’ International Journal of Public Administration 11, no. 5 (1988): 535.

23 City of Fort Collins, “Financial Management Policies,” 92.

24 Ibid., 110.

25 City of San Luis Obispo, California, “Section B, Policies & Objectives,” 2011–13 Financial Plan, B-11, slocity.org/finance/download/budget11-13/ Final%20FPWeb.pdf.

26 Ibid., B-9–B-10.

27 City of Olympia, “Policies and Guidelines,” 31.

28 City of Fort Collins, “Financial Management Policies,” 92.

29 City of Salt Lake City, “Financial Policies,” C-2.

30 City of San Luis Obispo, “Section B, Policies & Objectives,” B-17.

31 City of Olympia, “Policies and Guidelines,” 50.

cracy and democracy, special interests and collective interests, and public will and public welfare. The challenge for the local manager is to create an environment that uses the conflict in a constructive manner and to keep budget deliberations on track and focused on finding solutions that serve the long-term interests of the community.

A primary tool for managing conflict is a formal statement of budget policies that explicitly establish financial standards to guide deliberations. Such policies can be writ- ten or unwritten, but a formal statement provides a standard of budgetary performance that participants have agreed upon and that provides a framework within which both the executive and the legislative branches can engage in constructive dialogue through the budget cycle.

Notes

206 The Budget Cycle: Preparation and Legislative Approval

1. What is meant by a balanced budget? Conduct a web search to discover how a “structural deficit” differs from the definition of a budget deficit described in the text.

2. Go to the Fort Collins, Colorado, website on budgeting for outcomes (fcgov.com/bfo/index .php). Summarize the city’s use of this approach to entrepreneurial budgeting. Evaluate the impact of this approach on city departments.

3. Below is a series of scenarios of common conflicts encountered by chief executives and budget offices during budget preparation and legislative adoption. Summarize the appropriate course of action that the chief executive should take in each case. a. A proposal by a state legislator to increase the sales tax forecast provided by the state

comptroller b. A proposed 5 percent across-the-board reduction in base funding by the budget office c. Submission of the chamber of commerce’s budget request to the city after the deadline and

with incomplete information d. A department head’s appeal to the executive director of a nonprofit agency to restore a

3 percent reduction in base-level funding proposed by the agency’s budget office e. A proposal by the chair of the United Way’s board of directors to delay recognition of

certain expenditures until the following fiscal year f. The inability of the city council to adopt a budget before the deadline mandated by the city’s

charter g. Complaints from department heads that the budget office requests information that the

departments do not collect and cannot obtain within the time allowed by the budget calendar

h. A request from the university’s Department of Public Administration to add five new faculty lines with a promise to increase federal research funding by 25 percent and improve graduation rates by 15 percent

4. Budget policies provide local governments with a frame of reference for moderating conflict during budget preparation, adoption, and implementation. Use the website for the most recent budget year for the following local governments to answer the following questions: a. For the City of Peachtree, Georgia (peachtree-city.org/DocumentCenterii.asp?FID=11):

(1) The appendix provides an extensive summary of the city’s budget policies. What funds does the city include in the operating budget?

(2) What is meant by a baseline funding level and how is it used in the budget process? (3) Who is responsible for preparing the annual budget?

b. For the Village of Hanover Park, Illinois (hanoverparkillinois.org/Services/Finance/ AnnualBudget.htm):

(1) The financial policies section of the village’s budget requires what percentage of the general fund held as an unreserved fund balance?

(2) What conditions are required for amending the village’s budget?

c. For Mecklenburg, County, North Carolina (charmeck.org/Departments/County+ Managers+Office/Business+Management/Home.htm):

(1) In the Financial Management Policies section of the operating budget, what procedures are used to review and select capital projects?

(2) What is the county’s policy on the lapse of budget authority for year-end encumbrances?

REVIEW QUESTIONS

The Budget Cycle: Preparation and Legislative Approval 207

5. Using the criteria for operating budget policies discussed on pages 193–201, prepare a set of policies on the following topics. You may use language from any of the local governments with model statements referenced above, in the sidebar on page 194, or from any other organization’s budget policy statement of your choice. a. Budget coverage b. Balanced budget c. Budget reserves d. Procedures for preparing and amending the operating budget e. Assignment of responsibility for duties in the budget process

EXCEL EXERCISES Microsoft Excel is a tool widely used by budget analysts. The following Excel exercises introduce readers to the preparation of a departmental budget request and the preparation of revenue forecasts.

1. This Excel exercise requires analyzing the line-item budget for a city’s development department, which has responsibility for issuing building permits and inspecting residential and commercial construction. This city has a policy goal that development fees will cover operating expenditures of this department. The assignment is to develop a budget request for FY 2014–15 for this department and to determine whether this department will have sufficient revenues to meet its expenditures. Detailed instructions and data for this exercise are available at bookstore.icma .org/A_Budgeting_Guide_Teaching_Res_P2310C147.cfm.

2. This exercise introduces several features in Excel that aid in developing revenue projections using trend analysis and a moving average. The first task involves correcting the historical data on sales tax collections for inflation. The dataset is actual sales tax collections by month from October 1992 through February 2013. The corresponding consumer price index (CPI) for each month is provided. The data can be used to evaluate current-year trends as well as to project revenue for the next budget year. The assignment is to develop a moving average trend for the inflation-adjusted sales tax collections, compute the month-to-month percentage change in collections, and graphically display those percentage changes. Detailed instructions and data for this exercise are available at bookstore.icma.org/A_Budgeting_Guide_Teaching_Res_ P2310C147.cfm.

REVIEW QUESTIONS