This post was originally published in the California Employment Law Letter, Vol. 30, No. 12 on April 27, 2020.
You know that time between when you drop a paperweight and when it lands on your foot? You know it will hurt, but you don’t know how much or for how long. Public agencies are living in that moment right now. The COVID-19 shutdown is certain to increase the amount of services local governments need to provide while reducing revenues.
In the words of Donald Rumsfeld, we are now struggling with a lot of “known unknowns.” How long will this crisis last? How hard will local revenues be hit? Will the shutdown trigger a recession, and if so, how severe will it be? What will the impact on stock markets be, and how will that affect California Public Employees’ Retirement System (CalPERS) rates?
Now we’re learning that restrictions won’t be lifted all at once, but in phases, so the impact of economic inactivity will be prolonged. But at what level? My thesis is that we already know enough to begin to act, and the longer we delay, the deeper the ultimate cuts will be.
Revenues decline as spending increases
Let’s begin with revenues. On the good news side, the current crisis shouldn’t have a significant effect on property taxes and CalPERS payments for nearly two years. The immediate problem will be the more volatile revenue sources like sales taxes, transient occupancy taxes (TOTs), and real estate transfer taxes.
According to Michael Coleman’s California Local Government Finance Almanac, add-on sales taxes typically provide about 20% of general city revenues, a funding source expected to drop drastically and quickly. For many cities, that number is more like 40%. Much of that percentage is reliant on the purchasing of durable goods, such as cars or large home appliances. With nowhere to drive and less money in their pockets because of layoffs or pay cuts, individual consumers are far less likely to invest in those durable goods.
TOTs can provide anywhere from 5% to 70% of a city’s general revenues, depending on the local economy’s reliance on tourism. That funding is likely to largely evaporate—we’ve already seen it happening. The hotel industry is being hit especially hard by the coronavirus pandemic and its accompanying travel restrictions.
Coupled with the decline in revenue has been an increase in emergency spending. For example, local governments have created programs to shelter at-risk unhoused populations, build or modify facilities for testing and treatment, and augment existing networks and resources for healthcare worker. Most of this emergency spending will come directly from reserves, although some of it may ultimately be reimbursed by federal or state sources. So, while the impact on each locality will differ substantially, almost every jurisdiction is facing a shortfall versus its enacted budget and will be moving shortly to fill that hole for the remainder of the current fiscal year and for the coming fiscal year.
Assuming life returns to more or less normal by the end of the calendar year, the issue will then become the longer-term impacts of the lost year of 2020. The effect of the COVID-19 crisis on property taxes will depend entirely on whether the shutdown results in a serious recession. While property taxes are unlikely to go down given Proposition 13’s 2% escalator and undervaluation of property, we’ve been living in a world where we can
pay 3% wage increases and fund increases in pension costs of 2% of payroll largely because property taxes have been going gangbusters. So even a small decline in frothiness will make it harder to feed the pension beast while keeping up with wage inflation.
Impact on pension funds, labor contracts
But based on my informal poll of finance directors, the scarier long-term prospect is a significant impact on CalPERS rates (or other pension fund rates). Before COVID-19, we were already concerned that CalPERS rates were predicted to outstrip revenues. The below chart illustrates the effect of just a single year of bad returns. For example, a negative 5% return in fiscal year (FY) 2021 would increase safety rates by more than 10%
in FYs 2026-27, even if the plan hit its 7% target in each subsequent year. Blessedly, with the recent improvement in the equity markets, it seems likely that CalPERS will have at least a modest gain for the current fiscal year, albeit well below the 7% target.
Many local agencies are beginning or are in the midst of labor negotiations for contracts effective July 1, 2020. Historically, public agencies have pressed their negotiators to reach agreements ahead of the labor contract’s effective date to ensure a balanced budget. Now is a good time to ignore that rule. In my 30+ years of negotiating labor contracts, there has never been a year in which the level of economic uncertainty has been as high as it is today. So, my advice for agencies that have an open contract is to either roll over the existing contract for three to six months or, if you are feeling particularly brave, roll over the contract for a full year with no wage increases.
Public agencies that have ongoing labor contracts face a more difficult challenge. The most responsible course is for public agencies to meet with unions that have closed contracts and seek to defer wage increases. Alternatively, of course, layoffs and furloughs are possible. If an agreement cannot be reached, it may be appropriate to explore whether a declaration of fiscal emergency is justified.
What will happen to reserve funds?
Of course, if you propose cutting wage increases that are incorporated in ongoing memoranda of understanding, there will be those who ask, what about the city’s reserves? Isn’t this situation precisely what reserves are meant for? Most cities have done a good job in recent years of rebuilding their reserves, funding other post-employment benefits (OPEBs) and pension obligations, and creating rainy day funds. For those cities, the question really isn’t whether this is an occasion to draw on their reserves but how quickly the problem is drawing down their reserves. In the words of San Diego Mayor Kevin Faulconer: “The City Council and I have worked together to build up our reserves and restore core service levels since the Great Recession of 2008. This proactive planning has helped us save for a rainy day. Unfortunately, the ongoing fiscal impacts of the pandemic are more like a hurricane.”
San Diego’s new proposed FY 2021 budget outlines the projected change in the city’s major general fund revenue sources, property taxes, sales taxes, and TOTs from FY 2020 to FY 2021 in the context of the pandemic. The city’s predictions align with mine: Property tax revenue will remain relatively stable in the short term with a growth rate of 4.25%, while sales tax revenue is expected to plummet by 13.53% and TOT revenue is expected to decline by 10.91%. In San Diego, sales tax usually represents 18.3% of general fund revenue, and TOT usually makes up 8% of general fund revenue. The decline in revenue is significant, and it represents the impact of COVID-19 within only a single year; there’s no telling how many quarters will see losses to city revenues.
Taking early action to cut expenditures will be crucial for preserving reserves so local governments have room to move as answers to the unknowns come to light. Russ Branson, a well-respected consultant, makes the point this way: If, for example, you have $50 million in your general fund and you don’t reduce your expenditures by 5% in year one, even with no expenditure increases and assuming revenues will slowly return over a five-year period, you would eat up 34% of your reserves just to survive. Conversely, if you reduce expenditures by 5% in year one under the same assumptions and freeze spending at that level, you would require the use of only 4% of your reserves to balance the budget.
While our public-sector employees deserve raises, especially in view of the hardships many are enduring as essential workers during the coronavirus pandemic, labor contracts are negotiable. But many core services local agencies perform are not.
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Founding Partner, Renne Public Law Group