Travis St. Clair outlines how fiscal problems at the local level often stem from short-term fiscal and electoral incentives as well as voters’ limited attention. He reviews potential solutions to improve the financial transparency and long-term planning of local governments.
This article is part of a series examining the financial conditions of local governments in the United States and the forces that shape them. We will publish a new addition to the series every Monday for the next few weeks.
American voters can be forgiven for thinking that their local governments are in a constant state of fiscal crisis. New York City continues to struggle with an influx of migrants that has jeopardized its ability to maintain services and led the mayor to appeal for greater state and federal support. Chicago grapples with a massive pension shortfall and debt burden amidst persistent difficulty in finding common ground, as illustrated by the recent failure of a mayor-led initiative to reform the real estate transfer tax. Los Angeles faces a growing budget shortfall that imperils its efforts to confront a homelessness crisis. American cities are struggling to adjust to a post-pandemic world of empty office towers and shifting commuting patterns.
Yet, many of the fiscal problems that governments face predate the pandemic. In fact, one can’t help but wonder whether there has ever been a time that local governments have managed their finances prudently, when cities did not face impending budget cuts and threats of drastic service reductions. The answer is: they haven’t. And the reason why is the same reason why so many governance challenges persist: the institutional structure and the incentives that it gives rise to. Too often, municipal leaders simply are not incentivized to engage in prudent fiscal management.
To explain why, it helps to start with one of the most basic features of local government budgets: the balanced budget requirement. Unlike the federal government, city and state governments in the United States cannot engage in deficit spending. And while the details of these requirements vary from place to place, the overarching picture is the same: governments must balance their operating budgets on a cash (or near-cash) basis.
Cash budgeting relies on a straightforward principle–-the money flowing into the government must exceed the money flowing out of it. In fact, this simplicity is one of its benefits, as it is easy for administrators to understand. On the other hand, it also has the potential to divert focus from structural problems to short-term remedies. Cash budgeting often incentivizes government leaders to defer whatever expenses they can until future administrations, in essence passing the buck. The most visible illustration of these skewed incentives is the widespread problem of public pension underfunding. The largest liability of subnational governments is not muni bonds; it is unfunded pension liabilities, estimated at a $6.5 trillion shortfall in 2022 when measured on a market basis. How did governments amass such significant liabilities? It’s simple: it makes sense for governments to pay their employees lower salaries in exchange for generous retirement benefits that don’t come due for several decades. This approach gives lawmakers room in the budgets for current projects that benefit them politically, while deferring the problem of paying out those benefits to someone else (i.e. a future administration).
In fact, unfunded pension liabilities are just a particularly acute example of the challenges related to policy-making for the long-term. Citizens—as well as their elected representatives—are necessarily short-sighted. Voters pay little attention to local governance, and to the extent that they do, it is difficult for them to understand the trade-offs that policymakers must make between fiscally prudent decisions with long-term benefits and those with more immediate political advantages. Local officials, for their part, face short-term electoral time horizons. To the extent that they are concerned with re-election, their decision-making necessarily comes with a short-term bias.
However, short-term bias is not the only issue. Even apart from the general myopia of legislators and citizens, there is evidence that voters just don’t place a lot of value on fiscal management relative to other concerns. When parents are deciding on their choice of neighborhoods, the factor that typically drives their decision-making is access to quality schools. (Quality is, of course, difficult to parse. It might be more accurate to say that parents are motivated by the demographics of the schools that their child will attend more so than the quality of instruction per se.) This idea—that school quality plays a large role in residential choice, and that the demand for quality schools is capitalized into housing values—is well-established in the school finance literature.
This is not to say that voters don’t care at all about the fiscal health of their local governments. There is evidence that voters move or express dissatisfaction when confronted with evidence of fiscal problems. For example, governments that receive fiscal stress labels from state-monitoring systems see declines in house prices following the designation. And credit rating upgrades lead to increases in the vote share of incumbent politicians. But these effects are fairly small and ephemeral and pale in comparison to the types of responses observed when school districts show signs of test score declines.
So if voters are information-constrained and myopic, and consequently place little weight on effective fiscal management, what are we as a society to do about it? Is there any way that we can realign incentives to encourage local government leaders to engage in more fiscally responsible decision-making? For starters, it is unlikely that any silver bullet exists. Public-sector financial practices are often a reflection of culture and shared values that are constantly evolving and in flux. What may prove useful today may be a hindrance tomorrow.
For that reason, radical proposals are unlikely to succeed. We could require local governments to balance their budgets on an accrual basis rather than a cash basis. Accrual accounting records revenues and expenses when they are incurred, regardless of when the actual cash changes hands. This would certainly help to align governments’ short- and long-term incentives, which is why some countries around the world have tried including accruals in their budget process. However, accrual budgeting requires a certain amount of accounting knowledge to understand, something that few legislators and only a small proportion of the public possesses, and consequently technical accounting fixes may very well lead to less transparency and accountability.
Another alternative is to impose fiscal restraints through referendum, as several states and localities have tried, such as with California’s Proposition 13 or Colorado Taxpayer’s Bill of Rights. However, research has shown that imposing fiscal limits of this sort either has limited effects or leads to unintended consequences; local governments tend to find a way around them, either by creating new public authorities or shifting certain expenditures on to the state.
Is the solution to increase the involvement of the state in monitoring and information provision? Certainly, the research on fiscal monitoring systems suggests that providing voters and legislators with appropriate heuristics can lead to improvements in financial management. Introducing state-level monitoring programs leads to decreases in the likelihood that incumbents will be re-elected and improved long-term fiscal health. But monitoring programs alone are unlikely to be sufficient: fiscal labels must compete with voters’ limited attention, and simple financial benchmarks do not always present a complete picture.
In the end, governments are often persuaded to impose fiscal discipline when one of three things happens: 1) fiscal weaknesses threaten the government’s ability to access credit markets, 2) discipline is imposed on them from a higher-level government, or 3) finances become salient as a campaign issue. All three require reliable and transparent financial information as well as a public that is well-informed about financial matters. To improve the financial management of our local governments, we must keep working to improve the quality of the information that we provide as well as our citizen’s ability to make sense of that information.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
