Guide to Local Government Finance in California

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Guide to Local Government Finance in California

“Over the course of my twenty-seven years as a city manager, I would have loved to have had a resource like the Guide to Local Government Finance in California to provide to my council members and staff. It uniquely covers all of the ground that encomposes the complexities of local government finance in California—and in an easy-to-read way. It’s a great resource for elected officials and staff.” Kevin Duggan, Western Regional Director International City and County Managers Association

“For local elected officials, there has been no place to look for a detailed analysis, and careful evaluation, of local finances. There is now. Guide to Local Government Finance in California offers the best information on California local finances that I have read. It both answers specific finance questions and presents a larger perspective on the financial tensions and differences between local governments and the State.” Ronald O. Loveridge, Mayor of Riverside (1994-present) and Political Science Professor at University of California, Riverside (1965-present). Past President, League of California Cities and National League of Cities.

“The authors have written a book that should be read by every newly elected council member and anyone who will find themselves engaged in the topic. The book, given the subject matter, is surprisingly readable and is a must read if you want to understand local government finance in the Golden State.” Mike Kasperzak, Mayor, Mountain View President, League of California Cities 2012

Guide to Local Government Finance in California 2017 Second Edition

Michael Multari Michael Coleman Kenneth Hampian Bill Statler

Solano Press Books Point Arena, California

Guide to Local Government Finance in California Copyright © 2017 by Michael Multari, Michael Coleman, Kenneth Hampian, Bill Statler

All rights reserved.

Printed in the United States of America. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopied, recorded, or otherwise, without the prior written approval of the authors and the publisher. Solano Press Books Post Office Box 773 Point Arena, California 95468 tel: 800 931-9373 fax: 707 884-4109 email: [email protected] Cover and book design by North Star Press of St. Cloud, Inc. Cover photographs: Jon Eric Handel Index by: Lee Humphrey ISBN: 978-1-938166-17-4 (paper)

ISBN: 978-1-938166-18-1 (Kindle) Second Edition: June 2017

NOTICE This book is designed to assist you in understanding local government finance. It is necessarily general in nature and does not discuss all exceptions and variations to general rules. Also, it may not reflect the latest changes in the law. It is not intended as legal advice and should not be relied on to address legal problems. You should always consult an attorney for advice regarding your specific factual situation.

Chapters at a Glance 1 Introduction. .

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2 Overview: Local Governments in California and What They Do. . . . . . . .

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3 Fund Accounting: Sorting Out the Money . 4 The General Fund: The Flexible Fund .

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5 Special Revenue Funds: The Inflexible Funds .

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8 Labor: Employing People .

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11 Investments: Managing the Public’s Portfolio.

12 Reporting: Accountability and Telling the Financial Story . . 13 Local Economic Development: Fostering Business Vitality .

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14 Real Estate Development Feasibility and the City as Developer: Perspectives and Roles .

16 Looking Back: A Brief History of California Local Government Finance . . . . . .

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15 Fiscal Impact Analyses: Costs and Revenues of New Development . . . . . . 17 Going Forward: Outlook and Reform .

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9 Purchasing: Buying Things and Contracting for Services .

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7 Budgets and Fiscal Policy: Allocating Resources . . and Ensuring Financial Health . . . . . . . .

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Contents Preface to the Second Edition ....................................................................... xiii

Acknowledgements ...................................................................................... xv PART I INTRODUCTION AND OVERVIEW

Chapter 1. Introduction .................................................................................. The Heart of the Matter .................................................................................... Purpose of the Book .......................................................................................... Roadmap to the Major Topics ..........................................................................

1 1 3 5

Chapter 2. Overview: Local Governments in California and What They Do ................................................................... Cities ................................................................................................................... City and County Forms of Governance ....................................................... Counties .............................................................................................................. Special Districts ................................................................................................. Another Way to Look at Municipal Expenditures: Operations, Capital Projects, and Debt Service ..................................................... Summing Up ......................................................................................................

17 20

Chapter 3. Fund Accounting: Sorting Out the Money ................................ Fund Types under Generally Accepted Accounting Principles ................ Governmental Funds ....................................................................................... Proprietary Funds ............................................................................................. Fiduciary Funds ................................................................................................. Summing Up ......................................................................................................

25 26 26 27 29 29

PART II FUNDS

11 11 12 15 16

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Chapter 4. The General Fund: The Flexible Fund ...................................... What Municipal General Funds Pay For ....................................................... Sources of Money for the General Fund ...................................................... Taxes ................................................................................................................... Fees ..................................................................................................................... Other General Fund Revenues ....................................................................... Summing Up ......................................................................................................

Chapter 5. Special Revenue Funds: The Inflexible Funds .......................... Local Special Taxes ........................................................................................... State Subventions .............................................................................................. Community Development Block Grants (CDBG) and Other Grants ............................................................................... Development Impact Fees .............................................................................. Summing Up .....................................................................................................

31 31 32 32 40 41 42

45 45 46

49 49 50

Chapter 6. Enterprise Funds: The Business-like Funds ............................. What Is a Local Government “Enterprise” Service? .................................. Setting Rates ...................................................................................................... Rate Review Frequency .................................................................................... Rate Structure .................................................................................................... Rate Setting Policy ............................................................................................ Rate Approval .................................................................................................... Revenue Collection ........................................................................................... Summing Up ......................................................................................................

53 54 56 58 59 61 62 63 64

Chapter 7. Budgets and Fiscal Policy: Allocating Resources and Ensuring Financial Health ....................................................... Requirements for Adopting Budgets and Financial Plans .......................... Budget Preparation ........................................................................................... Approaches to Budgeting ................................................................................ Traditional Versus Emerging Budget Practices ............................................ The Importance of Public Policy in Resource Allocation ......................... Gauging a Local Government’s Financial Health ........................................ Summing Up ......................................................................................................

67 67 68 69 75 78 83 89

PART III THE PRACTICE

Chapter 8. Labor: Employing People .......................................................... 93 The Cost of the Workforce ............................................................................. 93 How Compensation and Benefit Levels Are Determined ......................... 95 Labor Relations and Collective Bargaining ................................................... 99 Major Compensation Issues: Pensions and Retiree Health Costs ........... 104 Adding It Up: Estimating the Cost of the Workforce .............................. 109 Strategies for Containing Workforce Costs ................................................ 110 Summing Up .................................................................................................... 112

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Chapter 9. Purchasing: Buying Things and Contracting for Services ..................................................................................... Placing Purchasing in Context ...................................................................... Basic Purchasing Tasks .................................................................................. Emerging “Best Practices” ............................................................................ Summing Up ....................................................................................................

Chapter 10. Capital Improvements and Debt Financing: Building Things .......................................................... Capital Improvement Plans ........................................................................... Paying for Capital Improvements ................................................................ Major Types of Debt Instruments for Local Agencies in California ..... Summing Up ....................................................................................................

Chapter 11. Investiments: Managing the Public’s Portfolio ...................... Fundamental Principles for Investing Public Funds ................................. Surplus Funds: Why Do They Exist? .......................................................... Investment Authority ..................................................................................... Investment Management ............................................................................... Investment Policies ......................................................................................... Investment Oversight Committees .............................................................. Reporting ......................................................................................................... Summing Up ....................................................................................................

contents 115 115 116 117 123 125 125 126 130 136

137 137 141 142 143 144 151 152 153

Chapter 12. Reporting: Accountability and Telling the Financial Story ......................................................................... Fund Accounting Concepts .......................................................................... Annual Reports ............................................................................................... Interim Financial Reporting .......................................................................... Summing Up ....................................................................................................

155 155 156 160 161

Chapter 13. Local Economic Development: Fostering Business Vitality ............................................................................ Reasons for Economic Development ......................................................... Thinking about the Local Economy ........................................................... Business Attraction ........................................................................................ Economic Development Strategic Planning .............................................. Tools of the Trade .......................................................................................... Redevelopment ................................................................................................ Summing Up ....................................................................................................

165 166 167 169 170 174 178 182

PART IV DEVELOPMENT AND MUNICIPAL FINANCE

Chapter 14. Real Estate Development Feasibility and the City as Developer: Perspectives and Roles .................................... 185 The Developer’s Perspective ......................................................................... 185

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Different Kinds of Feasibility ....................................................................... Players in the Development Process ........................................................... Capital Requirements ..................................................................................... Debt Financing ............................................................................................... Financial Feasibility ........................................................................................ Market Studies ................................................................................................. Local Government as Developer ................................................................. Partnering with the Private Sector: It’s Complicated ................................ Managing the Complications and Risks ...................................................... Summing Up ....................................................................................................

Chapter 15. Fiscal Impact Analyses: Costs and Revenues of New Development .................................................................... The Effects of New Development on Municipal Finance ...................... Fiscal Impacts Over Time ............................................................................. Uses of Fiscal Impact Analyses .................................................................... Consultants and Third Party Analysts ......................................................... Typical Techniques ......................................................................................... Criticisms ......................................................................................................... Fiscalization of Land-Use Planning ............................................................. Summing Up ....................................................................................................

186 188 191 192 194 197 199 201 202 206 209 209 210 212 213 213 217 218 218

PART V LOOKING BACK, GOING FORWARD: THE ROAD TO REFORM

Chapter 16. Looking Back: A Brief History of California Local Government Finance ........................................................... The Early Constitution and Local Home Rule .......................................... Proposition 13 and the Era of Limits ......................................................... The Gann Limit .............................................................................................. The 1980s: State Fiscal Retrenchment and Local Responses .................. ERAF: Educational Revenue Augmentation Funds ................................. Proposition 218 (1996): “The Right to Vote on Taxes Act” ................... Proposition 26 (2010): Refining the Definition of “Tax” ...................... Proposition 1A (2004) and Proposition 22 (2010) .................................... Summing Up ...................................................................................................

Chapter 17. Going Forward: Outlook and Reform .................................... Towards Reform ............................................................................................. Reform Efforts ............................................................................................... Challenges to Reform .................................................................................... Common Flaws in Reform Efforts ............................................................. Defining the Problem .................................................................................... Principles of Local Government Fiscal Reform ....................................... Summing Up ....................................................................................................

x

223 223 226 230 231 232 233 233 235 236

239 239 240 241 244 246 249 252

Appendix A. An Overview of Public Finance Theory ............................... 255

contents

Appendix B. Detailed City Budget Process ............................................... 261

Appendix C. Presenting Financial Information ........................................ 279

Appendix D. Useful Information Sources ................................................. 297

Bibliography ............................................................................................... 307

Glossary ...................................................................................................... 309

Index ........................................................................................................... 325

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Preface to the Second Edition

T

he reasons for writing a second edition of this book remain essentially the same as those when we undertook the first edition in 2012. In California, a complex array of local governments—cities, counties, and special districts— provides a wide range of important public services to its citizens. How those local governments pay for those services involves a municipal finance system that is complicated, with a byzantine structure governed by arcane rules. Yet, recognizing how that system works is critical to making effective and responsive public policy. Thus, the primary purpose of this book is to provide a solid foundation for those who are interested in better understanding and navigating the complexity of California local public finance. This, we hope, will not only result in better decisions within the current system but will also help in efforts to reform and improve it. To do so, this book provides a broad overview of local government finance in California: the structure of government service delivery; the responsibilities of different types of local governments; the sources of revenues and their limitations; the fundamentals of public budgeting and accounting; and the ways money can be borrowed to build infrastructure. Such an overview requires some grounding in the convoluted history of the relationship between the state and local governments. It must also touch on topics that are fundamental to both an understanding of the problems and the possibility of reform, such as labor relations and the fiscal implications of development. The problem with covering so dynamic a subject is that it is constantly changing: economic conditions evolve, new laws are enacted, different issues become especially topical to the public and the academy. That said, the main picture of local government finance in California as presented in the first edition remains largely recognizable. But changes in the scene accumulated to the point where a new edition seemed warranted. Foremost, much of the statistical information contained in the numerous charts and graphs has been updated. While the “big picture” hasn’t changed much, the data are more current. Also, some court decisions have occurred related to rate structures and pensions; some of the fiscal reforms that were emerging in 2012 have been advanced (or dropped); and other incremental changes to the system have taken place. These modifications are noted in this current version.

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When the first edition was submitted for publication, the Great Recession and its immediate aftermath dominated the financial discussion, and the competition for scarce resources between the state and its local governments was acute. Since then, the economy has recovered; state finances have, for the time being, at least, been restored; and some semblance of stability has resulted. At the time, the viability of some local governments was in doubt (and, indeed, drastic cuts in services and even a few bankruptcies occurred). While most local agencies have now weathered the worst times, there has been substantial interest in the early diagnosis of possible fiscal difficulties. This edition includes a discussion of that issue. In 2012, redevelopment, a long-used financing tool, had just been eliminated by the state with the resulting transfer of billions of dollars away from local to state coffers. The way that the redevelopment agencies would “wind down” was unclear. Again, since then, much of that restructuring has occurred; a more recent focus has been on how some of the benefits of redevelopment that were lost might be recaptured. A discussion of some of these ideas, including Enhanced Infrastructure Financing Districts, has been added. The glossary has been significantly expanded to help clarify some of the technical terms used in the book. Graphics have been improved. In sum, we hope that this new book not only brings the financial picture up to date, but also makes the book even easier to use. The original idea for the book rose from an undergraduate class in city and regional planning taught at the California Polytechnic State University in San Luis Obispo. As part of the required curriculum, students studied the financial impacts that their hypothetical plans and developments would have on the communities in which they would occur. No single textbook seemed to cover these topics comprehensively, especially as they related to the unique circumstances in California. And it was equally apparent that there was a need for such a book to assist not only budding planners, but also other students with an interest in local government as well as newly appointed and elected public officials, local government staff, and citizens at large. In outlining the scope of the topics, it became clear that the effort would benefit from the perspectives, experiences, and expertise of multiple authors, including especially practitioners in the field who appreciate not only just the technical issues, but also the cultural, historic and political elements. We thank the many readers, including local government officials and the professors and students at a growing number of universities and colleges, for finding the book valuable. We hope that the second edition continues to help people understand that complex but fascinating subject of local government finance in California. Michael Multari, Kenneth Hampian, and Bill Statler San Luis Obispo, 2017

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Michael Coleman Davis, 2017

Acknowledgements

E

ven though each author has extensive practical experience in local government finance, writing this book proved even more challenging than we anticipated. Local government finance in California is stunningly complicated, layered and at times baffling—even for those of us who have worked within the system for years. Fortunately, we have had a lot of help along the way in getting the facts right, expressing complex issues as clearly as possible, and keeping pace with the vagaries of a rather wild system. Foremost, we thank our publisher Solano Press and Ling-Yen Jones, with special appreciation for Natalie Macris for her encouragement, without which the project would never have been launched. We also thank Corinne Dwyer of North Star Press for her work on format and production, Maggie Cox, who gave us sound advice on graphics, and Michael Coleman, who designed all the charts, graphs, and many of the tables. We were also assisted by several experts who most generously and graciously devoted their time reading drafts and providing key insights: Monica Irons, whose knowledge of labor relations was especially valued; Claire Clark, for her review of the economic development chapter that resulted in an important course correction; Dennis Moresco, who brought the perspective of his successful career to the discussions of real estate development feasibility; Kay Chandler and Ned Connelly, who reviewed the chapter on investments; and Karl Mohr, whose insights on development and fiscal analysis were greatly appreciated. In addition, several people read the entire manuscript, for which we give undying thanks: Gere Sibbach, who provided an important county perspective to our city-centric tilt; Roger Picquet, whose years as a city attorney and superior court judge provided us with both a legal eye and the perspective of a careful general reader; and Bob Leland, who lent his many years of wisdom and practical experience as a highly respected city finance officer. xv

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Of course, any errors in the book are our own responsibility. We’d also like to thank Chris Clark, who offered advice and direction early on and encouragement throughout, and Dr. John Nalbandian, who generously allowed us to share his wisdom regarding the role of political values, gained through years of academic study and practical experience in local elected office. Lastly, we thank our spouses—Denise Fourie, Suzan Dargahi Hampian, Mary Ann Statler, and Ruth Coleman—for indulging us the time we spent at research and writing, for patience with us when staring at computer screens made us oblivious to any other sensory events, and for their essential support.

— MM, KH, WCS, MC

xvi

Introduction and Overview Part I

Introduction Chapter 1

A

The Heart of the Matter society’s capacity to deliver effectively basic day-to-day services to its members fundamentally affects whether those people can live in a healthy, safe and fulfilling way or must struggle near the ragged edge of survival. In the United States, local governments (also called “municipalities”) are typically at the forefront in providing these basic services—for example, enforcing the law, putting out fires, delivering clean water, safely disposing of unhealthy sewage, and maintaining local roads for the orderly movement of people and things. Therefore, how local governments are funded, and how well they are funded in order to carry out their mission, matters—a lot. The great majority of people in California live within incorporated cities: eighty-three Figure 1-1. percent of the state’s almost forty-million Where Californians Live residents in 2016.1 Cities, therefore, provide most Californians with some or all of their local public services. As of 2016, California’s 482 incorporated municipalities ranged in population from over four million (Los Angeles) to fewer than 100 (Vernon).2 If one sets aside the four largest cities (Los Angeles, San Diego, San Jose, and San Francisco) and the dozen or so very small ones with fewer than 1,000 people, the average size of a California city is just over 50,000 people. Thus, most of the city governments that provide local public services serve modestly sized communities, and, despite some unfortunate exceptions, are typically highly accountable and responsive to Source: california department of Finance, 2016. their citizens. 1

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California’s municipalities also include counties, What Are the Financial Duties of Local Governments? which provide many state-mandated services to all county residents as well as services similar to those While they are organized in a variety of ways, every municipality must of cities for those people who live in their handle certain financial functions, including: unincorporated areas. In addition, thousands of other local governments, collectively called “special • Revenue Collection and Accounting. the collection of taxes, fees and other revenues owed to the local agency, and accounting for those districts,” deliver a wide array of public services monies. throughout the state. The boundaries of special • Resource Allocation and Accounting. the expenditure of revenues districts are idiosyncratic, often owing more to for appropriate purposes that reflect the priorities of the community, historical events and circumstances than to any and accounting for those expenses. • Payments—Controller. the payment of bills owed by the agency to contemporary analysis as to the appropriateness or others, including payroll, vendor payments and disbursements to other efficiency of this form of local government. government agencies. The large number and variety of local • Purchasing. the fair and competitive procurement of goods and governments in California make the study of their services within the authorizations set by law and by the agency’s budget and policies. financial affairs complex, sometimes frustrating, • Budgeting and Financial Planning. the forecasting of revenues and but also immensely interesting.3 Regardless of expenses, establishing goals and priorities, allocating resources, and form, to meet their public service duties, these making adjustments, as needed, in response to actual revenues and agencies must raise, manage and allocate many expenses. • Auditing and Financial Reporting. the review and tracking of millions of dollars4 each year, employ staffs, financial activities to ensure fairness, consistency, and conformity with negotiate and manage contracts, and build and proper procedures, as well as transparency for the public and reguoperate public facilities, among many other lators. obligations, and do all this within a setting that • Employer. the employment of competent staff, including negotiating and providing wages, salaries and benefits, as well as maintaining must be continually open and accessible to the appropriate working conditions. public. This is a remarkable and most challenging • Cash Management and Investments. the proper maintenance of undertaking, especially given the daunting financial cash holdings and investments in light of day-to-day cash flow needs limitations most agencies operate within today. while assuring security of assets, providing liquidity, and generating a responsible level of yield, in that order. Money for delivering local government services • Capital Financing and Debt Management. the use of debt financing in California is raised largely through an intricate tools to manage temporary short-term cash flow issues as allowed by system of taxes and fees—a finance system that is law, as well as for paying for expensive and long-lived capital improvecomplicated and unique. That unique nature of the ments. system is due to many factors of law, history, and culture, including state constitution provisions enacted by voter initiative that prescribe strict limits on how municipalities can raise revenues—and even how they can spend their money. In addition, recurring financial crises in the state government have had dramatic repercussions at the local level, further stressing municipal revenues and services. How local governments decide to use their limited resources leads to a complicated intersection of public policy, community planning, and budgeting. In a democratic society, this intersection must be navigated with transparency and ongoing accountability to the community. The allocation of resources almost always involves more than only technical financial “efficiency” considerations. Major budget decisions often depend as much on the values held by the decisionmakers than any financial analysis.

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It is not uncommon for the proposal of a major development project to bring many concerned people to a public meeting, while city council or board of supervisor hearings on the adoption of a budget may generate little interest. This is perhaps a testament to the skills of municipal finance officials, but it may also reflect the perception that financial planning and budgets are mostly boring and routine. But running a city or county is much more than approving or denying the controversial shopping center or condominium development. The heart of the matter, in fact, is the ongoing work to balance limited revenues with the public demand for costly and often vital services and facilities.

chapter i: introduction

Purpose of the Book As diverse and complex as California is, there is one thing most Californians can agree on: major state-local financial reform is needed. However, it is also safe to say that most people do not have a good understanding of the system’s byzantine structure. Improvements to how Californians pay for needed and desired local public services and facilities can be realistically accomplished only with a sound understanding of the system, with all its wonderful, frustrating and sometimes illogical complexity. Unfortunately, however, even those who have toiled within the system for years can struggle to understand it. This book provides a guide to the many financial aspects of local government in California. The goal is to offer added understanding and new insight for both the general public and practitioners, whether novices or veterans of the financial system. The book is also intended to aid local government managers and staff, including community planners and policy analysts. And, it is hoped, the book will find an audience with elected officials because they will be critical in leading the way toward an improved public finance system. The book will also be helpful to teachers and students in our state’s colleges and universities, from where so many future agency staff, elected leaders, as well as voters, will come. Here are some ways that these different readers can benefit from this book:

Public agency managers and staff. The book offers city and county managers a single resource covering the wide range of local public finance topics tailored to the conditions found in California. Managers can also use this book to build deeper financial understanding and skills within the larger agency staff. For example, the book explains key laws that limit the ways public money can be raised and spent; it also outlines how competing priorities are reconciled through financial planning and budgeting. There is a natural tendency for agency staff to focus on their own departmental circumstances; this book will help broaden their understanding of “the big 3

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picture” and help to soften the boundaries between agency functions, leading to a stronger integration of services.

Planners and public policy analysts. Any serious planning practitioner or municipal policy analyst needs to understand how local government is financed. This book provides the necessary economic context for policy review and development. This subject is especially important for city planners who implement, revise and update community general plans. Plans that are not rooted in economic and financial reality are rarely implemented and, thus, often little more than exercises. Curiously, state law does not require an economic or financial element in a general plan. But a plan that does not consider the fiscal impacts of the proposed land uses may result in a financially unsustainable community. Furthermore, economically infeasible plans can undermine community development and revitalization, occupying shelves and websites while land remains vacant or underutilized and pressures build to develop it in ways contrary to the overall community vision. This book helps planners understand the basic economic and financial considerations that are part of sound planning practices, at both the project, and, more importantly, the general plan levels.

Elected and appointed officials. Many elected officials are surprised by the depth and scope of responsibilities they must undertake upon taking office. They are suddenly in charge of organizations with multi-million dollar budgets with unpredictable funding sources and demands for expanded and improved services, all occurring in a highly complicated legal context that is under continual public scrutiny. City council members, especially, will find this book to be a valuable overview of municipal finance, covering not only such basic topics as revenue sources in California, but also labor relations and negotiating, debt financing, budgeting and financial reporting, investment of public monies, assessing fiscal impacts of new development, and a better understanding of what drives local economies. Although the emphasis is on cities, many of the elements of theory and practice presented in the book are highly applicable to California’s other local governments, namely, its counties and special districts. Thus, the elected counterparts in counties and special districts will find the book useful. Throughout the text, key differences between cities, counties, and special districts are highlighted.

The book will similarly benefit most appointed officials—including planning commissioners, parks commissioners, and others—to better appreciate the relationships between their specific duties and the broader purposes and financial capacities of the organization. Citizens. The book will be interesting to anyone who wonders how local communities have developed and paid for their systems of public facilities and services, and how those systems are maintained, changed and expanded.

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It will also be helpful to persons perplexed about why their local government seems to be frequently stressed by financial problems, often linked to the ups-and-downs of the general economy and to the state budget. Anyone who has asked what income sources actually underlie municipal budgets or why certain services suffer cuts while others are expanded, or who have heard their local officials decry the intrusions of state government diminishing their ability to maintain services such as police patrols or road repairs, will find this book valuable. The book also assists citizens interested in reform by offering criteria for judging proposals put forth by those in elected office or those seeking office.

chapter i: introduction

Students. This book should be of practical help to students, particularly at the college and university levels, studying local government, planning and public policy. As great as California may be, its current financial system is not sustainable into the future, statewide or at the local level. Changes are needed, but these changes will only come about through leaders, agency staff, and citizens who are grounded in a practical understanding of the system, including how it has evolved and what is needed in the future.

This book has been written primarily to provide a practical understanding of the current system, its past, and the bumpy road to reform. However, for readers looking for some basic background on the theoretical underpinnings of public finance, Appendix A provides a very brief overview of the most common philosophical questions dealt with in this field. Roadmap to the Major Topics The book is organized into five parts: I, this introduction and an overview of what California local governments do; II, a review of a fundamental aspect of local government finance: the concept and management of “funds;” III, the key topics in the practice of municipal finance, including budgeting, labor, purchasing, capital improvements, investing and reporting; IV, topics related to development and local government finance including the municipality’s roles in real estate development, fiscal impact assessments of plans and projects, and community economic development; and, V, a look back at the history that has led to today’s severely stressed financial system and a look ahead toward the future with suggested principles for reforming that system. Part I: Introduction and Overview Anyone who wants a thorough grounding in municipal finance—what it consists of, how it works, and the political and economic forces that influence 5

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it—will find the entire book useful. The book is also a written as a guide for those needing to learn about specific topics of greater interest or urgency. The remainder of Chapter 1 provides short summaries of the topics covered in each chapter.

Chapter 2 sets the stage by providing an overview of what California local governments do. There are almost 6,000 local governments in California (not counting school districts) that have different legal bases, wide-ranging responsibilities for providing public services, and varied and sometimes competing funding sources. This chapter summarizes the principal differences among cities, counties, and special districts, and gives a statewide perspective on the types of local services these municipalities provide in California, how much money is expended in their delivery, and the main ways of paying for them. Part II: Funds Chapter 3 introduces the concept of funds—how money from different sources and intended for various uses must legally be accounted for by public agencies. This chapter explains the concept of funds and the basic language of municipal finance needed to understand the more detailed topical discussions that comprise the remainder of the book.

Chapter 4 examines the “general fund,” the flexible fund that holds a local agency’s “unrestricted” revenues to pay for such important services as police, fire, parks, and roads. The kinds of local taxes that contribute to the general fund in California cities and counties are described, as well as other sources of general purpose income. These revenues are nothing less than essential to cities and counties, and yet they are subject to numerous limits that diminish the local community’s control over them. When local governments talk about their fiscal woes, they are almost always talking about the general fund.

Chapter 5 looks at “special funds,” restricted funds whose revenues must be earmarked for specific purposes only. These inflexible funds include special taxes, subventions, and grants. They comprise significant revenues to cities, but are especially important to counties, which are charged with providing such critical and expensive services as welfare and public health that are both mandated and largely funded by the state.

Chapter 6 focuses on the “enterprise funds,” the business-like funds supporting services that agencies deliver much like the private sector by charging fees directly to customers for services such as water, sewage disposal

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and garbage pick-up. Based on their revenues and expenditures, statewide, these enterprises account for about a third of what local governments do in California. In many ways, enterprise functions are afforded greater flexibility when it comes to raising needed money, and, with some important exceptions, typically aim to be financially self-supporting. This chapter specifically includes some practical suggestions related to rate setting processes and principles.

chapter i: introduction

Part III: The Practice Chapter 7 introduces the “kingpin” of local government financial practice, budgets and fiscal policies. Budgets are king because it is through the allocation of resources that an agency declares its priorities (overtly or not). And yet budget processes are often misunderstood, poorly executed or even ignored. This chapter describes the purposes, types, and requirements of municipal budgets. It also discusses the importance of basing budgets on open, accessible processes that articulate community goals and priorities. The chapter includes examples of the types of financial questions faced by elected officials when adopting budgets whose answers are not necessarily technical in nature. Appendix B provides practical suggestions for developing and adopting an effective budget.

Chapter 8 discusses the foremost budget driver—labor, the cost of employing people. It is indeed through people that most local public services are delivered— thus, issues related to staffing costs are fundamental to municipal finance. The chapter identifies the typical components of compensation, including benefits and other obligations, that account for the real cost of labor. It discusses why these costs typically increase faster than the general inflation rate. Labor negotiations and collective bargaining often overwhelmingly shape budgets in many local jurisdictions. The chapter covers negotiation processes, the key players, and different routes to reaching agreement.

Chapter 9 is about purchasing—buying things and contracting for services. While supplies, minor equipment and service contracts typically comprise a smaller percentage of a budget than labor, government procurement garners considerable attention—for good reason. Historically, it is an area where corrupt officials have manipulated the processes for personal gain, with ensuing scandals that launched major local government reform movements in America. Past reforms have included emphasizing formal and centralized procurement systems. Such systems, however, sometimes lead to unnecessary bureaucracy and inefficiencies. This chapter describes emerging best practices that aim to assure the integrity of the procurement process while fostering improved efficiency. 7

Guide to LocaL Government Finance in caLiFornia

Chapter 10 addresses the final major part of most local government budgets, capital improvements and debt financing; that is, planning and paying for long-lived facilities and infrastructure like police and fire stations, roads, wastewater treatment plants, parks, libraries, and city halls. Public agencies often borrow money through the issuance of bonds to construct capital improvements and pay off the debt service over the lifetime of the facility. This chapter explains municipal bond basics and the types of debt financing instruments available to California local governments.

Chapter 11 addresses another vital practice, investment, managing the public’s portfolio. This is also an area that has been rocked by calamities and scandals due to unwise practices. The chapter answers key questions such as: What should agencies do with the public’s portfolio until saved money is needed? How can officials assure that the investments are being managed properly? The chapter suggests best practices, including that agencies follow the “SLY” maxim: safety, liquidity, and yield (and in that order).

Chapter 12 covers reporting and accountability—the ways that an agency presents its financial condition to regulators and the public. While auditing and financial reporting may sound dull, these functions are at the center of governmental integrity by opening the organization’s books to answer such important questions as: Is proper stewardship of the public’s resources being exercised? Is the governing body performing in a transparent and open way? Can citizens rely on their government’s financial statements? This chapter describes the types of required reports and their essential contents and purposes. In addition, given the severe financial distress faced by many municipalities over the last decade, the chapter discusses how properly to diagnose California local government financial health. Appendix C expands on this topic, detailing best practices for presenting financial data in a thorough, yet understandable, way for decision makers and the public. Part IV: Development and Real Estate Finance Chapter 13 examines a field of municipal finance that currently earns a lot of interest, local economic development—fostering business vitality. Despite the enthusiasm for economic development, especially in recessionary times, many local governments have learned that success in this area is difficult without careful planning and analysis. The chapter starts by exploring what constitutes a “local economy” and then discusses goal-setting and strategic planning, business attraction and retention, before briefly describing several contemporary economic development techniques.

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Chapter 14 introduces the reader to a closely related topic, real estate development and the local government as developer. The relationships among private development, local economies, and municipal costs and revenues are discussed. The chapter also examines the differing perspectives of the private sector and the public agency, and identifies the complications that must be managed when the local government acts as both developer and regulator. Engaging in entrepreneurial, risk-taking ventures is typically not among the core competencies of most local governments, and, therefore, assembling the right team of advisors and conducting business in as open a way as possible are essential to protect public resources and to avoid major mistakes.

chapter i: introduction

Chapter 15 reviews how fiscal impact analyses are used to assess the ways different types of development will likely worsen or enhance an agency’s financial position. This chapter outlines the most common techniques and potential pitfalls of such studies. Although constraints imposed on local revenue by the state legislature and voters have been severe, chasing new revenue (especially sales tax) to the point where it overshadows other important community planning values has costs, too. This dynamic, often called the “fiscalization of planning,” can take its toll on public interests such as environmental protection, housing opportunities, traffic congestion, air quality, and community character. Part V: Looking Back, Going Forward: The Road to Reform

Chapter 16 looks back to provide a brief history of California local government finance, including the very real limits to raising revenues, many of which have been incorporated into the California constitution by voters. It is not a simple or linear story—and it certainly isn’t a pretty one, either. California is complex, politically and socially, and many of its finance rules have evolved in a chaotic and disconnected way. Thus, changes to one element of the system have led to repercussions that too often have been unforeseen and counterproductive. Understanding this history is important to avoid repeating the mistakes of the past as well as to consider options properly for future reform.

Chapter 17 concludes the book by looking forward with an eye on reform. Without substantial change, local governments will continue to struggle with uncertainty, erratic fluctuations in funding, and inflexibility regarding their ability to raise revenues—even as the demand for public services increases. In short, the present system is unsustainable. Whether the problems, which are more conspicuous during difficult economic times, result in wholesale restructuring of California’s government finance system or, more likely, in continued 9

Guide to LocaL Government Finance in caLiFornia

incremental adjustments to advert looming crises is not clear. This chapter suggests principles to help guide the way to reform regardless of the route eventually taken.

The book also includes a large glossary to help readers understand the terminology of municipal finance, including references to California’s many propositions, regulations, and other peculiarities. The bibliography lists sources explicitly used in the writing of the book. Appendix D provides a quick reference matrix that links various public finance topics with additional print and electronic information sources.

NOTES City/County Population Estimates, Department of Finance, State of California, 2016. Note, too, that the US Census of 2010 indicated a state population of about thirtyseven million, while state agencies argued that the population was undercounted and that the correct figure was more than 38.5 million at that time. See “State Calls Census Count Flawed,” Los Angeles Times, December 29, 2010. 2 In 2010, scandals in the city of Vernon led to proposed state legislation to force disincorporation of the city. The city responded with a variety of reforms and a fierce political, legal and public relations defense with apparent success: in the closing hours of the 2011 legislative session, after easily passing in the Assembly, the bill narrowly failed to gain passage in the State Senate. See http://articles.latimes.com/2011/aug /29/local/la-me-0830-vernon-20110830. 3 School districts, of course, are also forms of local government, but are not the subject of this book. 4 In 2007, the City of Los Angeles had an operating budget of several billion dollars, which was larger than that of more than half of the countries in the world at that time, based on the CIA Factbook, 2009. 1

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Overview: Local Governments in California and What They Do Chapter 2

A

complex web of local governments provides Californians with municipal services. Apart from local school and community college districts, which are responsible for public education, there are three general classes of local government1 in California that deliver these services: • Cities • Counties • Special Districts

This chapter outlines how local governments in California are categorized by their basis in state law and by the range of services for which they are responsible and discusses the most common functions and funding sources. Key differences among cities, counties, and special districts are highlighted. Cities

Cities are independent general-purpose local governments that provide public services uniquely tailored to and controlled by the communities they serve. All California cities are municipal corporations, and, therefore, the territory encompassed by their boundaries is called incorporated. In California, while many incorporated municipalities choose to use the term “town” rather than “city,” legally speaking, all are cities.2 The state constitution grants cities their powers. Cities themselves are created only by the request and consent of the residents in a given area through the incorporation process. In California, cities fall into three categories: about seventy-five percent are general law cities, and the remainder are charter cities, with one unique exception, San Francisco, which is a consolidated city and county. General Law vs. Charter Cities. General law cities are those organized and operated in accordance with specific rules in the California constitution and

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Guide to LocaL Government Finance in caLiFornia City and County Forms of Governance

most citizens believe that mayors actually manage cities. and, indeed, mayors did run most cities over much of our nation’s history. However, inspired by the reform movement of the early 1900s when high-profile corruption permeated many major cities, a new form of local government began to emerge: the council-manager model. this form of government brought non-partisan professional management to local government, reducing the politics (and patronage) in basic service delivery and administrative matters. viewed broadly, in the council-manager structure, the elected council establishes community goals and policies, and employs a city manager to accomplish them. the city manager typically hires department heads, who cannot be fired directly by the council, and directs the organization and its resources in order to achieve the council’s work program and direction. Within the councilmanager system, the mayor enjoys certain ceremonial duties, chairs council meetings, and often serves as the “city hall spokesperson.” However, the mayor is granted no special legislative or administrative powers: mayors get one vote, like all other council members. most california cities have adopted the council-manager form of government. However, as is true nationally, the largest california cities tend to have some version of a “strong mayor” system. in this type of municipal organization, the mayor typically has different powers from the city council (veto power, for example) and may have the authority to hire and fire department heads. these cities tend to be ones where city council members are elected by districts and where there is a need to consolidate political power in a mayor’s office to promote compromise and overcome political gridlock. Strong mayor cities in california include Los angeles, San Francisco, oakland, San diego, and Fresno. county government structure is in many ways an anachronism, a form harkening back to california’s early, rural history. as a result, the governmental organization in most counties is much different from that in cities, notably, with certain elected department heads in charge of such professional—and even technical—duties as auditor-controller, clerk-recorder, coroner, treasurer, and sheriff. nevertheless, modern county government also contains elements of the council-manager form by employing a chief administrative officer who oversees some department heads and many administrative and policy-related tasks, such as budget development and oversight.

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state law. Alternatively, the constitution allows the local electorate to adopt their own city charter—a set of binding rules related to how the city government is to be organized, which offices are elected and which are appointed, and procedures for conducting various municipal functions (within certain parameters).3 Changes to a city’s charter also require voter approval. The principle that a local community, rather than the state, can better determine its preferred municipal organizational structure, election process, contracting methods and other governmental activities underlies the charter city option. Existing general law cities may convert to charter status with voter approval. While the formation of a charter city may seem like the obvious choice because it appears to provide stronger “home rule,” that is not guaranteed. In some cases, for example, special interests have garnered voter approval of charter provisions that effectively pre-empt the power of the elected city councils regarding labor negotiations or contracting practices. In addition, in recent years, the distinction between general law and charter cities has lessened as state legislation and numerous ballot measures have pre-empted local preferences (notably in many matters of municipal finance), thereby also eroding local autonomy. Therefore, creating a charter can be a contentious and complex undertaking and communities should carefully consider risks, as well as benefits, prior to pursuing charter status. City and County Forms of Governance What Cities Do. Every incorporated community assembles its palette of municipal services based on its unique history, needs, and preferences. Other than broad rules to ensure that these services promote the public health, safety, or welfare, and not private gain, cities have considerable latitude in deter mining what constitutes a public purpose, resulting in a rich variety of municipal services and facilities. Some municipal services are closely tied to the climate and geography of the community: Truckee provides snow removal while Pismo Beach hires lifeguards and Morro Bay operates harbor patrol boats. Other municipal facilities and services are simply idiosyncratic with the history and preferences of particular communities, as interpreted and implemented by their elected officials. Some cities, for example, operate zoos, museums, art centers, sports arenas, hospitals, and golf courses. A few cities also provide electrical service (similar to water

chapter 2: overview: Local Governments in california and What they do

service); a handful offer natural gas service; and several operate airports, marinas, harbors, and water ports. Some offer financial assistance to lower-income and first-time home buyers, provide grants to non-profit social service organizations, promote tourism and economic development, commission public art, build parking structures, or purchase natural habitats, among myriad other concerns that the individual community perceives as worthy and appropriate. Within this very broad range of possibilities, there are some services that are common to many cities: • Police—law enforcement and crime prevention • Fire suppression and prevention • Emergency medical response • Land use planning and zoning, building permits and inspections • Local parks and public open spaces • Youth, adult and senior recreation programs • Water supply, treatment and delivery • Sewage collection, treatment, and disposal • Storm water collection and drainage • Solid waste collection, recycling, and disposal • Local streets, sidewalks, bikeways, street lighting, and traffic controls. • Public transit

Cities that are responsible for providing all or most of these functions are called full service, whether the services are provided in-house or contracted through a private entity or another public agency. In other cities, some of these functions are the financial responsibility of other local agencies such as the county or special districts. For example, in about thirty percent of California cities, a special district provides and funds fire services. In sixty percent, library services are provided and funded by another public agency such as the county or special district. It is important not to confuse the method of service delivery (i.e. contracting or in-house) with the financial responsibility for providing a service. City Revenues and Expenditures. State law requires all local governments to report their expenditures and revenues annually to the State Controller. These reports sort all revenues into two major categories: functional or general.

Most Common City Services

there is significant variability regarding the particular types and amounts of services different cities provide, as well as considerable variety in the labels used for similar types of services. However, the most common functions provided by cities in california include:

Police and Fire. in most california cities, the largest general fund expenses are tied to the provision of police and fire services. this category often includes emergency medical response. it is not uncommon for police, fire and emergency medical costs to account for well over half of a city’s general fund operating expenses.

Community Development (Planning and Building). all cities prepare and update General Plans as well as review development proposals for consistency with applicable laws and standards. the city is frequently the lead agency under the california environment Quality act for projects within its boundaries and as such is responsible for legally required environmental reviews. the city also checks plans for compliance with applicable building codes and inspects new construction in the field. Parks and Recreation. most cities provide local parks and offer recreation programs such as youth and adult sports, exercise classes and some social programs such as health enhancement, daycare, and so on. the number and type of programs offered varies significantly among different jurisdictions.

Public Works and Municipal Utilities. this general category can encompass streets and sidewalks, storm water drainage facilities, sewage collection and treatment, water supply and distribution, garbage collection and recycling programs, city street tree maintenance, and a variety of other services, again highly idiosyncratic with the individual city. Some of these functions, for example, water, sewer, and garbage, are largely paid for through service fees. others, like street trees and streets, for example, are typically paid for with general revenues such as taxes. General Government. the services described above must be supported by administrative and policy functions such as the city council and its appointed commissions and committees; the city manager, city attorney and city clerk, as well as their related staffs; a Human resources or Personnel department that is responsible for recruiting employees and ensuring applicable labor laws are met; a Finance department that collects revenues, assists in preparation of the city budget, manages finances and performs related work; and an information technology department that oversees computing capabilities. in some jurisdictions, these functions are called out separately; sometimes they may be combined into a different array of departments or divisions; and the actual scope of these functions can again be rather idiosyncratic from place to place.

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Guide to LocaL Government Finance in caLiFornia Parks and Rec by Any Other Name . . . Would Still Include Softball Leagues

one reason it can be difficult to generalize about local government finance is that cities, counties, and special districts can organize their functions in any way that seems useful. Furthermore, they can use different descriptors for categorizing identical or similar functions. thus, for example, one finds city recreational programs under Parks and Recreation in Sacramento and Bakersfield; Leisure, Cultural and Social Services in San Luis obispo; Community Services and Public Works in ventura; Arts, Recreation and Community Services in Walnut creek; Culture and Recreation in delano; and so on. although roughly parallel, these departments not only have different names, but they may also encompass different constellations of services.

Figure 2-1. Functional vs. General Revenues, California Cities

Source: california State controller’s annual reports.

Functional revenues are those derived from fees or rates that the city charges for public services, including municipal utilities. Perhaps surprisingly, electrical service is the single largest revenue-producing municipal utility. But only about two dozen cities are in the electrical generation business and, among those, the revenue from Los Angeles Department of Water and Power is larger than that of all the others Annual Financial Transaction Reports combined. On the other hand, hundreds of cities provide water, sewer, and garbage collection. Other major california local governments are required to submit annual Finanfunctional activities include city-operated airports, cial transaction reports to the State controller that summarize the array of services they provide, their costs, and the revenues to pay marinas, harbors, and water ports. Revenues that may be for them. these reports require the agencies to separate revenues used only for specified purposes, such as state or federal and expenditures into two types, functional and general. Functional grants, also fall into the “functional” category. revenues are those generated by fees and charges paid directly General revenues are those that are unrestricted and can by users of some municipal service or facility. Sources of functional be used for any legitimate public purpose. Taxes are the revenue include water and sewer bills, building permits, fees for participating in local recreational sports leagues, and transit fares. major sources of general revenues, with the local share of Functional revenues are spent to cover the costs of providing the property and sales taxes the most significant, accounting particular service. also included in the controller’s functional catefor nearly half of all general city revenues statewide. Other gory are most grants from state or federal agencies that can only local levied taxes, such as the utility user, transient be used for a single or very limited purpose. occupancy and business license taxes, also contribute General revenues, on the other hand, are not directly tied to the payment for a particular service and are largely raised significant amounts of general revenue statewide. through taxes, including the local portion of the property and sales The principal expenditures of general revenues are for taxes, utility user and transient occupancy taxes, and business police, fire, streets and storm drains, parks and recrelicenses. ation, and legislative, management and other support functions. More than half of these monies, statewide,

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chapter 2: overview: Local Governments in california and What they do

pay for police and fire services. Community planning, despite being highly visible to the public and important in many communities, accounts for only a relatively minor fraction of cities’ general spending. Counties

In the unincorporated areas, beyond city boundaries, counties play a role similar to that of cities. However, unlike cities, counties are extensions of the state government and, as such, provide important public services that are available to all county residents, whether they live in or outside of cities. These functions include public assistance (notably welfare programs and aid to the indigent), public health services (including mental health and drug/alcohol services), local elections, local corrections, detention and probation facilities and programs (including juvenile detention), and property tax collection and allocation for all local agencies including schools. More than half of county revenues come from state and federal funds, mostly targeted for these countywide purposes. Within the unincorporated portions of their jurisdictions, counties take on many of the responsibilities for providing municipal services that cities fulfill Figure 2-2. City Revenues by Source California Statewide

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Guide to LocaL Government Finance in caLiFornia

Figure 2-3. City Expenditures by Function California Statewide

within their boundaries, including police protection (through county sheriff departments), roads and some highways, planning, and building permits. Similar to cities, revenues for these functions come from a combination of taxes for general functions and fees for specific services furnished to users of those services. Counties may also provide city-type services in certain unincorporated areas through dependent special districts (see next section) such as water, sanitation or lighting districts. While county governments have other positions typically not found in cities (e.g. nurses, social workers) there are also many similarities in staff, advisory and elected positions. Counties can be either “general law” or the electorate may adopt a county “charter” affording a higher degree of “home rule” (similar to general law versus charter cities). Charters have been approved in fourteen of the state’s fifty-eight counties. Special Districts

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Various municipal services in both unincorporated areas and in incorporated cities are provided through special districts. While there are hundreds of incorporated cities in California, there are thousands of special districts in the state (the number varies from over 3,000 to almost 5,000 depending on who’s counting and what criteria are being used).4 Special districts are considered independent when they have a board of directors who are directly elected. If the board is comprised of officials elected to other government positions (for example, county

chapter 2: overview: Local Governments in california and What they do

supervisors or city council members), it is considered to be dependent. For the most part, special districts provide one or just a few municipal services to a defined geographic area. The provision of fire protection, library, water services, sewage collection and treatment, garbage collection and disposal, flood control, cemeteries, parks and open space, and mosquito abatement are common examples. These are considered single function districts. Other districts are multifunction, providing a number of municipal services. For example, community service districts (CSDs), one form of special district, can provide as many as sixteen different types of services, approximating the scope of some cities. Special districts offering direct services usually fund those services through user fees. They are considered to be enterprise districts. Some districts, however, offer more generalized services where individual benefactors may be difficult to identify. In such cases, for example in fire or library or parks districts, property taxes most frequently fund the district operations. These are known as non-enterprise districts. Like cities and counties, however, different revenue sources may be combined to finance different services provided by a special district, such that some have both enterprise and non-enterprise elements. Another Way to Look at Municipal Expenditures: Operations, Capital Projects, and Debt Service

Previously in this chapter municipal expenditures have been characterized by the function or service provided: police, fire, planning, roads, etc. But, another way of looking at the same expenses (and regardless of the fund type where these expenses occur) is to attribute them to operations, capital projects, or debt service. Figure 2-4. County Revenues by Source California Statewide

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Guide to LocaL Government Finance in caLiFornia

Figure 2-5. County Expenditures by Function California Statewide

Operations. Operational costs are the day-to-day expenses for salaries, benefits, utilities, supplies, equipment, contractual services, and similar costs. Because most city services are provided directly by people, labor costs usually account for the largest portion of operational costs. Historically, labor costs have risen faster than the general inflation rate. Thus, it is often difficult for cities to maintain levels of services as salaries, health insurance, pensions, and other employee-related costs increase over time. For example, an analysis conducted for the City of Atascadero found that even when population increases, the general inflation rate, and level of service provided to the community were all taken into account, the cost of city government had still increased at about four percent per year during the 1980s, due primarily to labor-related expenses.5 The United States Census compiles data on employment and payroll costs among local governments. In 1997, the census counted the equivalent of about 222,000 full-time workers in California’s local governments (excluding schools and community colleges). The combined monthly payroll was $887 million. By 2007, the full-time equivalent employment had increased to about 251,000 positions, but payroll costs had jumped to over $1.5 billion per month.6 Local government payroll costs had risen at an annual average rate of 4.5 percent per employee, substantially higher than the general inflation rate in California during that period of about 3.4 percent. Data on health care costs are even more dramatic. The California HealthCare Foundation estimates that between 2000 and 2007, the costs of providing healthcare coverage increased on average more than eleven percent per year, about three times the general inflation rate.7 As municipal governments typically provide some level of health care coverage to their workers, these increases were reflected in rising labor costs, and, thus, operational expenses. 18

chapter 2: overview: Local Governments in california and What they do

The significant recession that started in 2008, combined with the severe budget contractions in California at the state and local levels in 2009 and beyond, dampened this longstanding rise in public sector compensation. Many labor agreements were renegotiated to reduce costs. It remains to be seen if this signals a long-term slowing in wage and salary increases, or is just a temporary dip in the historical upward trend. Labor-related costs are more fully treated in Chapter 8.

Figure 2-6. Types of Special Districts (and Some Examples)

Sources: “What’s So Special About Special Districts,” California Senate Local Government Committee, Fourth Edition, 2010; East Bay Regional Parks District and San Luis Obispo County websites.

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Guide to LocaL Government Finance in caLiFornia

Capital Projects. Capital projects are those items that the local government buys or builds that are generally expensive and long-lived. Examples would include fire stations, sewage treatment plants, and parking structures. There is no general rule about how big or how long-lived an item needs to be to qualify as a “capital” expense. For example, in some cities, police cars might be considered a capital expense. In others, they might be part of the police department’s operational budget. Local governments can pay for capital projects two ways: they can buy them with cash, or they can borrow money and pay back the loan over the life of the capital item. The former approach is often called “pay as you go.” The repayment of borrowed principal and interest is called “debt service.”

Debt service. This simply refers to the portion of a city’s budget expenditures devoted to paying back principal and interest on loans. Capital improvement financing, including municipal borrowing, is discussed more fully in Chapter 10.

Summing Up Californians get their local public services through fifty-eight counties, hundreds of incorporated cities, and thousands of special districts. This complex mosaic of local governments is responsible for such basic services as police protection, fire response, planning, roads, storm drainage, garbage collection, sewage treatment, water supply, jails, courts, public health, and public assistance—among many others including some idiosyncratic ones deemed important by individual communities. Revenues to support these services come from an equally complex system of taxes, fees, and state or federal funds. These revenues are discussed extensively in other parts of the book. Obviously, it is important to keep accurate track of where the money comes from and how it is spent. The fund accounting system used by local governments to sort and categorize different sources of income and different types of expenditures is the topic of the next part of the book.

NOTES A fourth type of local government, Community Redevelopment Agencies (RDAs), also provided some local services and, particularly, infrastructure. However, the state legislature essentially eliminated RDAs as of 2012. See Chapter 13. 2Unincorporated towns are not cities but communities within a county’s unincorporated jurisdiction that have recognizable names. 1

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chapter 2: overview: Local Governments in california and What they do

California Constitution, Article XI, § 3(a). For example, What’s So Special about Special Districts?, California Senate Local Government Committee, Fourth Edition, 2010, provides the lower figure, but does not count joint powers agencies as separate special districts; the State Controller’s Office includes joint powers agencies among special districts and, thus, reported the higher number in 2008. 5Atascadero Long-term Financial Analysis, Michael Multari, Karl Mohr, Steven French, Prem Pangotra, City of Atascadero, 1992. 6U.S. Census of Governments, U.S. Department of Commerce, Economic Censuses, 1997 and 2002. 7California Employer Health Benefits Survey, National Opinion Research Center, for California HealthCare Foundation, 2007. 3 4

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Funds Part II

Fund Accounting: Sorting Out the Money Chapter 3

M

unicipal services—whether unusual or nearly universal, whether provided by cities, counties, or special districts—all require financial resources to perform. Where do these financial resources come from? Whether generated locally, or reallocated by other levels of government (e.g. the federal or state governments), they come from citizens in one way or another—mostly through taxes and fees. Therefore, in a democratic form of government, accountability for how the resources of citizens are being used is a fundamental duty. Accountants have developed a framework that is generally agreed upon for tracking local government money as it is raised from different sources and spent on different functions. This framework relies on the grouping of revenues and expenditures into funds. A fund is an accounting category established to track money used for some specified purposes. One might visualize a fund as a pot into which money is placed from various sources and from which money is taken to pay for certain things. All local government revenues and expenditures are accounted for in different funds. In the broadest sense, local governments use two types of funds: the general fund and all others. The distinguishing feature of the general fund is that the uses of its resources are typically unrestricted and, thus, available for any legitimate public purpose. In the case of all other funds, the use of their resources is restricted in some way—either by the agency itself, or by state or federal law, or by grant regulations. The following is a brief overview of the various types of funds used by California local governments. The most important and commonly used ones are discussed in greater detail in later chapters.

What Are “Generally Accepted Accounting Principles”?

Generally accepted accounting Principles (GaaP) are set for state and local governments by the Governmental accounting Standards Board (GaSB) and provide a standard framework for presenting the results of financial operations in a manner that allows “apples-to-apples” comparisons between years, and with other agencies. all local government agencies strive for an “unqualified” opinion by their independent auditors stating that their financial statements “present fairly . . . the financial position . . . in conformity with accounting principles generally accepted in the united States.” in this case, “unqualified” is a good thing, meaning without any qualifications (exceptions).

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Guide to LocaL Government Finance in caLiFornia Confusing Terminology

the fund categories used by cities under GaaP are similar, but not identical, to those used in the controller’s Financial transactions reports (see chapter 2). enterprise and special revenue funds are always found in the controller’s “functional” category; the general fund, naturally, falls mostly in the “general” category. in many cases, however, a program might be funded by a combination of sources. consider a city’s community development department. Planning and building permit fees are paid for services such as plan checking and inspections. a federal grant could be awarded for housing-related work. and, tax receipts might be used to pay for an update of the city’s general plan. the first activity could be treated as an enterprise fund; the second a special revenue fund; and the last would surely be part of the general fund. For convenience, however, the city might choose to categorize the entire department as being within the general fund, and then use sub-accounts to track the permit-related income and the grant money. as long as the money is properly accounted for in proper sub-accounts, labeling it all as part of the general fund is permissible. However, for the controller’s reports, the permit fees and grant would be considered in the functional category while the portion derived from taxes would be considered in the general category. differences among local agencies in organizing complex mixes of revenues and expenditures can make detailed comparisons among them difficult without a careful analysis of how they are treating different functions and revenue sources.

Fund Types under Generally Accepted Accounting Principles Generally accepted accounting principles (GAAP) are the prevailing national standards for presenting and reporting financial information. For public agencies, GAAP sets forth three main fund categories: Governmental, Proprietary and Fiduciary. Proprietary funds are those used for municipal operations that are run similar to businesses in the private sector in that they provide services to some users and recover the costs through fees or charges for those services. Fiduciary funds are those used to account for money held for another party, and which cannot be used for the government’s actual operations. An example would be money kept for employees’ pensions. Governmental funds account for all other city operations and activities. Governmental, proprietary and fiduciary funds are further organized into various subtypes. Governmental Funds

General Fund. The general fund is used for the widest range of municipal purposes; it is typically a city’s largest fund. Most revenues assigned to the general fund are considered to be “general purpose” in nature; that is, they have “no strings attached” to them: they can be used for any legitimate municipal function. The general fund can even be used to supplement or subsidize other funds such as enterprise or other special funds (although this is seldom a good idea, as discussed in subsequent chapters). In cities, police and fire services usually account for the largest amount of general fund expenditures; however, the general fund is also the source of money for long-range planning, street maintenance, parks and recreation, libraries, and many other activities deemed important by city leaders. Revenues to the general fund come primarily from taxes but also from fees, fines and forfeitures, leases, investments, other governmental agencies, and other non-restricted sources. Chapter 4 is devoted to a fuller analysis of the general fund.

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Special Revenue Funds. These funds account for the proceeds from revenue sources whose purposes are restricted externally by state or federal law. Common examples of this in California are gas tax funds that account for monies provided to cities and counties by the state that are limited to transportationrelated purposes, and community development block grants (CDBG) from the

chapter 3: Fund accounting: Sorting out the money

federal government that can be used only for housing and other specifically defined purposes. Special revenue funds also account for the use of income from benefit assessments such as downtown business improvement districts, or lighting and landscape maintenance districts. Chapter 5 discusses special funds in more detail.

Capital Project Funds. These funds account for money used in the construction or acquisition of major capital facilities or equipment, apart from those financed through proprietary or fiduciary funds (see below). Sources include the proceeds from debt financing, development impact fees, or transfers from other funds. Debt Service Funds. These funds account for the accumulation of resources related to general long-term debt and the repayment of principal with interest (apart from debt service obligations included specifically in the proprietary or fiduciary funds). They are typically established to account for dedicated revenues from general obligation bond financing. Bond financing is discussed again in Chapter 10.

Permanent Funds. These account for resources where only the investment earnings on an endowment are available to provide services, such as a perpetual care cemetery. The principal may not be reduced to pay for services. These are uncommon in most local governments. Proprietary Funds There are two types of proprietary funds: enterprise and internal service funds.

Enterprise Funds. Enterprise funds are used to track monies received and expended for municipal services where fees or charges to the users of those services pay wholly or in part for such services. There are four situations where accounting for a municipal activity as an enterprise fund makes sense: •

•

•

The agency intends to recover the cost of providing the service largely (if not solely) through fees and charges. Water and sewer services are the most common examples. The local agency delivers, for example, water to customers (residents and businesses) and then sends them monthly bills to pay for the service. The activity is financed with borrowing, and service fees and charges will be used to make debt service payments. Laws or external restrictions require the activity to be accounted for as an enterprise fund, even if the revenues are not sufficient to cover the cost of the services. A common example occurs with public

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Guide to LocaL Government Finance in caLiFornia

•

How Can the City Build a New Park When It’s Laying off Police?!

it’s not unusual to hear public comments at city hearings or to read letters to the editor that berate a city government for building a new facility or increasing one service, while cutting back on others. Sometimes, the explanation is the give and take of local politics as one constituency exerts more pressure than others. But sometimes it’s simply a matter of different funds. For example, money for new park construction might be in a special revenue fund that collects development impact fees. those fees can only be used for park purposes. at the same time, the general fund may be stretched due to declining tax receipts, so that the city council feels compelled to cut back on police services, which are paid for out of that fund. that’s one reason why one might see police operations cuts while parks facilities are being upgraded.

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transit. Transit systems rarely recover their costs through fares.1 But the state, which has provided significant funding for transit systems through the Transportation Development Act (TDA), requires that agencies using TDA funds treat transit as an enterprise activity. The activity is similar to a service often provided by the private sector, such as a golf course or parking.

Thus, in this context, enterprise funds can be thought of as municipal businesses (although in the case of transit, usually a highly unprofitable one). Unlike most private businesses, however, the local agency frequently has a local monopoly over the service (consider water, sewer, and garbage as typical examples). Also, rates charged to customers are set by the elected officials through a political process, not solely by the open market. In addition, municipal enterprises, strictly speaking, do not make a profit, but can only recover the reasonable cost of providing the public service (though that may include overhead, savings for future capital and equipment replacement needs, and contingency reserves). The key advantage of having a public provider for such essential services as water and sewage treatment is that certain efficiencies can be realized by having a single system and by requiring everyone to participate in that system. Furthermore, the local government is directly accountable to the public through their elected officials and, therefore, can institute pricing structures that consider social costs and benefits in addition to strictly economic ones. For example, a city council might establish progressively higher rates linked to water consumption to encourage conservation, or might set policies limiting the delivery of water service outside of its boundaries as part of its growth management strategies.2 Fees charged for services must be reasonably related to the costs of those services and not for unrelated purposes. For example, it would be inappropriate for a city to increase water rates and use the increased revenues to pay for new police officers. It would be appropriate, however, to use some of the revenues from water rates to pay for general government services like the City Attorney, accounting, technology support, but only to the extent that general functions are doing work for the water department. The latter is sometimes referred to as “full cost accounting” in that the costs of these “overhead” functions (City Council, City Manager, City Attorney, accounting, human resources, etc.) are charged to other municipal departments using a method that fairly apportions these costs to those programs that benefit from those services, including the municipal enterprises. In Chapter 6, which discusses enterprise funds in more detail, this is best documented through a formal Cost Allocation Plan. In many communities, services such as water supply or garbage collection are in fact provided by private entities, and fees charged for those

chapter 3: Fund accounting: Sorting out the money

services are paid to the private service provider. In other cases, the city (or county in unincorporated areas) may contract with a private provider to deliver the service. The public agency can then review and alter the contracts under different circumstances so that it retains overall control over the level of service and costs. Internal Service Funds. These funds may be used in accounting for services provided internally to the organization, such as printing, fleet maintenance, or computer services. Each department is charged for the specific services as if they were external customers. Fiduciary Funds

These are established where the agency holds monies in a trustee or third-party agent capacity, and as such, the resources cannot be used to support the local government’s own operations. Fiduciary funds include pension and other employee benefit trust funds, or situations where the local government is holding money on behalf of another agency or organization. Summing Up Local governments are entrusted with revenues from various sources to be used for public purposes. Surely, accounting for where the money comes from and how it is used is a critical concern. Generally accepted accounting principles (GAAP) have been developed by the Governmental Accounting Standards Board; public agencies should subscribe to these standards in order to present financial information clearly and fairly. Revenues received from various sources and used for certain purposes are placed into “funds”—accounting tools for tracking money. GAAP prescribes a number of funds. In California local governments, three types of funds tend to be the most common, the largest and the most important: General Fund, Special Revenue Funds, and Enterprise Funds. The first accounts for “general purpose” revenues, those that may be used by the agency for any of its legitimate activities. Special revenue funds account for monies that are earmarked for certain purposes. Enterprise funds account for revenues and expenditures associated with municipal “businesses” such as water and sewer services, as well as other functions for which fees are charged to cover the cost of the service. These major fund types are the subjects of the next three chapters.

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Guide to LocaL Government Finance in caLiFornia NOTES In fact, few transit systems in California recover more than twenty percent of operating costs through fares and other charges. 2In Capistrano Taxpayers Assn. v City of San Juan Capistrano (2015), the court ruled that such tiered rates are not illegal as long as they are based on the actual cost of providing water at various levels of usage. 1

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The General Fund: The Flexible Fund Chapter 4

A

city, county, or special district general fund, as its name indicates, accounts for revenues of a general nature, including most taxes. Such revenues are sometimes called “general-purpose” or “discretionary” monies, those that are not legally required to be accounted for separately and not linked to specific purposes. Unlike enterprise and special revenue fund incomes, that have significant restrictions on how they can be spent, most general fund monies can be used for any legitimate public purpose that the particular community finds important and in the amounts or proportions deemed appropriate. California local agencies, however, have limited control over the amount of general fund revenues they receive (see a discussion of that history in Chapter 16). Consequently, the general fund poses the most interesting and difficult budgetary questions for the local government: How much discretionary revenue can the municipality reasonably expect to receive given its lack of direct control over most of its sources? And, how should the discretionary money be spent given all the competing public purposes it can be used for? What Municipal General Funds Pay For The types of programs and levels of service that a local agency provides from general fund resources vary from place to place.1 Services commonly supported from city

General Fund or Other Fund?

most cities consider community development, and particularly planning and building, as a general fund function. However, some of these types of services are paid through fees, which make them similar to enterprise functions. it is possible to create a separate enterprise fund for, say, building permit and inspection processing, in which those services, and the levels at which they are provided, are strictly supported by fees alone. Practically, however, planning and building personnel perform important work besides that covered by fees (for example, answering questions at the public counter or fielding complaints about possible code violations or undertaking long-term planning for the community). the revenues for such services are not fully or even mostly fee-based, but must derive from non-specific sources such as taxes. thus, the funding of community development usually involves a combination of taxes, fees (and even sometimes grants). most cities and counties place the entire function into the general fund, and track the different revenue sources and corresponding expenditures through sub-accounts to the extent it is useful or required. Similar situations arise with regard to other functions, such as parks and recreation, where certain services are fee-based and others are supported in whole or in part by general revenues. in some cases, the fee-based services may be treated as enterprise funds; examples might include different social services such as day care, or specialized recreational facilities such as golf courses. But in many municipalities, parks and recreation functions are all placed in the general fund for organizational and budgeting purposes, and sub-accounts are used to track different classes of expenditures and their supporting revenues.

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general funds in California include police, fire, parks, and libraries as well as the general government functions that support them (financial, personnel, administration, legal, data systems, fleet management, etc.).2 Other programs and services that are typically found in the general fund include community development (planning and building), non-enterprise public works (especially roads), and recreation programs. Typically thirty to sixty percent of general-purpose revenues are spent on police services. In all but a few very small towns, police services are funded by the city (even if those services are provided in the city under contract by the county sheriff or another public agency).3 Fire protection services are the financial responsibility of over 300 cities in California. Among these cities, fire programs typically cost from ten percent to thirty percent of city general-purpose revenues. Police and fire services combined typically amount to forty percent to eighty percent of a California city’s general-purpose revenues. Any particular city’s breakdown, of course, will be different depending on the perceived importance of different municipal services, the affluence of the particular community, organizational structure and accounting practices, and alternative service arrangements (such as whether or not some of these functions are provided by special districts). The relative emphasis on different functions, even in a single jurisdiction, will also vary at different times, depending on factors such as the overall strength or weakness of the economy. For example, when the economy is weak and general tax revenues shrink, so-called “non-essential” community services such as recreational programs and libraries tend to be cut, thus comprising a smaller percentage of the general fund total. Sources of Money for the General Fund Money for a local agency’s general fund comes from numerous sources including taxes, permits and fees, fines and forfeitures, franchises, lease or sale of property owned by the local agency, return on investments, and transfers from the state and federal governments.4 Taxes

The California constitution, as amended by Propositions 13 and 218, differentiates two broad categories of local taxes: general and special. New or increased general taxes must be approved by a simple majority of the local electorate. Revenues from general taxes go into the jurisdiction’s general fund and can be used for any legitimate municipal purpose. Special taxes are those dedicated to specific purposes. New or increased special taxes require a two-thirds super majority voter approval. For example, if a community wanted to tax itself and direct that revenue to, say, additional police, it would be a special tax and require 32

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Figure 4-1. General Purpose Renenues and Expenditures: Typical Full-Service California City

Streets, Drainage 5%

the two-thirds approval. If they simply wanted to direct the revenue to the general fund and allow the elected officials to determine how it is ultimately to be used, a simply majority approval suffices.

Sales and Use Tax; Transactions and Use Tax. In California, there are actually three related taxes that most people refer to informally as the “sales tax”: the actual sales tax on in-state retail sales; the use tax, which is applied to sales outside the state; and a transactions and use tax, which functions essentially as an add-on to the local sales and use tax. All are rates that are applied to the sale of tangible personal property. Currently in California, services are exempt from these taxes; other exemptions include medicine and most groceries. For many cities in California, the sales tax, with the closely related use and transactions taxes, constitutes the single largest source of general fund revenue. The sales and use tax is divided among the state and local governments. In 2009 the legislature temporarily increased the statewide base rate from 7.25 percent to 8.25 percent. That temporary 1.0 percent additional rate ended in 33

Guide to LocaL Government Finance in caLiFornia General vs. Special Taxes

according to the california State constitution, as amended by Proposition 13 in 1978 and Proposition 218 in 1996, a general tax is a tax imposed for general governmental purposes. a majority vote of the electorate (those voting on the measure) is required to impose, extend or increase any general tax. Special districts may not impose general taxes.5 a special tax is a tax that is collected and earmarked for a specific purpose. a two-thirds vote of the electorate is required to impose, extend or increase any special tax. use of revenues

Governing Body approval

voter approval other rules

34

General Tax

Special Tax

unrestricted

specific purpose

charter cities: majority majority a general tax election must be consolidated with a regularly scheduled general election of the city council members or, in the case of a county, members of the Board of Supervisors, unless an emergency is declared by unanimous vote among those present. Special districts may not adopt general taxes

2/3 Special tax funds must be deposited in a separate account. the taxing agency must publish an annual report including: 1) the tax rate; 2) the amounts of revenues collected and expended and 3) the status of any project funded by the special tax.

General law cities and counties: 2/3

majority

2011. Thus, the 2011-2012 base rate includes5 5.0 percent for the state general fund plus 0.5 percent that is allocated to counties to fund various health and welfare programs, 0.25 percent distributed to counties to fund public transportation services, 0.5 percent passed through to fund various local public safety programs, and 1.0 percent that is collected by the state on behalf of cities and counties.6 Revenue from the last increment is distributed to the city (or, if generated by sales within unincorporated areas, the county) in which the taxable sale took place, and it is that 1.0 percent portion that goes to the city’s or county’s general fund.7,8 The use tax is similar to the sales tax but applied to retail items that are purchased outside California for use in the state. These sales are taxed at the same rate as the in-state sales tax. While the sales tax is imposed on the seller, the use tax is imposed on the purchaser because the seller does not collect the tax owed. Most out-of-state purchases are subject to the tax, but collection is sometimes difficult. Most use taxes collected are related to vehicle purchases, or other leases or to purchases by business, from out-of-state sellers. The local share of the tax does not go to the jurisdiction in which the sale took place, of course, but to the local jurisdiction in which it is to be used. Sometimes, the determination as to where an asset is used is difficult to ascertain. In such cases the tax collected by the state is distributed to counties and cities in proportion to the allocation of revenues from other taxable sales.

chapter 4: the General Fund: the Flexible Fund

In addition to the sales and use taxes, cities and counties can impose a “transactions and use tax” that acts essentially as an additional sales and use tax increment. Voters in many counties have approved such taxes for transportation improvements and are thus accounted for in a special fund (see Chapter 5). Voter-approved general-purpose local tax rate increases are common since 2003 when California law was changed to allow them broadly. As of June 2016, over 143 cities and thirty-one counties in California have adopted add-on transactions and use tax rates, ranging from 0.125 to 1.50 percent.10 Like any tax increase, transaction and use taxes require majority voter approval if used for general purposes or a two-thirds supermajority voter approval if earmarked for special purposes. For most sales activity, transactions and use taxes do not differ from sales and use taxes in how the tax is applied and distributed. But there are some important differences. For example, in the case of a sale or lease of a vehicle, vessel, or aircraft, a transactions and use tax is charged and allocated based on the location in which the property will be registered rather than where the sale takes place. In 2016, the combined rate of state and local sales and use tax with transaction and use tax add-ons varied in California from 7.5 percent to ten percent.11 For example, the City of La Mirada in Los Angeles County had a sales tax rate of ten percent that included the 7.5 percent base rate plus 1.5 percent approved for county-wide public transportation projects and a voter-approved 1.5 percent transaction and use tax rate for the city general fund. The State Board of Equalization (BOE) collects the sales and use tax (including add-on transactions and use rates). The amounts to be distributed to local governments are determined quarterly, with monthly advances based on interim estimates. Data about a city or county’s sales receipts generated by various business sectors are readily available in a variety of BOE reports.12

Property Tax. The property tax is the largest source overall of discretionary funding for California cities and counties combined. It is based on a percentage tax rate applied to the assessed value of real property (land and developments) as well as certain moveable properties (for example, business equipment). In California, the base tax rate is one percent of the assessed value. Increases to the one percent base rate can only be approved by a two-thirds majority of the voters, and then only to pay debt service on general obligation bonds (see Chapter 10). The assessed value of real estate is based on the sales price13 upon change in ownership14 (the “base year”), plus annual increases thereafter, limited to an annual maximum of two percent or the change in the consumer price index, whichever is lower (the “factored base year value”).

The Triple Flip: Temporary Sales Tax for Property Tax Swap

if anyone questions that california’s public finance system is convoluted and that it strains the relationship between the state and local governments, the story of the “triple flip” will erase those doubts. in march 2004, the voters of california approved Proposition 57, the california economic recovery Bond act. under state laws9 implementing the proposition, 0.25 percent of the local sales tax rate was effectively taken by the state to repay the bonds effective July 1, 2004. However, local governments would be reimbursed for the sales tax by property tax. the so called “triple flip” consisted of 1) reducing all local sales tax rates by 0.25 percent and increasing by 0.25 percent the state’s sales tax rate, 2) repayment of lost sales tax to cities and counties with additional local property tax previously allocated to local schools, and 3) repayment to local schools through the state general fund. thus, the statewide composite base sales and use tax rate remained unchanged at 7.25 percent to the taxpayer. Proposition 1a, passed later in 2004, prohibited the legislature from extending the triple flip beyond the period necessary to repay the Proposition 57 bonds and constitutionally protected the reimbursement to cities and counties under the triple flip. although the triple flip delayed some revenue, cities and counties were fully reimbursed for any local sales tax diverted to fund the state’s economic recovery bonds. Because the replacement revenues provided a dollar for dollar replacement of sales tax revenue, they were properly budgeted and accounted for as sales tax revenues in the general fund. the triple flip ended in 2016.

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Guide to LocaL Government Finance in caLiFornia Figure 4-2. California Sales and Use Tax Components as of January 1, 2017

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chapter 4: the General Fund: the Flexible Fund

However, if the market value of a property falls below its factored base year value, the county assessor must temporarily lower the assessed value of a property. In subsequent years, the assessed value of a property that has received such a reduction may increase more than two percent in a single year, so long as it does not exceed the factored base year value. If additions or significant improvements are made to a property, the value of those additions or improvements is added to the assessed value. Such increases, however, do not trigger an entirely new assessment of the whole property. Furthermore, certain improvements, such as those for residential handicapped accessibility, earthquake safety improvements, and fire sprinkler systems, are exempt from reassessment. There are a number of exemptions from the property tax, such as most property owned by public agencies and non-profits. In addition, owneroccupied residences get a small annual discount and a more significant exemption applies to veterans with certain disabilities. The Williamson Act allows owners of agricultural or open-space properties to receive property tax discounts if they enter into contracts with a participating city or county that restricts the use of the land to those purposes for at least ten years. Until 2011, the state reimbursed the local agencies for lost revenues; the future of these discounts is uncertain. Property tax in California is administered by counties. County assessors determine property values based on Proposition 13 limitations; county tax collectors bill and collect the tax; and county auditors determine the distribution of the revenues to the county, cities, school districts, and certain special districts, in accordance with the most current state law. Due to variations in the agencies serving different areas, differences in pre-Proposition 13 tax rates, and variations in city and county service responsibility, the allocation among local agencies varies from place to place. City shares of property tax depend in part on service responsibilities. Full-service cities generally receive higher shares than those that do not provide the complete range of municipal services. For example, in a city where fire services are provided by a special district, the city will get a lower share, with a portion of the property tax revenues going directly to the fire district that provides the service instead. When an unincorporated area is brought into a city, either by the incorporation into a new city or through the annexation of land into existing incorporated cities, most municipal services previously provided by the county become the responsibility of the city, and, thus, a portion of the county’s share of property tax is usually transferred to the city (determined by state law and negotiations between the city and county).

Transient Occupancy Tax (TOT). The transient occupancy tax, often referred to as the “bed tax,” is a rate applied to the price of a hotel or motel room (the tax can also be applied to other short-term lodging, such as RV campgrounds). For

County Fiscal Officers counties are responsible for the administration of the property tax in california including assessment, collection, and allocation among local agencies in accordance with the state constitution and state laws. County Assessor—the assessor sets values on property and produces an annual property tax assessment roll.

County Auditor-Controller—Based on the assessed values determined by the assessor, the auditor-controller calculates the amount of property tax due and the allocation among the county, cities, schools, and special districts in the county. County Treasurer-Tax Collector— the treasurer-tax collector administers the billing, collection, and reporting of tax revenues including the property tax.

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Figure 4-3. Where Property Tax Goes: Typical California City Property Owner

example, if a city’s TOT rate is ten percent, and someone rents a motel room for $100, the visitor will be charged an additional ten dollars in tax, which goes to the city. Counties may impose a TOT in unincorporated areas. Among the 400 cities and fifty-five counties that impose a TOT, rates vary from 3.5 percent to fifteen percent, but ten percent is most common.15 Places with high motel/hotel demand, such as resort areas, tend to have higher rates. The TOT is an especially important revenue source for communities popular with tourists and that can charge relatively high rates because of the high demand for hotel and motel rooms. Like any local tax, voter approval rules apply.

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Utility User Tax. Many California jurisdictions charge a utility users tax (UUT) in the form of a percentage rate applied to utility bills. It is a tax on the utility user not the utility provider. The utilities on which a UUT can be based may include not only natural gas and electricity, but also water, sewer, garbage, telephone, and cable television services. As of 2016, over 150 cities impose a UUT, and several counties charge a UUT in unincorporated areas. Rates vary among jurisdictions from one percent to over ten percent of the utility bill. Five percent is the most common rate.16 Again, like any local tax, voter approval rules apply.

chapter 4: the General Fund: the Flexible Fund Figure 4-4. Sales Tax and Property Tax Revenues California Cities and Counties per capita, adjusted for inflation

VLF Swap, State Budget Shifts

ERAF Shifts

Prop13

California Cities

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Business License Tax. Cities and counties may impose business license taxes on all manner of business activities, including the rental of homes. The most common formula is to apply a percentage rate to a business’s gross receipts. Businesses below a certain size typically charge a relatively low, flat rate. And, again, like any local tax, voter approval rules apply. In recent years, some cities have adopted taxes on particular business activities such as sugary drinks and marijuana. These taxes are actually forms of business license taxes. Under state law, they may not be imposed as sales taxes.

Documentary Transfer Tax. The Documentary Transfer Tax (DTT) is collected when real estate is transferred (most commonly, when it is sold). The rate adopted throughout California is $1.10 per $1,000 value of the real estate transferred, the maximum allowed under state law. In most incorporated areas, the proceeds are split between the city and the county. However, charter cities are allowed to enact a “real property transfer tax” in lieu of the DTT. In these places, the entire DTT goes to the county, while the charter city receives the property transfer tax, instead. In most charter cities that have adopted the property transfer tax in lieu of the DTT, the tax rate is usually much higher than they would receive from the DTT (thus, both the county and the charter city receive more tax proceeds than otherwise). As of 2016, about two dozen charter cities have adopted real property transfer taxes in lieu of the DTT. Any new or increased DTT is subject to voter approval rules.

Parcel Taxes. A parcel tax is a charge on each privately held parcel of real property. The tax may be a simple flat rate or it may vary depending on various characteristics of the parcel but not on the value of real property. Parcel taxes are more common among special districts than cities or counties and, whether general-purpose or special-purpose, require two-thirds voter approval for new taxes or increased tax rates.17 Most parcel taxes, however, are earmarked for special purposes and are, thus, accounted for in special funds, not the general fund (see Chapter 5).

Other Local Taxes. Local jurisdictions have imposed other general taxes in California including an admissions tax on tickets to shows or performances, a parking tax on off-street parking rents, and construction taxes on new development (different from impact fees discussed in Chapter 5). While such taxes may be important to particular cities, none is used as commonly as those discussed elsewhere in this chapter.18 Fees

40

After taxes, fees are usually the next most important source of general fund revenue for cities in California. This is confusing, because fees, unlike taxes

chapter 4: the General Fund: the Flexible Fund

which are more truly “general-purpose,” can only be charged in certain circumstances, must be related to certain services or public benefits, and, thus, the relationship between the fee and its use must be accounted for. Nonetheless, a number of fees are typically listed in a jurisdiction’s general fund, while also documenting through sub-accounts or other methods the relationship between the fee and its ultimate use.

User or Service Fees. Fees may be charged to recover all or a portion of the costs of providing a municipal service. A fee may not exceed the reasonable cost of providing the service for which it is charged. Many fees are accounted for in enterprise funds along with the costs of those enterprises, but for some services, it is common to track these revenues in sub-accounts of the general fund. For example, a municipal golf course may be funded strictly through greens fees and other golf-related revenues and accounted for as an enterprise separate from the general fund. However, fees for copying documents in a police department or city clerk’s office are typically placed in the general fund where the costs of those services are paid.

Regulatory Fees and Permits. Cities may charge fees to cover the costs of services that benefit the general public under the police powers afforded the local government. An example would be building inspections. Those services not only benefit the developer of a project, but more generally ensure code compliance for the safety and welfare of the future users of the development. The fees for those services are considered “regulatory” and must be reasonably related to the type and cost of the service provided. They are often included in the general fund. Chapter 6, which examines enterprise activities, discusses fees in greater detail. Other General Fund Revenues

State Subventions. A subvention is a provision of financial assistance or transfer of public monies to a local agency from a higher level of government. Historically, the state has imposed and collected certain taxes and fees that it then “subvened” (distributed) to local agencies. For example, state assistance constitutes a very large portion of county revenue as counties are responsible for major public health and welfare services provided on behalf of the state. On the other hand, state aid is only a relatively minor source of city income. The legislature has frequently responded to its own budget problems by reducing these subventions. Currently, most subventions are designated for specific purposes and must be accounted for in special funds, as discussed in Chapter 5.

Vehicle License Fee

With its roots in the local property tax, the vehicle License Fee had been a longstanding subvention providing discretionary general revenue for cities and counties. Prior to 1935, vehicles were subject to the property tax. this approach had some obvious practical problems with tracking assessed value and determining which local jurisdictions was the appropriate recipient of the local share of the tax. the state legislature substituted the vehicle property tax with the vLF.19 Proposition 47 of 1986 requires that the revenues from the vLF be allocated to cities and counties, but the state retains the authority to adjust the tax rate and the specific formulas for allocation between cities and counties. the rate, as of 2011, is 0.65 percent of the value of the vehicle, all of which is transferred to the local governments. However, the manner by which the current tax formula was arrived at, like so many other california public revenue sources, has a convoluted history, which is described in some detail in chapter 16 to illustrate some of the difficulties with fiscal reform efforts. in 2011, the legislature diverted the vLF to fund state law enforcement grants to cities and counties that had previously been paid for from the state general fund.

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Franchises. Cities and counties impose franchise charges on cable television, electricity, gas, water, trash collection, and oil distributors. Special districts may also have franchise authority over some services. The concept is that these types of businesses are using public streets and rights-of-way, and they can be charged “rents” for that use. The laws governing franchises varies somewhat depending on the nature of the businesses using the public right of way, but the revenues are unrestricted and, thus, placed in the general fund. Penalties, Fines, and Forfeitures. These include payments for violations of municipal codes, including local traffic and parking fines. Their use is unrestricted, although in some cases, cities may choose to place parking fines in a special fund with other parking revenue to support the costs of building, maintaining and operating parking facilities.

Other General Fund Revenues. Municipalities also collect other generalpurpose revenues, although in most cases, they are almost always minor portions of the general fund, especially compared to the main tax sources. For example, local governments can charge rents and leases on facilities that they own such as auditoriums, conference centers, and meeting rooms. Sometimes agencies have entered into long-term land leases with private developers, garnering income as prescribed in the agreement. Likewise, local governments may receive income from the sale of surplus property. Many agencies charge concessions to a wide-variety of businesses that use their facilities. Local government agencies also often hold significant reserves that are invested until needed. Investment income on monies in the general fund can be used for any purpose. Investment income derived in enterprise or special funds is usually returned to their respective funds. Investments are discussed in Chapter 11. Summing Up

In most local agencies, the general fund is the most interesting, and challenging, among municipal accounts because its resources are quite flexible as to use, but are at the same time difficult to control in terms of income generation. A city’s general fund, for example, is usually the source for a wide variety of public services, including parks, community development, as well as the needed support functions such as finance, administration, human resources, and the city attorney. In most cities, however, more than half of the general fund goes to pay for police, fire and emergency response services. Revenues that go into the general fund come mostly from generalpurpose taxes. Major city and county taxes include portions of the property tax and sales tax. Utility user taxes, transient occupancy taxes, and business license taxes are also quite important in many locations. 42

chapter 4: the General Fund: the Flexible Fund

Local governments can charge fees for services, provided that the amount is reasonably related to the cost of delivering the subject service. Many fees—such as utility rates and development impact fees—are not accounted for in the general fund, but some others are typically included. In California, all major local government general-purpose revenues have been closely circumscribed by the state legislature and by statewide voter initiatives. Local elected officials no longer have the authority to raise taxes without voter approval, and there are detailed limits and procedures related to fees. Many local government responsibilities, however, are paid for in ways different from general-purpose revenues. Special funds and enterprises are the subjects of the following chapters.

NOTES The differences among communities as to how general fund money is spent reflects their varying needs and priorities. Cities, for example, differ in what programs they are responsible to provide. Less than twenty-five percent of California cities are full-service cities, responsible for funding all of the major city general fundsupported services such as police, fire, library, parks and recreation, and planning. In about three out of ten California communities, a special district provides fire services with property tax revenue that would otherwise go to the city. In six out of ten cities, library services are provided and funded by another public agency. On the revenue side, these differences in financial responsibility among cities are reflected in the allocation of general property tax revenue. Other city tax rates and revenue allocations are unrelated to service responsibility. 2However, through cost allocation plans, enterprise and special funds can fairly pay for a share of these general functions proportional to the extent such functions also support the enterprise or special funds. 3This estimate includes the general functions reported in the Cities Annual Report cited earlier, as well as certain functional expenditures typically assigned to city general funds. 4Although in contemporary California, most intergovernmental transfers or subventions are indicated for specific purposes and, thus, must be separately accounted for (See Chapter 5). 5Revenues and Responsibilities: An Inventory of Local Tax Powers, California Local Government Committee, Second Edition, 2010. 6The one-percent local rate is locally imposed by almost every city and county as authorized by the Bradley Burns Local Sales and Use Tax Law of 1955. 7This “situs” basis for allocation is a central issue in the “fiscalization” of land use discussed in Chapters 15 and 16, as there is a premium placed on having sales tax 1

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Guide to LocaL Government Finance in caLiFornia

generators located within one’s city limits and not across the line in a neighboring jurisdiction. 8California Municipal Revenue Sources Handbook, League of California Cities, 2014 Edition. 9California Revenue and Taxation Code Section 97.68. 10California Municipal Revenue Sources Handbook, League of California Cities, 2014 Edition. 11A very few cities have local sales tax rates slightly lower than the typical 1.0 percent. 12See http://www.boe.ca.gov/sutax/sutprograms.htm 13More technically, this is “the current full market value of a property.” 14There are certain circumstances where change in ownership does not trigger a reassessment, such as placing a property into a trust or certain intra-family transfers. In addition, some counties have adopted ordinances that allow the elderly or disabled persons to transfer the adjusted base year value of existing homes to replacement residences of equal or lesser value, sometimes resulting in substantial savings; where allowed, such transfers are limited to once in a lifetime. 15California Municipal Revenue Sources Handbook, League of California Cities, 2014 Edition. 16Ibid. 17Ibid. 18Ibid. 19The VLF has sometimes been referred to as the motor vehicle in-lieu fee in recognition of its genesis.

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Special Revenue Funds: The Inflexible Funds Chapter 5

R

evenues that are legally restricted for specific purposes, or that are otherwise required to be tracked separately from other monies, are accounted for in special revenue funds. Common examples include funds for local special taxes, for state subventions, and for grants. Some of the most common special revenue funds are discussed below. In addition, if monies are restricted solely to capital improvements, they are placed in “capital project funds.” This is typically the case for development impact fees, which are also discussed in this chapter. Local Special Taxes Local agencies may enact new or increase existing special taxes with two-thirds voter approval. Such special taxes are earmarked for specific purposes, and thus must be accounted for separately from other local revenues and expenditures.1 Although general-purpose taxes are far more common, some cities and counties have adopted special utility taxes, transient occupancy taxes, and add-on transactions and use taxes. Cities, counties, and special districts all have the authority to impose new or increased parcel taxes, which require two-thirds supermajority approval and, if designated for a specific purpose, they should be accounted for in a special revenue fund.

Countywide Transportation Sales Tax. California law specifically allows voters to approve countywide transaction and use tax2 increases for improving local and regional roads and transportation systems. Typically called “Transportation Sales Taxes,” they are special taxes that require two-thirds supermajority voter approval. As of 2010, they had been enacted in nineteen counties. The revenues are administered by a county transportation authority, a distinct public agency, whose board of directors includes representation by the county board of supervisors and elected officials from cities within the county.

County Transportation Agencies with Transportation Sales Taxes

alameda county contra costa county Fresno county imperial county Los angeles county madera county marin county orange county riverside county Sacramento county San Bernardino county San diego county San Francisco San Joaquin county San mateo county Santa Barbara county Santa clara county Sonoma county tulare county

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Guide to LocaL Government Finance in caLiFornia State Subventions As described in Chapter 4, a subvention is a provision of financial assistance, usually from the state or federal governments to local governments. Historically, the state has imposed and collected certain taxes and fees that it then distributed to local agencies. Most of these are designated for specific purposes and must be accounted for in special funds. State assistance constitutes a very large part of counties’ revenues as they are responsible for major public health and welfare services provided on behalf of the state. Aside from the VLF (see Chapter 4), state subventions to local governments are increasingly rare. The VLF was a general purpose revenue but in 2011 the legislature diverted it toward law enforcement grants.

Motor Vehicle Fuel Tax (Highway Users Tax). The State of California imposes taxes on various transportation fuels,3 including gasoline and diesel.4 California’s gasoline and diesel fuel tax rates are tied by statute to comparable federal taxes. Motor vehicle fuel tax revenues may be expended for research, planning, construction, improvement, maintenance, and operation of public streets and highways or public mass transit guideways. They are allocated among the state, counties, and cities under a complex formula in state law. City funds are essentially allocated according to population. County allocations are largely based on the number of registered vehicles and miles of county roads Law Enforcement Grants. The state provides a number of grant programs for local law enforcement, crime prevention and recidivism reduction programs that are often accounted for in special revenue funds.7

Figure 5-1. State Motor Vehicle Fuel Tax Flow Chart

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• Citizens Option for Public Safety (COPS) and Juvenile Justice Grants.8 Citizens Option for Public Safety (COPS) (directed largely to cities) and Juvenile Justice programs (directed largely to counties) provide funding for “front line law enforcement services” including anti-gang, community crime prevention, and juvenile justice programs. The funds are allocated by the State Controller to counties for deposit in a Supplemental Law

chapter 5: Special revenue Funds: the inflexible Funds Figure 5-2. Allocation of Highway User Tax Revenues

•

Enforcement Services Fund (SLESF) established in each county. Frontline law enforcement funds are allocated to each city and county based on population with a minimum $100,000 grant.

Jail Detention Facility—Booking Fees.9 Counties receive funding directly into local detention facility revenue accounts, to be used for operations or capital projects.10 Cities that operate detention facilities are also eligible to receive funds from their county’s local detention facility revenue account.

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Guide to LocaL Government Finance in caLiFornia The Gas and Fuels Tax Swap of 2010

in 2010 as a part of a special budget session, the state legislature passed new laws providing for a swap of state sales taxes on gasoline (including Proposition 42 revenues) for an increase in the motor vehicle fuels tax. the purpose of the swap was to get around constitutional restrictions tied to the use of the gasoline sales tax that do not apply to the motor vehicle fuel tax, and, thereby, affording the state greater flexibility in the use of the revenues. the state, thereby, effectively re-allocated funding to pay state general fund transportation bond debt— funds that previously were used for local public transit. Proposition 42 allocations have thus been replaced and fully funded but from a new higher motor vehicle fuel tax (highway users tax) rate (per california Streets and Highways code Section 2103). the rate is adjusted annually in order to obtain the amount of revenue that the Proposition 42 tax on gasoline would have generated.

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•

Proposition 172 Public Safety Sales Tax. In 1992, voters approved Proposition 172, the Local Public Safety Protection and Improvement Act, which created a new half-cent sales tax to be dedicated to local public safety purposes.11 Proposition 172 funds must be expended only on public safety services including sheriffs, police, fire, county district attorneys, corrections, and ocean lifeguards.12 Cities and counties that receive Proposition 172 funds must maintain public safety functions to certain prescribed minimums.13 The one-half-cent sales tax imposed by Proposition 172 is apportioned to each county based on its share of statewide taxable sales. Each county is required to deposit this revenue in a Public Safety Augmentation Fund (PSAF) to be allocated to the county and cities within the county. Each County Auditor distributes the revenues in the PSAF among the county and each city in that county based on their proportionate share of net property tax loss due to a portion of the 1992 Educational Revenue Augmentation Fund (ERAF).14 Cities that received no property tax or that did not exist in 1980 are not affected by this phase of ERAF and consequently are ineligible for Proposition 172 revenues. About ninety-five percent of those revenues go to counties.

Williamson Act Open Space Subvention. The California Land Conservation Act of 1965, also known as the Williamson Act (named for Assembly member John Williamson, the author of the bill), is a voluntary, locally administered agriculture and open space land protection program.15 In 2010, over sixteen million of the state’s twenty-nine-million acres of agricultural land were covered by a Williamson Act contract, thus, discouraging conversion to urban uses. Under the Williamson Act, private landowners may enroll their properties in ten- to twenty-year contracts restricting them to agricultural and openspace uses. In return, restricted parcels are assessed for property tax purposes at a rate consistent with their actual use, rather than potential market value, a much lower level. All prime agricultural parcels of at least ten acres are eligible, as are non-prime farmland and certain other open spaces at least forty acres in size. Local governments can impose additional requirements on contracts, including larger minimum parcel sizes. Agricultural landowners who participate in Williamson Act contracts typically save from twenty to seventy-five percent in property tax liability each year.

chapter 5: Special revenue Funds: the inflexible Funds Community Development Block Grants (CDBG) and Other Grants The state and federal governments provide grants to local agencies for myriad purposes. Even in the 2000s, state grants related to water quality, open space and resource conservation, cultural facilities, coastal access, transportation, emergency preparedness, homelessness, and many other topical issues were surprisingly numerous given the recurring fiscal crises in Sacramento. These grants were awarded on a competitive basis and were available only for specific purposes. Thus, they are accounted for in special revenue funds. In almost every instance, the grant monies constituted minor, albeit welcome, contributions to an agency’s overall financial picture. Similarly, the federal government administers hundreds of grant programs that provide monies to local governments for specified purposes. The most widely known federal grant program for local governments is the Community Development Block Grant (CDBG). CDBG monies may be used for a number of pre-approved purposes, mostly related to infrastructure, housing, economic development, and social services. In response to the financial crisis of 2008, and the ongoing economic recession that resulted, the federal government offered billions of dollars to states, local governments, and non-profits as part of the American Reinvestment and Recovery Act (ARRA). These, too, were awarded on a competitive basis, and although the scope to which “stimulus” money was applied was quite broad, each fund-dispersing program prescribed eligible types of applicants and projects. Contemporary federal grants, including CDBG and ARRA, are typically accounted for in special revenue funds. Development Impact Fees Another common source of local revenue that must statutorily be accounted for in special funds are development impact fees. These fees are levied on developers to offset impacts on infrastructure or other public facilities related to the approval and construction of new projects. State law16 prescribes the requirements for adopting such fees, codifying what had been previously a common but irregularly applied planning practice. Prior to imposing a fee, the local agency must first identify the purpose and use of the fee. The agency must find that there is a reasonable relationship between the new development and anticipated impacts on the public facilities, and determine that there is also a reasonable relationship between mitigating the impact and the use and amount of the fee charged. The findings must be supported by plans and studies; to pass legal scrutiny the relationships between development, impacts, and mitigation through fees need not be precise, but “reasonable.” 49

Guide to LocaL Government Finance in caLiFornia

The fees must be placed in separate capital project funds and used only for the designated public improvements identified as needed to alleviate impacts. The agency must make annual findings as to the status of these funds, with the intent that they be used in a timely way.17 Summing Up

Special revenue and capital project funds are used to account for revenues that are legally required to be expended for specific purposes or are otherwise required to be tracked separately. Common special revenue funds in California local governments include those for special taxes and for intergovernmental subventions designated for particular purposes. For example, every city and county will have special revenue funds to track state highway users tax revenues for streets and roads. Other common special fund revenues are grants. State law requires that development impact fees also be accounted for in separate funds. In addition to the general fund and various special revenue and capital project funds, the largest and most important funds are those that separately account for municipal enterprises, the topic of the next chapter.

NOTES California Constitution article XIIIC. As described in Chapter 4 transaction and use taxes differ somewhat in application and allocation from the sales and use tax. 3 California Constitution article XIX § 1; Revenue and Taxation Code §§ 7301 8404, 8601 9355; Streets and Highways Code §§ 2104, 2105, 2106, 2107 & 2107.5. The State Board of Equalization registers fuel suppliers, administers tax returns, audits tax payers, administers appeals and refunds. The State Controller collects and allocates the revenues, and audits the use of the revenues. 4 Gasoline and diesel taxes are imposed on any liquid usable for propelling motor vehicles powered by certain common types of engines, while a use fuel tax is imposed on vendors and users of motor vehicle fuels that are not taxed under either the gasoline or diesel fuel tax, such as liquefied petroleum gas, ethanol, methanol and natural gas (both liquid and gaseous). Use fuel tax rates vary depending on the type of fuel. 5 California Government Code § 14524, Revenue and Taxation Code § 7104. 6 Proposition 1A (2006). 7 These programs, amounting to around $500 million annually, were paid from state general fund revenues through FY2008-09. In FY2009-10 and FY2010-11, they were 1 2

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chapter 5: Special revenue Funds: the inflexible Funds

funded from a temporary 0.15 percent state vehicle license tax. As a part of the 2011 state budget agreement, the state shifted local VLF revenues, including all remaining discretionary city and county VLF, to pay for the grants. 8 California Government Code §§ 30061-30065. 9 California Government Code §§ 29550-29553. 10 Counties have the authority to charge a “jail access fee” for each booking in excess of each agency’s three-year average (recalculated annually) of bookings for the following low-level offenses: municipal code violations, and misdemeanor violations except driving under the influence, domestic violence offenses, and enforcement of protective orders. 11 The legislature and Governor Wilson agreed to place this measure on the ballot to help offset some of the effects on local agencies from ERAF (see Chapter 16). 12 California Government Code § 30052. 13 California Government Code § 30056. 14 Mindful of the substantially larger proportion of ERAF paid statewide by counties than by cities or special districts, legislative leaders in 1992 initially considered allocating all Proposition 172 proceeds to counties only. But they realized the success of Proposition 172 with the voters would be enhanced with the support of city officials, police and fire chiefs, police officers and city firefighters, so a portion was allocated to cities. 15 California Government Code § 16140 et seq. 16 California Government Code §§ 660000-66025. 17 These types of fees are discussed in much greater detail in two other Solano Press books, Exactions and Impact Fees in California and the perennially updated Curtin’s California Land Use and Planning Law.

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Enterprise Funds: The Business-like Funds Chapter 6

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ocal government enterprises are those services provided by a municipality that are paid for wholly or in large part by fees, rates, or charges borne by the recipients of the services.1 Based on their revenues and expenditures, statewide, enterprise functions account for about one-third of what local governments do in California. In many respects, enterprise functions are more analogous to private businesses than other governmental activities. Unlike private businesses, however, public enterprises can only charge fees sufficient to cover costs (although costs for reasonable reserves and overhead costs are allowed). Enterprises may be subsidized by the general fund if a community deems such support is warranted to maintain preferred levels of service or to make a service more affordable. However, enterprise monies cannot be used for general government purposes not related to the delivery of the enterprise service. California local governments provide a broad range of enterprise services, including those in the following list.

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Guide to LocaL Government Finance in caLiFornia Figure 6-1. Enterprise Funds as a Share of Total Local Government Expenditures

Source: State controller’s annual reports.

In many communities, some or all of these services may be provided by the private sector. Why these types of services are delivered in one community through local government and by the private sector in another is the result of local history, tradition, and preference. But, collectively, delivering enterprise services is a large part of what California local government does. As shown in Figure 6-1, enterprise services account for over one-third of all local government expenditures and almost two-thirds in special districts. What Is a Local Government “Enterprise” Service? Enterprise services are differentiated from general purpose governmental functions in that they are similar to ones provided in the private sector (either by for-profit or not-for-profit organizations), and it is the agency’s intent to cover most or all of the service costs (operating, capital, and debt service) through user charges. This may include an appropriate share of indirect costs like accounting, human resources, insurance, and information technology. In some cases, it is clear that generally accepted accounting principles (GAAP, see Chapter 3) require that the service be accounted for as an enterprise fund, such as water, electricity, gas, and hospitals. Sometimes, there are statutory requirements that certain activities be treated as an enterprise fund. 54

chapter 6: enterprise Funds: the Business-Like Funds Figure 6-2. Major Local Enterprise Functions in California ($ millions)

Source: california State controller reports 2014-2015.

However, for many services, it is discretionary as to how they are accounted for. Consider the following examples: Parking. Some agencies account for parking operations in their general fund. Other agencies account for their parking operations within an enterprise fund.

Storm water. Many agencies have adopted fees for storm water management (in many cases to help fund federally mandated “clean water” requirements under the National Pollutant Discharge Elimination System permit program). Some of these agencies account for these costs and revenues in their general fund, some in a special revenue fund, and others in an enterprise fund. Planning and building. While many cities and counties strive to recover most (if not all) costs associated with development review in their planning, building and engineering programs, very rarely are the revenues and costs associated with these services accounted for within an enterprise fund.

Indirect Cost Allocation Plans

in order to maximize cost recovery, and to make the best rate setting decisions, an agency must have an accurate understanding of its full costs for delivering a service. that full cost will include “indirect” costs such as accounting, legal services, purchasing, insurance, building maintenance, technology and information services that the agency has available to support all its programs and activities. in addition, indirect costs should include a share of agency-wide management and oversight. a cost allocation plan distributes indirect costs in a logical and consistent manner to all of an agency’s programs, including enterprise functions. once its indirect costs are determined, the enterprise fund can reimburse the general fund, accordingly, through fund transfers or expense credits. of course, programs and costs change over time, so cost allocation plans should be regularly updated. (in order to recover indirect costs for state or federally funded programs, the cost plan must be prepared in accordance with u.S. office and management Budget requirements as set out in omB circular a-87.)

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Guide to LocaL Government Finance in caLiFornia Wholesale or Retail?

an agency’s enterprise service may entail all of the functions required for the delivery of service to the “end customer”—or just some of them, in the case of water delivery, for example, many local agencies are responsible just for “retail” water distribution (and billing their customers for it): they purchase treated water from a regional wholesaler (who may, like the calleguas municipal Water district in ventura county, in turn purchase water supplies from an even larger regional water wholesaler like the metropolitan Water district of Southern california). on the other hand, some of the largest water districts are solely in the “wholesale” supply or treatment business: they do not deliver water on a “retail” basis to customers. in other cases, agencies are responsible for all facets of the water operations: producing water supplies through reservoirs and groundwater; treating these water supplies; and then distributing the water to their individual residential and business customers. Similar situations exist for wastewater: some agencies provide full pre-treatment, collection and treatment services. other agencies may directly provide only collection services, and then contract with another agency for treatment. (this is the case for twenty-seven cities in Los angeles county, who contract with the city of Los angeles for wastewater treatment at the Hyperion Plant.) Because of this, caution needs to be exercised in comparing staffing in local agencies that provide similar “retail” services: in some cases, an agency may be responsible for all functions related to the service, in which case, even with a similar number of customers, it is likely to have more employees than an agency that is solely in the “retail” business.

Municipal golf courses. Some agencies may view their golf course operations as being conceptually no different from the other recreation services they provide, such as swimming pools, after-school daycare programs, or organized sports (which the private sector also provides, both by not-for-profit and for-profit organizations) and as such, account for them in the general fund along with those other park and recreation programs. Others agencies take a different view and treat golf course operations as an enterprise fund.

Thus, an agency may classify various activities for which fees area charged as part of the general fund, not as a separate enterprise fund. Even in those cases, the local government must track those fees and their uses in subaccounts. If the agency establishes a service as an enterprise fund, it must be accounted for on a full accrual basis, using similar accounting principles as private sector organizations, plus some additional requirements set by the Governmental Accounting Standards Board (see Chapter 12). Setting Rates One of the most difficult problems for local governments associated with enterprises is the setting of fees or rates. Part of the problem is technical, part philosophical and part political. There are two conceptual approaches to setting rates:

Return on Investment. With this approach, rates are set based on a targeted return on investment. For example, the service-provider may set a goal of earning a ten percent annual return on its investment (similar to the target that California Public Utilities Commission has set for private water companies). While this is a “business-like” approach to setting rates, it is most applicable to investor-owned utilities and is rarely used by local agencies in setting rates.

Flow of Resources/Working Capital. With this approach, agencies make projections of their cash flow needs in meeting operating, capital and debt service costs while retaining working capital balances at appropriate levels. Given the goal of “just” recovering costs, this is the approach used by most local agencies in setting rates. The basic model under this approach to determine rate revenue requirements is typically a four-step process: 56

Step 1: Determine Total Revenue Requirements

chapter 6: enterprise Funds: the Business-Like Funds

• • •

Operation and maintenance costs Capital improvement plan (CIP) projects Debt service obligations (existing and projected)

• • • • •

Account start-up fees Connection charges Development impact fees Revenues from other agencies Investment earnings

•

Revenue needed from rates is the difference between revenue requirements (Step 1) and non-rate revenues (Step 2). If cost recovery goals are less than 100 percent (that is, if the local decision-makers find that subsidizing the enterprise with general-purpose revenues is necessary or desired), that should be accounted for in this step.

Step 2: Subtract from This Amount Non-Rate Revenues

Step 3: Identify Rate Revenue Requirements

Step 4: Determine New Rates •

In simple rate structures, this is the difference between rate revenue requirements from Step 3 and revenues generated by current rates. In more complex rate structures, this may require modeling the rate base for use by various classes of customers.

If the governing body finds that rates will not likely cover expenses, and is uncomfortable or unable to increase rates to the necessary level, then four options are available to the agency for prudently managing its finances: • • • •

Reduce operating costs Scale back capital projects Increase non-rate revenues Use working capital balances (reserves) if available

It should be noted that using reserves is a short-term strategy that may result in much larger rate increases in the future. Most communities will be better served by smaller, frequent increases than by infrequent large ones. While this model can be applied on an annual basis, it makes more sense to set rates based on multi-year projections. Figure 6-3 illustrates a simple model for how this approach can lead to better rate stability in a hypothetical water fund. 57

Guide to LocaL Government Finance in caLiFornia Figure 6-3. Rate Setting Model: Hypothetical Water Fund

In this example, there is a gap in Year One of $500,000 between rate revenue requirements and revenues from the current rates. This gap grows to $1.7 million by Year Five, largely due to increased operating and debt service costs for a needed treatment plant. Even if the agency had working capital balances that could cover cumulative deficits through Year Four of $4.1 million, an increase of 17.4 percent would be need to cover the $1.7 million gap in Year Five. On the other hand, modest rate annual increases of 3.25 percent would achieve the needed revenues by Year Five. Other factors that would need to be considered in this analysis include maintaining adequate reserves and meeting all applicable debt service coverage requirements. The key point is that rate stability is more likely to be achieved through multi-year planning. And this approach tends to be more transparent, especially if rate increases are required to realize important service delivery goals. Rate Review Frequency

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Even when multi-year-rate analyses are used, agencies should still review rates at least annually. Even the best models and assumptions are subject to unexpected

circumstances that are more easily discerned with frequent, regular reviews. While annual reviews could occur at a different time, it makes sense to do so as part of the budget process, since costs are what drive rate requirements. Agencies may want to consider formally adopting multi-year rates. This has two key advantages. First, where significant rate increases are needed for several years in order to fund key programs or projects, multi-year rate setting allows the governing body to make just one major policy decision and not have to keep revisiting the same issue year after year. Secondly, it provides a benchmark for interim annual rate reviews: once multi-year rates have been set by the governing body, staff will work hard to present budgets that live within those parameters. Rate Structure The rate model in Figure 6-3 shows the amount of revenue needed from water rates; however, that revenue can be generated from a wide variety of rate structures. On one hand, all the needed revenue could be generated from flat rates. For example, if there were 15,000 customers, a monthly flat rate of $55.56 per customer would cover the revenue rate requirements of ten million dollars. On the other hand, this flat-rate approach means that customers who use small amounts of water will pay the same amount as those who use large amounts (which is, incidentally, not much of an incentive to conserve a valuable resource). Thus, alternatively, the rates

chapter 6: enterprise Funds: the Business-Like Funds Thinking about Fees

cities may charge reasonable fees for any service they provide. However, several factors are considered when a municipality decides whether or not to charge a fee and, if so, how much. Here are some of those key considerations.

Identifying the user. a key to charging a fee for service is to easily identify the persons who are benefiting from that service. Sometimes that is very expensive or impractical. For example, cities could charge people for using local roads and streets. However, that might require limiting access through some kind of toll entrance. For local streets, this is almost entirely impractical. However, it is not uncommon for local governments to charge fees for certain significant roads or, even more commonly, bridges. in those cases, it is relatively easy to funnel users through a tollgate. toll roads are much more common in the eastern u.S. but they are increasing in california.

History and politics. cities could, for example, charge people for using local parks. they could put a fence around the park, have a pay booth at the entry, and allow people only to enter if they paid a fee. However, historically, local parks are open to the general public for free. trying to charge a fee for general park use would unlikely be politically acceptable in most places. even when there is no legal reason or even administrative reason to prevent fees for services, there may be strong political reasons why certain fees would not be tolerated in a community.

Encouraging or discouraging use. another consideration in levying a fee for service is whether or not the city wants to encourage or discourage the activity associated with that service. For example, a city wanted to better control fence heights and locations because of complaints about lack of compliance with local zoning regulations. in order to better regulate fences, it instituted a fence permit ordinance, requiring people to obtain a city permit prior to installing fences. at first, the city charged a “full cost recovery” fee based on the actual time for plan checking and processing the permits and doing compliance inspections. the cost was several hundred dollars, sometimes a significant fraction of the cost itself (especially considering that small projects like fences are often done by residents or businesses on their own). the result was that very few people sought a permit, but rather went ahead with their fence building. thus, the new regulation had little impact on controlling fence heights or locations, but did develop a scofflaw culture. Later, the city reduced the fee to twenty-five dollars, even though that meant that the full cost of regulating the fences would not be covered by the charges. But the low cost encouraged people to comply with the regulations and get the required permits, allowing the city a better interface with the public to minimize the original problems with fence heights and locations. thus, policy makers must realize that high fees will discourage an activity which may be contrary to the policy they are trying to implement.

Alternatives. another consideration is whether or not there are viable alternatives to charging the fee for a service. For example, a city may want to offer after-school child care free of charge. However, because of money limitations, the city may find that it faces a choice between offering this service and charging a fee, or simply not offering the service at all because there is no practical funding alternative. Sometimes, charging a fee is the only realistic way of providing a desired public service.

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Figure 6-4. Sample Rate Structure Comparison: Flat Versus Use Rates (Hypothetical Water Fund)

Tiered “Water Conservation” Rates and the “Capistrano” Decision

in 2015, the orange county court of appeals ruled that the city of San Juan capistrano’s “tiered” water rates to encourage conservation did not meet Proposition 218’s requirement that rates reflect the cost of service. this ruling does not prevent agencies from setting tiered rates (where higher rates are set for higher levels of consumption) to encourage conservation; but it does mean that there needs to be a clear analytical basis—a “nexus”—between the cost of service and the rate structure. in the case of tiered water rates, this may mean showing that the marginal costs of new supplies are high, and thus appropriately recognized in the tiered-rate structure. in summary, while agencies have discretion in setting rates based on underlying policies and goals, these also needs to be a justifiable relationship between rates and cost of service.

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could be based solely on consumption. Use is measured by some “billing unit” (typically 100 cubic feet of water) and customers are charged for each billing unit actually consumed. Figure 6-4 shows the impact of the two rate structures on customers based on their usage. Both of these rate structure will generate the same amount of revenue (ten million dollars annually) necessary to cover expected costs in the example. However, the small water user (five units per month) will pay $27.76 more per month under a flat rate system—twice as much as under the structure based on consumption. On the other hand, large users will pay significantly less— $27.84 less for fifteen units and $55.64 for twenty units under a flat rate structure than they would under the consumption-based system. This example also underscores an important point about rate structures: the average customer will pay about the same amount under either rate structure. Therefore, the rate structure really determines how costs will be allocated to non-average customers: will they pay more or less than the average customer if they use more or less of the service? Note, too, that different structures can generate the same amount of revenue. Thus, different rate structures are not about revenue adequacy but about who pays how much. In the example, a valid argument can be made for flat water rates. At any particular time, most water costs are fixed and do not vary much with changes in total consumption. Flat rates also have the advantage of providing a high degree of predictability to the customer, as well as revenue stability compared with those based on consumption (as consumption can vary by several exogenous factors such as weather). On the other hand, if the marginal costs of providing additional new water supplies are high, consumption-based rates may be superior. And, of course, as noted throughout the book, governmental fees are set in a political context, and it may simply appear inherently fairer to decision-makers and the community that those who use more should pay more.

chapter 6: enterprise Funds: the Business-Like Funds

Lastly, depending on the price elasticity of demand (as discussed below), the amount of water consumed may decrease when rates are based on consumption. This is ideal if the goal is to use the pricing structure to send conservation cues to consumers; but it may require adjusting projected water sales and rates if reduced consumption adversely affects the adequacy of revenues to cover costs. Rate Setting Policy

In setting rate structures, governing bodies should consider first adopting policies that articulate the underlying community philosophy for the enterprise. For example, in the case of water rates, appropriate policies might include: • • • • • •

Comply with legal requirements Encourage conservation Ensure revenue adequacy to fully meet system operating and capital needs Provide fairness among customer classes based on cost of service Be easy for customers to understand and for staff to administer Facilitate rate stability and predictability for customers

Appropriate polices for fees or rates would also include cost recovery targets. In some cases, the recovery target is simply 100 percent. However, as noted earlier, there may be other public benefits to subsidizing charges for certain services. (There are usually also political benefits for subsidizing costs of services enjoyed by important constituencies, but catering to those political benefits may be more expedient than really providing for the long-term best interests of the entire community.) See Figure 6-5. Some of these rate-setting goals are complementary, and some may be in conflict. For example, rates designed for conservation may not be as stable as flat rates and may jeopardize revenue adequacy, which may mean unavoidable spikes in rates later. For these reasons, governing bodies should also express some sense of priority among their rate structure policies.

Price Elasticity of Demand. Depending on the circumstances, a ten percent increase in price may not yield a ten percent increase in revenues. In fact, depending on the “price elasticity of demand” for the service, it is conceivable that total revenues could actually decline. How much revenue will be produced for a given price increase depends on how responsive the quantity demanded is to price changes. That is, if the price is raised, how many customers will cut back on the service? If many customers reduce their consumption of the service either by forsaking it or by finding less expensive substitutes, then overall revenue might decline because there are just fewer people buying the service.

Comparing Rates to Other Communities

While the pressure to compare rates with neighboring communities is probably inevitable, agencies should avoid having their service levels and related rates driven by others. it is important to ensure “apples-to-apples” comparisons. For example, water agencies that rely largely on groundwater will have much lower supply costs than agencies that rely on surface reservoirs, which require extensive (expensive) treatment. (and, of course, new reservoirs will have much higher construction costs due to stricter environmental and geotechnical standards.) Similarly, agencies that discharge wastewater to the ocean are likely to have lower treatment costs than those that discharge to creeks (especially if those creeks support—or could support—salmon or steelhead populations). For these reasons, if agencies feel the need to consider rates set by other agencies as part of their own rate setting process, they should select agencies as benchmarks that have similar regulatory requirements and service delivery characteristics.

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Guide to LocaL Government Finance in caLiFornia Can Rates Be Set Higher Than the Cost of Providing the Service?

Yes, but any revenue generated above the cost of providing the service is considered a tax. in that case, voter approval would be required to set rates in amounts greater than cost recovery. this is why discounted rates for seniors or low-income customers cannot be funded by water or sewer rates. it is a subsidy by ratepayers unrelated to the cost of providing the service. thus, if an agency wants to provide this type of discount service, it must fund it from other funding sources, such as the general fund, grants, or donations. on the other hand, tiered rates or “inclining” rates where higher rates are charged per unit as consumption increases are allowable based on the higher marginal costs of new water supplies.

Figure 6-5. Factors Favoring Limited vs. Full Cost Recovery

Private or other public sector alternatives do exist.

Where demand is high due to necessity and few (or no) other substitutes exist, increased revenues are likely to be nearer to the amount of the price increase. On the other hand, where the service is considered discretionary and other alternatives are available, it is unlikely that revenues will be generated in proportion to the rate increase. As enterprises such as golf courses, museums, and zoos have experienced, it is certainly possible to raise rates and generate even less money than before due to drop-offs in participation. Rate Approval

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Unless there are special requirements in local ordinances (or city charters), there are no voter approval requirements for enterprise fund rate increases, provided that fees are based on recovering costs—and no more. (Non-enterprise services for which a fee is tied to property ownership—not use of the service—is the primary basis for determining the amount to be paid require majority voter approval by those who pay the fee.) Although voter approval is not required, there are extensive notice and protest requirements for fee increases related to water, sewer and refuse services. Under Proposition 218, mailed notice to all ratepayers is required at least forty-five days before the governing body can consider rate increases. The consideration of the rate increase must include opportunities for citizens to voice concerns through a public hearing. The notice can be a separate mailing or included with utility bills. The notice must provide current and proposed rates; the date, time, and place of the public hearing; and the effective date of the rate changes. While not

chapter 6: enterprise Funds: the Business-Like Funds

required, agencies should also consider providing information in the notice about the need for the proposed rate increase, along with how to get more information about it, including contact phone numbers and website links as appropriate. Multi-year rates can be adopted by the governing body at one public hearing, as long as the proposed rates were included in the forty-five-day notice. Where future increases are linked to some index, such as the consumer price index, that must be included in the notice. The governing body may adopt rates lower than those indicated in the notice but it cannot adopt higher rates (that would require a new forty-fiveday notice). While voter approval is not required, there are other limits on the governing bodies. If a majority of customers file written protests by the noticed public hearing date, the governing body cannot adopt an increase. However, the governing body is not precluded from reconsideration of a rate increase following another forty-five-day noticing process. Lastly, Proposition 218 allows for the reduction or elimination of water, sewer and refuse fees through the initiative process. Thus, formal protests may not have been successful in preventing rate increases, but voter rollback or elimination of fees is possible at any time. While there are no specific state requirements for other enterprise fund rate increases for services like golf, parking, hospitals, airports, or harbors, providing ample notice and meaningful opportunities for input at workshops and public hearings is an excellent idea. The more controversial the rate increase is likely to be, the more important it is to meaningfully engage stakeholders in the process. Revenue Collection

Fees, charges, rates—all need to be collectable. In the case of water services, for example, this means investing significant resources (which need to be recovered from rates) in installing meters, reading them, entering (or downloading) this data into utility billing systems, preparing and issuing bills, collecting and posting payments, following-up on delinquent accounts and at some point, discontinuing service for non-payment. Regardless of the service, agencies need to consider how customers will be notified of the amount due and what

Some Reasons Why a City Cannot Be “Run Like a Business”

Legal constraints. unlike businesses, cities cannot make a profit on the services they provide. For example, building permits and related fees are priced to reasonably cover the cost of the processing, plan checking and inspections. imagine if, during housing booms, cities charged what the market could bear for permits, not just an amount to reasonably cover actual cost!

Prices are frequently set by a political process, not the market. Local agencies are often pressured to provide high levels of public service, yet not charge the full cost of providing them. For a simple example, a city council in a medium-sized city operated a municipal golf course. the course manager and finance director proposed adjusting greens fees to cover the actual cost of the course. at a hearing to discuss fee increases, a large contingent of senior golfers testified that the increase in greens fees would price them out of using the municipal course. in the face of this political pressure, the council actually agreed to lower fees for seniors. this worsened the financial conditions by encouraging more use but at a price insufficient to cover the costs of running the course. the course was then subsidized with general fund revenues.

Many public services are those that are inherently not likely to be profitable. many of the services public entities provide are often those that a community desires but that can’t be profitably provided by the private sector. that’s precisely why they must be provided by the public sector and not private businesses. an example is public transit. many cities provide levels of public transit service at costs much higher than can be recovered by fares. Because public transit cannot be run profitably as a business, a public agency is created to provide the desired service. of course, that means that other revenues, such as grants and/or the general fund, must subsidize the service.

In a democratic society, government legitimacy is more important than efficiency. in a democracy, the way in which decisions are made is more important than what the decisions are. the process of civic involvement, open meetings, and decision-making transparency make for good government, but frequently are not the most cost-efficient way of providing public services.

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the consequence will be for non-payment. Where the consequence is viewed by customers as minor or non-existent, operating the service as a full costrecovery enterprise will prove challenging at best. “Bad debts” will need to be incorporated into the revenue requirements and rates adjusted upward, accordingly, to cover them. Summing Up Local governments in California provide a wide range of “business-like” services, which together comprise over one-third of all their total expenditures. In most cases, the costs and revenues related to providing these services are accounted for within separate enterprise funds. Fees must be based solely on the cost of providing the service, unless surplus amounts above cost recovery have been approved by voters. There are extensive notice and public hearing requirements for water, sewer and refuse rate increases. Moreover, the governing body’s rate-setting authority is limited by the protest and initiative provisions of Proposition 218. In setting fees, rates, or charges, governing bodies should start by establishing policies and articulate the priority among them should there be conflicts. Rate setting, even when voter approval is not required, takes place in a political context, and articulating policies early in the process helps elected officials better navigate that environment.

The last three chapters have described the major fund types that local governments use for accounting for revenues and expenditures. Anticipating those revenues and costs, and planning the scope and levels of services the agency will, therefore, provide, is the art of budgeting, the topic of the next chapter, as Part III of the book begins, dealing with key issues in the practice of local government finance.

NOTES Some local services must be considered “enterprises” due to statutory requirements. Transit is the prime example: statewide, transit services typically collect only about twenty percent of their costs through fares to customers.

1

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The Practice Part III

Budgets and Fiscal Policy: Allocating Resources and Ensuring Financial Health Chapter 7

B

udgets raise many of the most important policy decisions that local elected officials face on behalf of their communities. Budgets determine what will get done—and perhaps more importantly, what won’t. Along with “what,” budgets also determine “who”—who will benefit from these services and who will pay for them. “Budgeting is translating financial resources into human purposes.”1 Whatever a community’s needs and aspirations may be, they require resources to accomplish them. And while municipal resources are limited, community desires are not. Thus, a municipal budget’s primary importance is the allocation of resources that determines the type, amount, and quality of services that will be provided and how they will be paid for. But the budget plays other, related roles in a public agency’s affairs. The Government Finance Officers Association2 of the United States and Canada (GFOA) notes that in addition to being a fiscal plan that identifies and appropriates public resources, a local government budget should also be: 1) a policy document that sets forth goals and objectives to be accomplished and articulates the fundamental principles upon which the budget is prepared; 2) an operations guide that describes the basic organizational units and activities of the agency; and, importantly, 3) a communications tool that provides the community with a blueprint of how public resources are being used. Budgeting is surely among the most important functions of local government officials. Requirements for Adopting Budgets and Financial Plans

In California, counties are required to adopt budgets pursuant to detailed procedures in Government Code Section 29000 (“County Budget Act”). Budget requirements for special districts vary depending on the statutory authority that creates them. There is no state mandate that cities adopt budgets, but all cities do.

Budget: The Process Versus the Product

“Budget” is both a process and the resulting document. However, the process and the type of budget that results from it are closely related. Stated simply, form tends to follow function. For example, it is unlikely that a lineitem budget will be the type created from a process focused on goals and outcomes. consciously or not, when it comes to the budget process and the resulting budget document, all local governments seem to follow Stephen covey’s advice in The Seven Habits of Highly Effective People to “begin with the end in mind.”5 in other words, program budgets are likely to be focused on programs during the budget process; performance budgets focus on outcomes; and line-item budgets focus on detail and control (and likely to miss a more explicit linking of resources with goals).

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Guide to LocaL Government Finance in caLiFornia Where in the Organization Should the Budget Function Reside?

regardless of where the budgeting function resides, preparing budget recommendations to the elected officials is one of the agency manager’s most fundamental role. Preparing the budget is not (or at least, shouldn’t be) primarily a numbercrunching exercise: it is one of the most important policy documents of the local government. and, as such, because the chief executive is also the chief policy advisor to the governing board, it is essential that the budget clearly reflects the executive’s thinking and recommendations, regardless of where the budget function resides in the organization.

Many jurisdictions also undertake long-term financial planning in addition to short-term budgets, in order to better project trends and possible future conditions. Developing and adopting such plans may also be the proper way to articulate key public policies about resource allocations, debt financing, contingencies, risk management, investments and other similar issues (the importance of policy is discussed later in the chapter). However, budgets uniquely authorize expenditures. The responsibility for preparing the local government budget falls to the city manager in cities (or the mayor’s office in a handful of the larger cities using the strong-mayor structure); the county administrative officer in counties; and the general manager in special districts. In cities, the budget preparation function is typically located either directly in the city manager’s office or in a finance department. Similarly, the budget function in special districts may also be located in either the general manager’s office or a separate finance department. In counties, while the auditor-controller may assist with the process, the responsibility for preparing and recommending the budget to the board of supervisors most often rests with the county administrative officer (or equivalent).3,4 In counties, where the administrative officer does not have direct authority over key financial officials, the necessary coordination may be especially difficult. While developing a draft budget is the province of the professional staff, budget adoption—the appropriation of funds and authorization for expenditures—is solely in the realm of the elected governing body. While the overall approach and attendant subtasks (including the level of organizational participation, community involvement, and governing body direction in setting budget goals) will vary significantly among local agencies, there are four basic steps in the budget process: preparation, review and adoption, implementation, and monitoring/corrective actions. Budget Preparation

The complexity of budget preparation is directly related to how the agency views the purpose and goals of the process. For example, if the agency views the budget process as largely a “numbers crunching” exercise that will result in a line-item budget, budget preparation is likely to be straightforward with relatively few steps. On the other hand, if the agency plans to meaningfully engage the community in the budget process and provide the governing body with the opportunity to set policies and goals that will drive expenditure decisions, then the process will necessarily be more complex. Regardless of the approach, there are several key tasks in the traditional local government budget preparation cycle: 68

• • • • • •

• • •

chapter 7: Budgets and Fiscal Policy: allocating resources and ensuring Financial Health

Setting the budget calendar Establishing budget instructions Policy review/environmental scan Revenue projections and assumptions about ongoing expenses Department-by-department budget preparation Central budget preparation (most notably regular staffing cost projections) Internal budget review Preliminary budget preparation Budget review and adoption

Appendix B discusses each of these steps in detail, as well as some ideas about implementation and monitoring, including practical suggestions and examples. Approaches to Budgeting Generally speaking, there are four kinds of budget documents (although many will contain elements of each), which tend to reflect the focus of the budget process: • • • •

Line-item budgets Program budgets Performance budgets Zero-base budgets (ZBB)

Each is discussed further below.

Line-Item Budgets. Line-item budgets focus on costs, showing in detail what goods or services will be purchased, such as office supplies, asphalt, chemicals, phones, gas, electricity, and contract services. Line-item budgets have some major appeals. First, just as they were when initially implemented in the wake of government corruption at the beginning of the twentieth century,10 line-item budgets are well suited to ensuring financial control. They appropriate very specific amounts of money for very specific types of expenditures. Also, they can be useful tools for monitoring and holding down costs by allowing easy comparisons with prior years. They reflect the prevailing traditional, incremental approach to funding government programs, and are familiar and comfortable to many local agency elected officials. Len Wood, author of Local Government Dollars and Sense notes: Many elected officials love line item budgets, and the more detail, the more love. Line item budgets lend themselves to comfortable, yet inconsequential questions

GFOA and CSMFO Budget Award Programs

these two organizations provide checklists and rating criteria for recognizing exemplary budgeting. the GFoa checklist (along with an explanation of the rating criteria) is available on-line at no cost on its web site at www.gfoa.org. the california Society of municipal Finance officers (cSmFo) also provide a checklist (along with the reviewers Guide, which is helpful in outlining what reviewers are looking for) that is available online at no cost on its web site at www.csmfo.org. While both programs and checklists are excellent, the cSmFo program has components more closely tailored to california. in addition to excellence in operating budgets program, the cSmFo also has expanded awards programs in capital budgeting and innovation. For access to “best budget examples,” both web sites provide listings of past award recipients.

Assumptions and Estimates

neither budgeting nor financial planning is a precise exercise, of course. Like any effort to guide future actions, they require making assumptions about that future. in the case of financial affairs, those assumptions become the basis for estimating revenues and costs. What is often not appreciated is that, sometimes, small variances in the assumptions or estimating techniques can dramatically affect the outcomes. thus, budgets should articulate the assumptions and methodologies used, provide for periodic adjustments as the future turns into the present, and include some “variance analysis” or “sensitivity analysis” to highlight how changes in the assumptions will alter the outcomes.

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Best Practices

unlike generally accepted accounting principles as established by the Governmental accounting Standards Board for reporting financial results (see chapter 12), there are no “rules” for the preparation and presentation of budgets. However, there are recognized sources for “best budget practices.” Both the Government Finance officers association of the united States and canada (GFoa) and the california Society of municipal Finance officers (cSmFo) have developed budget award programs that provide detailed “checklists” for what makes up a good budget document. the national advisory council on State and Local Budgeting (nacSLB)6 has developed a comprehensive set of recommended budget practices. its Recommended Budget Practices: A Framework for Improved State and Local Government Budgeting provides sample documents. the nacSLB states that an effective budget process:

• • • • •

Incorporates a long-term perspective, Establishes linkages to broad organizational goals, Focuses budget decisions on results and outcomes, Involves and promotes effective communication with stakeholders, and Provides incentives to government management and employees.

“These key characteristics of good budgeting make clear that the budget process is not simply an exercise in balancing revenues and expenditures one year at a time, but is strategic in nature, encompassing a multi-year financial and operating plan that allocates resources on the basis of identified goals. A good budget process moves beyond the traditional concept of line-item expenditure control, providing incentives and flexibility to managers that can lead to improved program efficiency and effectiveness.”7 the nacSLB also strongly recommends meaningful “stakeholder” involvement in the budget process. it defines stakeholders broadly, including citizens, customers, elected officials, management,

employees and their representatives (whether unions or other agents), businesses, other governments and the media.8 as summarized below, the nacSLB recommends four broad principles, with twelve related elements.9 Principles

Elements

decision making

challenges and opportunities

Establish broad goals to guide government a government should have broad goals that

provide overall direction for the government

and serve as a basis for decision making. Develop approaches to achieve goals

a government should have specific policies,

plans, programs and management strategies

•assess community needs, priorities,

•identify opportunities and challenges

for government services, capital

assets, and management

•develop and disseminate broad goals

•adopt financial policies

•develop programmatic, operating,

and capital policies and plans

to define how it will achieve its long-term goals. •develop programs and services that are consistent with policies and plans •develop management strategies

Develop a budget consistent with approaches •develop a process for preparing and

to achieve goals

a financial plan and budget that moves toward

achievement of goals, within the constraints of

available resources, should be prepared and

adopted.

adopting a budget

•develop and evaluate financial options

•make choices necessary to adopt a

budget

Evaluate Performance and make adjustments •monitor, measure, and evaluate

Program and financial performance should be

continually evaluated, and adjustments made,

to encourage progress toward achieving goals.

performance

•make adjustments as needed

Recommended Budget Practices: A Framework for Improved State and Local Government Budgeting (including examples) is available on-line at no cost on the GFoa web site at: www.gfoa.org/services/nacslb.

such as: why do we need so much for office supplies? Travel has gone up $100 between this year and last year, and has gone up over $300 over the last three years. Why? 11

Line-item budgets are relatively easy for the staff to prepare and present to the elected officials (and budget staff are not immune to the temptation to ask the same questions of department heads and program managers as those presented above for elected officials). 70

Budgets and Fiscal Policy: allocating resources and ensuring Financial Health

These strengths are why line-item budgets continue to have many adherents; Len Wood estimates that sixty percent of all local governments present their budgets this way.12 On the other hand, line-item budgets have several potential weaknesses. By focusing in on specific expenditures, they often miss the far more important purpose of budgets, which is to express larger community needs and high-priority goals, and evaluate how well those are being accomplished. With a strictly line-item approach, information on what will be accomplished with the proposed expenditures (rather than how much will be spent on what) is usually not presented to decision-makers. And elected officials tend to be agenda-driven. If they are presented with a budget document that focuses on the input details, that is what they likely will focus on. On the other hand, if they are presented with budget materials that focus not on specific expenditures but on programs—for example, by raising questions such as: What services are being delivered and why? What are the major fiscal challenges facing the agency in providing services? What are the benefits of enhanced service levels? What are the adverse impacts if services need to be cut in light of tough fiscal circumstances?—they can better attend to these higher level issues. In short, like the rest of us, elected officials (as well as senior managers) tend to order from the menu they are provided. Program, performance, and zero-base budgets are intended to mitigate the downsides of line-item budgets.

Program Budgets. Program budgets shift the focus to service delivery by answering two key questions: What is the agency trying to accomplish? And, how much it will cost to do so? With this approach, budgets are organized by similar functions and related programs, which may often cross departmental lines, and offer narrative (rather than solely line-item detail) on program purpose (mission), goals, activities in delivering services, objectives for improving service delivery and cost. Questions may still arise about why costs have changed from the past. But with a program budget, the focus shifts from why a specific line item changed to why the cost of delivering programs changed. Compared with line-item budgets, program budgets better direct the budget discussions by elected officials and the community to what the agency wants to achieve relative to its goals, focusing attention on the “what and why” of the organization, rather than just “how much.”

Performance Budgets. Performance budgets enhance program-type budgets by incorporating measurable goals or objectives (performance measures). The focus on measurable outcomes typically results in discussions about whether 71

Guide to LocaL Government Finance in caLiFornia Line Items Don’t Go Away

even in program, performance or ZBB budgets, line-item detail still plays a role. But it will be for more for internal information and accountability purposes than the focus of governing body and community discussion. on one hand, it is important to not miss the forest for the trees. on the other, it is a mistake to forget that, ultimately, the forest consists of individual trees. in order for elected officials and the public to have confidence in the program and performance budgets, the staff has to perform its due diligence faithfully that the internal budget review process is rigorous, and that individual trees have been closely examined.

or not programs are actually achieving their purpose and if service delivery is efficient and cost-effective. Obviously, these kinds of budgets require the agency to actually establish performance measures. But finding meaningful measures is often challenging for the following reasons: •

•

•

•

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Cause and Effect. How can we be certain that the service effort caused the improvement? How much control does the agency in fact have over performance measures that may also be significantly affected by exogenous variables? For example, many attribute the significant reduction in crime in New York City in the 1990s to the “broken windows” strategy of no tolerance law enforcement for “minor” crimes such as graffiti and littering, combined with a modified system for deploying resources. While the policy and programmatic changes may have affected crime rates, the observed reductions may have also been significantly affected by unrelated variables, such as economic and demographic changes. This case highlights how it may be difficult to set meaningful performance standards that measure what the agency actually has control over.

Apples-to-Apples Comparisons. The use of performance measures inevitably gives rise to comparisons with other agencies, and using such benchmark comparisons can be a powerful tool in improving performance. But benchmarking must be done with discernment, to meaningfully make “apples-to-apples” comparisons. For example, significant differences between agencies may not be due to organizational performance, but rather, to significantly different socio-economic conditions or geographic differences.13

Measuring What Matters. There is a tendency to measure what can easily be measured, rather than what’s really important in accomplishing the organization’s mission. When this occurs, the unintended consequences of success can be severe. The agency can end up allocating limited resources to things that don’t really make a difference or, worse, that take the organization in the wrong direction. Unclear or Conflicting Goals. It is not uncommon for agencies to have unclear or conflicting goals, so that positive performance on one dimension may interfere with performance on other measures. For example, a community may have the twin goals of protecting the environment and encouraging public access to open space areas. But what happens when improved access also adversely impacts

chapter 7: Budgets and Fiscal Policy: allocating resources and ensuring Financial Health

•

•

•

valued habitats? If the performance measures for the goals were simply acres of habitat protected from degradation and acres of open space accessible to the public, then success along one parameter will indicate agency failure on another. Without further clarity about how to resolve or mitigate conflicts or setting priorities or guidance regarding the balance of competing goals, the measures will not likely be useful for allocating resources, that is, for budgeting. Finding Measures for Qualitative Goals. A related problem occurs when measures are trying to capture what is often non-financial (or for that matter qualitative not quantitative) information about whether an agency is, in fact, achieving its goals. Many municipal goals (consider “providing adequate public safety”) are really shorthand for the cumulative effects of interrelated, complex and multi-layered actions. The challenge is to find performance measures that encapsulate those complex goals.

Balancing Effectiveness and Efficiency. Many performance standards are unrealistically open-ended, so they may be lofty sounding “goals” but are not true standards. Consider the water agency that sets a performance measure of “developing and operating a world-class, state-of-the-art water treatment plant that meets highest drinking water standards.” It would also be wise to add an efficiency measure like “at a per-liter cost that is equal to or less than Napa Valley merlot.” Organizational Inertia and Resistance. Without senior management commitment and follow-through, “been there, done that” employee attitudes are likely to seriously undermine the success of performance budgeting systems.

Performance budgeting and measurement will continue to be a major theme in local government financial management. Even with their potential drawbacks, performance budgets can play an important role in focusing organizational and community attention on results—and accountability for them.

Zero-Based Budgeting (ZBB). ZBB has its roots in the private sector.14 It received its first notable use in government when Governor Jimmy Carter introduced the concept in the State of Georgia in 1973 and later in the federal government as president in 1977. 15 The underlying principle of ZBB is that funding for each budget cycle “starts from scratch.” Unlike traditional incremental approaches, it assumes no present commitment exists to past programs; and as such, past funding and

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Guide to LocaL Government Finance in caLiFornia ICMA Center for Performance Measurement

through its center for Performance measurement, the international city and county management association (icma) provides an excellent resource for information on collecting, analyzing and applying performance measurement for improving municipal service delivery. the center began its work in 1994 with an initial consortium of forty-four cities and counties whose managers identified a need for accurate, fair and comparable data about the quality and efficiency of service delivery to their communities. the center has since expanded to over 200 communities, with data collection intended to provide for meaningful interagency benchmarking as well as internal performance improvement comparisons. more information about the center is available on the icma’s web site at: www.icma.org.

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staffing levels play no role in determining upcoming resource commitments (at least in theory). All budgets begin with a blank slate. The baseline for the upcoming budget is zero (and, thus, budgets are “zero-based”). With its emphasis on using analytics, instead of simply past expenditures, to drive resource allocation, the concept of ZBB is appealing. However, it has several drawbacks and, because of these, while many local agencies have tried ZBB, few have sustained its use. Foremost, ZBB is extremely resource intensive: to a large degree, it is impractical to truly assume a program has no historical benchmark from which to start and to prepare anew detailed rationales and analyses of the purposes and resource needs of programs with every budget process. Jonathan Walters wryly encapsulates this main criticism of ZBB: ZBB operated on the theory that every budget cycle was the dawning of a new day. Now, if you’re running a lemonade stand, that might be a defensible way to handle your budget. If you’re running a slightly more complex entity, say the United States Department of Defense, ZBB would require that you devote something like 364 days of your fiscal year to the budget process and one day a year to maintaining world peace.16

For this reason, the most effective uses of ZBB have not been to start literally at zero, but establish some baseline of minimum program funding for analysis—such as eighty percent of current funding levels, and to set an upperend for analysis—such as 110 percent of current funding levels. This modified approach moves closer to other budgeting practices when it uses the recent past to set the parameters for assessing the impacts of lower or higher funding levels for various programs. The kind of problem that ZBB is intended to address is also, not surprisingly, a major obstacle to its implementation. No local government program was ever launched that wasn’t intended to meet a legitimate need at some point for some group. Over time, however, it may no longer meet that need—at least not effectively or efficiently—or other priorities may have emerged that are currently deemed more important. Nonetheless, a constituency—and resulting political commitment—to the program almost always still exists at some level (which is why eliminating a program or re-allocating resources from one program to another, while always possible, is more easily said than done). Another criticism of ZBB is that it relies too heavily on technocracy and hierarchy; it assumes that decision-making is concentrated at the top of the organization and that priorities and allocations will flow solely (or at least largely) in some objective and obvious manner. Because many public policy choices are not really technical in nature, but are driven by values that overlay and, in many instances, must precede the technical data collection (see below). Finally, a local agency may have multi-year commitments to employee cost

chapter 7: Budgets and Fiscal Policy: allocating resources and ensuring Financial Health

levels, and sometimes even staffing levels, as part of negotiated labor agreements that may constrain a “start from scratch” approach. Traditional Versus Emerging Budget Practices Traditional Budgeting. As noted earlier, the majority of public agencies adhere to traditional approaches to the budget process, despite the following kinds of problems: •

•

•

•

Line-Item Budgets. Again, line-item budgeting focuses on inputs, not outcomes. This makes it difficult for community stakeholders, staff and elected officials to concentrate on broader resource allocation issues.

Short-Term Focus. The typical one-year nature of budgets creates a fiscally unhealthy focus on making the numbers work for the current year (and the use of one-time solutions and “smoke and mirrors” to balance the budget) rather than an emphasis on longerterm sustainability.

Staff Centric. In the typical local government budget process, the staff begins budget work four to six months before start of the new fiscal year. The chief executive then issues a preliminary budget near the end of the fiscal year, followed by a few (usually cursory) workshops or public hearings. The result is that staff effectively programs all of the available resources into the preliminary budget, and, constrained by legal deadlines, this makes significant adjustments to that draft budget by the community and elected officials more difficult.

Incremental. The budget becomes focused on marginal changes from the status quo rather than a conscious linkage of goals and resources. This approach assumes (and, thus, helps ensure) that programs and practices will continue in the same way as they have in the past. Managers have few incentives for developing new ideas or to reduce costs. In fact, traditional budget practices often encourage spending up to the maximum budget appropriation, so that the same level of funding is more easily justified next year (“use it or lose it”). Rather than encouraging lower costs, traditional practices tend to encourage managers to overestimate funding needs to increase their program’s share of resources and to more easily appear to have achieved favorable results. 75

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On the other hand, these traditional methods endure due to some notable strengths. •

•

•

Stability. Traditional budget approaches embrace stability so that change is gradual, which is more comfortable, even re-assuring, for the community. Simplicity. The traditional budget process is relatively simple, straightforward and easy to understand. Managers feel that they can operate their departments on a consistent basis over time, and spend fewer resources on justifying what they do rather than simply doing it. Reducing Controversy. Conflicts among departments or programs are largely worked-out prior to the major involvement of elected officials and, thus, controversies are reduced in the public forums. Elected officials can then more comfortably fulfill their control and oversight roles.

Even with these strengths, many organizations are moving away from traditional budgets, embracing some combination of program and performance budgets that emphasize results. They also provide the community with meaningfully opportunities to participate early in the budget process and ensure that elected officials’ goals drive the allocation of resources. Another factor pushing budget practices that are different from traditional ones is the remarkable changes in communications technology. Community members today have virtually unlimited access to information about their local governments; and, accordingly, people have increased expectations regarding providing input into agency activities and transparency in governance, including financial management. The following discusses various approaches that local agencies are taking to improve their budgeting systems.

Integrating Goal-Setting into the Budget Process. As discussed earlier, by allocating limited resources, budgets determine what municipalities will do. However, with traditional budget approaches, the linkages among resources, goals and results are rarely clear. Setting the course for the organization occurs mostly by default as a result of incremental decision-making over years, rather than through an intentional process. For this reason, some agencies have moved towards formally integrating goal-setting into the budget process. Using this approach, the governing body articulates clear goals and priorities for the upcoming year (or longer if multi-year budgeting is used) prior to the staff drafting a preliminary budget. Thus, the governing body plays the most critical

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role in determining the direction of the agency, rather than just reacting to a budget presented by the organization’s chief administrator. For this process to be effective, the agency officials must set focused goals and clear priorities; long laundry lists of wishes do not really produce meaningful decisions. Sometimes, utilizing professional facilitators can greatly improve the goal-setting process.

Multi-year Operating Budgets. Due to the timeframes needed to plan, design and build capital facilities, Capital Improvement Plans (CIPs—see Chapter 10) routinely extend over several years. Although actual appropriations are made annually, the plan forecasts activities and expenditures much farther into the future. Many local agencies now prepare multi-year budgets for their operations, too. Usually, these budgets make operational funding commitments for two years (longer timeframes are rare) with annual reviews. There are several advantages to this: •

•

•

Better linking of goals with resources. Few goals or objectives fit into neat one-year increments; more realistically they require more time to be planned, implemented and evaluated (as CIPs recognize). Thus, affording agency leaders a longer-term perspective makes both goal setting, and resulting resource allocations, more meaningful.

Mitigating the “Use It or Lose It” mentality. In traditional budgeting practices, there is a strong incentive for program managers to exhaust their annual appropriations. If they do not, decision-makers may conclude that the year’s budget was overly generous and can be cut in the next budget cycle, based on a year-to-year line-item analysis. Extending the budget period does not eliminate this motivation, but it does help both agency staff and elected officials take a more complete view, rather than just comparing a series of annual snapshots. Also, when managers know that unexpended funds can be carried over to the following year, the usual year-end rush to mete out all the budgeted money is no longer warranted.

Saving time and resources devoted to budget preparation. To work, multi-year budgets require the staff and elected officials to diligently do the usual budget processes (goal setting, cost and revenue estimates, etc.) for the elongated budget period. However, the marginal cost of looking at two years ahead, instead of just one, is usually significantly lower than doing the budget process separately in each of those two years. Also, if goal-setting and public participation is taken seriously, these time-consuming efforts become more manageable when they are biennial rather than annual. 77

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Taking a longer-term perspective. Simply forcing the agency to look at the fiscal picture over a longer period of time may force decision-makers to deal with systemic fiscal issues that can sometimes be “papered over” for a short time, creating more serious financial problems later. It is also interesting to note that agencies do not usually create systemic financial problems during bad times— they recognize that there are problems and take a more cautious approach. Rather, a short-term perspective combined with good financial times, often leads to decisions that are not sustainable over the long haul.

Long-term Financial Planning. Many agencies are preparing long-term fiscal forecasts and plans as part of their budget process in order to improve financial sustainability. Beyond simply expanding the budget term from say one year to two, long-term plans try to anticipate conditions much further into the future— five, ten, even twenty years. Of course, the longer one forecasts, the greater the uncertainty. Nonetheless, agencies are better poised to meet changing conditions if they have modeled that future and contingencies.

Transparency: Meaningfully Engaging the Community in the Budget Process. Transparency and community involvement in goal setting and resource allocation increases the legitimacy of the budget process, and usually enhances the results. Strategies toward these ends include:17 •

•

•

• • •

Extensive advertising for opportunities for public involvement, such as workshops and forums. Inserts into municipal utility bills explaining the process and inviting participation. Active engagement of advisory bodies, such as the Planning Commission. Ad hoc task forces or advisory committees. Professional public opinion surveys. Use of cable television, websites and social media to reach the public.

The Importance of Public Policy in Resource Allocations Municipal finance is often viewed as a predominately technical discipline, and indeed much of the work is about numbers, data, and strictly prescribed legal requirements. However, the management of a California community’s financial resources occurs in the context of local politics and values. This political and valuedriven environment might be summed up as the messy realm of democracy. 78

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Finances and the Public Trust. As noted by Aaron Wildavsky,18 one the foremost authorities on budgeting and its links to public policy and governance: Public policymaking decides what programs will be enacted, who will benefit from them, and at what monetary levels will they be supported. Public policymaking is epitomized through the budget [emphasis added]. So is implementation, for when push comes to shove, programs will not be carried out as intended (or not at all) unless commitment is memorialized by money.19

Polls consistently show that citizens trust local government more than either federal or state government. For example, according to a 2010 CNN poll, only twenty-six percent of the public trusts the federal government most of the time; about thirty-three percent trust their state government. However, the number jumps to fifty-two percent for local government.20 Not coincidentally, this is the level of government most accessible to the average citizen. In order for governmental bodies to work effectively, public trust must be sufficiently high to create an atmosphere in which problems can be confronted thoughtfully and where citizens will accept solutions that involve compromise and, at times, sacrifice. Maintaining the public trust requires professional governance and the proper legal stewardship of public money, including sound financial practices, adherence to professional standards, and “clean” annual audits. However, while fastidious technical practices are necessary, they alone are not enough.

The Vital Role of Public Policy. Most local governments organize their work around formally adopted plans covering such diverse areas as land use, housing, information technology, facilities, capital projects, public safety, economic development, traffic circulation, and recreation. A budget, too, is essentially a plan that articulates community priorities over a defined period of time. The best of such plans are created by an open process viewed as legitimate by the public and, once adopted, express policies for guiding future governmental actions. “Good government” is inextricably tied to good public policies and the legitimacy of the process used to develop and implement such policies over the long term. Public policies articulate a community’s values and create the framework for future decisions. Adopted policies not only can guide routine decision-making, they also help communities deal with the stresses arising from difficult situations. The adoption of thoughtful policy is not necessarily an easy thing (for example, in many cities and counties, it takes years to adopt general plan updates) and usually occurs only after an extensive public involvement process. And, of course, leaders sometimes find upholding those policies in the face of heated controversies and political pressures difficult. However, even in such circumstances, the governing body is far better off if guiding principles, in the form of policy, 79

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are already in place. While the presence of written policies in itself does not guarantee consistent decisions, reference to such policies will typically have a powerful impact on both the decision-making process and final outcomes. Adopted policy, legitimized by an open process, serves as the “north star”—a guiding light toward values articulated outside of the pressures of the moment.

Some Key Policy Questions Related to Municipal Finance. What policies, then, are most germane to financial affairs? The following lists typical and fundamental questions that most public agencies must resolve, either implicitly or, much preferred, explicitly. While the specific answers will depend on the individual community, thoughtful financial management requires that they are best addressed through publicly adopted and memorialized policies—that are adhered to, periodically reviewed and amended as changing conditions warrant. •

•

• •

•

• • 80

Long-Range Financial Planning. How often and for what time period should financial plans and related budgets be prepared for operations? For capital improvements? Budget Balancing. Local government budgets must be balanced, but must operating revenues in any given year always cover operating expenses? Under what circumstances should reserves be built up and when should they be accessed?

Reserves and Fund Balance. What is a prudent level of reserves in order to manage revenue shortfalls, unpredicted expenses or emergencies?

One-Time and Unpredictable Revenues. Should revenues that may be temporary in nature or otherwise unreliably available over time be used only for one-time costs? When, if ever, may they be used to help pay for on-going expenditures?

User Fee Cost Recovery. To what extent should users of public services be expected to cover the cost of providing the service? Under what circumstances may general purpose revenues subsidize certain services and to what levels?

Cost Allocation Plan. To what extent should the full overhead (indirect costs) of an agency be recovered from its special revenue and enterprise funds?

Debt Management. Under what conditions is debt financing appropriate for short-term cash flow? For capital projects? Among

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•

• •

• • •

the types of debt instruments available to the agency, which are most appropriate for different situations?

Financial Reporting. How often and how extensive should financial reports be prepared that compare actual expense levels (and revenue levels) to those budgeted? Who should review them and how will the agency determine that adjustments need to be made?

Productivity and Levels of Service. What scope of services should the agency provide? What level of services should be maintained?

Risk Management and Levels of Service. Providing public services—consider for example, fire and police response, environmental protection, flood management, building inspection and seismic safety, among many more—frequently involves setting acceptable levels of risk. That requires balancing factors such as public preferences, an agency’s realistic financial capacity, the frequency versus intensity of different types of risky events, and priorities among competing demands on resources. What types and levels of risk are acceptable? Investments. In conformance with state law, how should the cash resources of the agency be invested considering day-to-day cash flow requirements, security, longer-term liquidity needs, and yield? Compensation Philosophy. How does the agency wish to position itself relative to the competitive labor market in terms of salary and benefits?

Growth Management. Cities and counties face the questions of growth: how big, how fast, and in what proportion in terms of alternative land uses (e.g. residential, commercial, industrial). How will the services and facilities needed for such growth be provided? To what extent should new development pay for needed infrastructure and other public facilities? For ongoing operations? Will the types and amounts of new land uses generate sufficient revenues to offset service costs? If not, what impacts on existing residents and businesses are acceptable in accommodating new growth? Special districts will also be impacted by these growth management choices.

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Guide to LocaL Government Finance in caLiFornia Understanding Political Values

John nalbandian persuasively argues that there are four overarching political values at play in the resolution of most complex policy issues.21 they are: ●Efficiency (the usual focus of staff)

● Rational and analytical thinking ● Best use of resources: greatest good, for greatest number ● Will the solution work—and at what price? ● What do the experts say? ● What have we learned from past experience?

● Representation

● Government answers to will of the people ● Elected officials must listen to what those affected have to say ● Elected officials must be responsive to what people are saying

●Social equity

This is not an exhaustive list, and every agency will add or modify it based on its peculiar circumstances, but it does highlight the types of important issues facing most local governments for which articulated policies should be adopted.

Political Values and Public Policy. Developing policies to direct financial decisions at the local level is not strictly based on technical analyses, but is also about values. The addition of values into a policy equation often means that there is more than one “right” answer. As defined by Dr. John Nalbandian,22 an academic and former city council member in Lawrence, Kansas, problems that have more than a single “right” answer are those that, after all the facts are known and technical analyses conducted, people can still disagree about the solution because their values differ. Such problems require more than factbased answers—the solutions are heavily influenced by values. This includes, of course, many of the most significant matters that come before a city council, board of supervisors, or district board. The following are examples of local issues that ultimately hinge on political values rather than simply on technical analyses: •

•

● No second-class citizens ● Equal treatment of one group vs. another

●Individual Rights

● Property rights ● Civil rights ● Protecting individuals from unreasonable or capricious acts of government

•

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Weighing the revenue-generating benefit of a major development project against the “quality of life” impacts, such as traffic generation and the loss of open space. While a major commercial project might efficiently produce net added revenue to a city, and thus greater ability to provide more or better public services overall, to what extent should decision-makers weigh the concerns of those fearing impacts from the added growth, including such subjective impacts as aesthetic concerns and the loss of open space?

Assigning the “fair share” allocation of processing and development impact fees to residential development in a community where housing affordability is a sensitive political issue. While fully recovering costs from new development may be a sound fiscal practice, will it prevent potential low- and moderate-income buyers the opportunity to participate in home ownership? How does it affect the ability of the private (or even public or nonprofit) developers to provide a full range of housing opportunities in the community?

Keeping a municipal golf course open that is enjoyed by senior citizens and other persons of limited means (not the country club set), when the course is not “breaking even” and must have sizable general fund subsidies to continue. Other recreation programs also require subsidies—why single out lower-income golfers for this beneficial treatment?

Increasing water rates to bolster flagging operational revenues during a period of drought-induced mandatory water conservation

chapter 7: Budgets and Fiscal Policy: allocating resources and ensuring Financial Health

requirements. While it is analytically obvious that there is a revenue problem when water consumption drops and corresponding income falls, shouldn’t our elected representatives be sensitive to the sacrifice already being made by ratepayers and, therefore, subsidize the cost with the general fund?

The list of examples is unending. The answers to these questions are not ultimately based on technical analysis, although such analysis may help the decision-makers. Agency staff who better understand how non-technical, valueladen considerations underlie these types of issues will be more capable of presenting information, and designing processes and options, that lead to better policy outcomes. And, as noted earlier, having existing city policy in place prior these kinds of debates helps decision-makers facing the pressures of the moment. Gauging a Local Government’s Financial Health According to economists, California’s “great recession” began in December 2007 and ended in June 2009. These years, and those following, were difficult for most local governments. In addition to deep reductions in local government revenue, cities, counties, and special districts struggled with state take-aways of local funds, the dissolution of redevelopment agencies, and mounting costs of retiree pensions and benefits. At the same time, the demand for local services did not decline, but rather increased in many sectors as people struggled through the recession. The severity and combination of these financial impacts varies, but in a few well-known instances, cities (Vallejo, Stockton, San Bernardino) sought the legal protections of Chapter 9 Bankruptcy to restructure their contractual obligations, and at least one county required financial intervention from the state. Several special districts also filed for bankruptcy in recent years. These cases highlighted a growing public interest in ways to gauge a local agency’s “financial health” so that problems can be identified early and remedies undertaken in a timely way. Bankruptcy for a municipal government does not mean going out of business; Vallejo, Stockton, and San Bernardino never ceased operation. Municipal bankruptcy means that the agency’s financial condition was such that it did not have the financial resources to meet its legal obligations to pay employees, contractors, suppliers, and creditors. Bankruptcy provides the legal protection of the court, while a financial restructuring plan can be agreed upon and put into action. Even a municipality that avoids bankruptcy can be in a severely distressed financial condition with unsustainable expenditures versus income, or an inability to fund public service levels to meet the minimum needs of its constituents. An in-depth look at agencies that have experienced financial distress reveals that this sort of condition typically arises from many converging

Timely and Accurate Data

the goal of financial reporting is to provide data that is timely and accurate. However, achieving both of these goals can conflict in the real world of limited resources. Getting information out fast is likely to result in reporting errors that can easily lead to bad conclusions. on the other hand, waiting until the data is perfect may result in dangerous delays before taking corrective action. effective financial reporting means balancing these two resource conflicts: providing highly reliable information (at least for the “most important” things) within a reasonable period of time when appropriate action can be effectively taken if needed. that said, it is not possible to perform this balancing act effectively without a sound, reliable financial management system that captures transactions meaningfully at the source. and, no finance management system will give timely, accurate information if transactions are posted late or incorrectly.

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Guide to LocaL Government Finance in caLiFornia The Great Recession

Governments carry reserves. Like that of the state, the fiscal health of local governments in california tends to fail or thrive as the greater economy declines or grows. in good economic times, tax revenues increase as retail sales rise and real estate appreciates, and the state legislature finds it unnecessary to take local revenues to solve yet another budget crisis. in bad times, the opposite effects occur. in the late 2000s, the united States experienced its most profound economic crisis since the Great depression. the financial sector came near the brink of total collapse, and california’s housing sector imploded. and while there has been slow improvement, the Great recession will continue to affect local government financing well into the future. among the impacts of this economic downturn on municipal finance were the obvious ones of lower sales tax revenues and stagnant property tax revenues (or declines in some places). real estate development came nearly to a standstill, depriving local governments of related taxes, fees, and infrastructure construction. as revenues declined, governments deferred the maintenance of existing facilities, and public facilities deteriorated. in many cases, services were cut just when social service demands were increasing due to high unemployment, under-employment, and the stresses that accompanied them.

factors. Awareness of these factors and a thorough, competent, and honest evaluation of a government’s financial condition is essential in order to manage financial distress before it becomes a crisis. A critical component of the difficulties of the most financially distressed local governments has been a lack of recognition and agreement among local leaders, staff, and key interests (labor, retirees, creditors) regarding the agency’s actual financial condition and what must be done in order to achieve sustainability. Most financial crises can be managed without court or outside agency intervention if leaders, staff, and key interests have the courage, competence, and collaborative attitudes to recognize (and agree upon) the local government’s real financial condition, and to implement the necessary changes to set the local government on a sustainable financial course. Core Components of a Good Financial Health Diagnosis. Government financial health may be viewed in four related financial contexts: •

• • •

Cash solvency. The ability to meet immediate financial obligations—generally over the next thirty or sixty days (accounts payable, payroll). Budgetary solvency. The ability to meet all financial obligations during a budget year. Long-run solvency. The ability to meet all financial obligations into the future. Service-level solvency. The ability to provide the desired level of services for the general health and welfare of a community.

In the context of difficult financial straits, people tend to be primarily concerned with the ability of a local government to meet its financial commitments now and into the future (cash, budgetary and long-run solvency). However, a more expansive evaluation of financial condition would examine the community’s economic environment and ability to meet the service-level desires of the community (service-level solvency). A government is in financial distress if it has a continuing imbalance between its level of financial commitments and its available financial resources over time. If revenues and spending are not brought into balance, financial distress can progress into financial crisis, when the government is simply unable to meet its financial obligations. Unique Aspects of California Local Government Finance. As discussed throughout the book, California local governments’ tax- and revenue–raising

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choices are strictly limited. Property tax is the single most important source of general-purpose revenue for most cities, counties, and many special districts. Yet local governments have no authority over the property tax base, rate, or allocation. Other tax increases require voter approval. Over the last several decades since Proposition 13 (1978), the state has shifted away from property tax and vehicle license taxes and eliminated virtually all general-purpose state aid to local governments. At the same time, the legislature has shifted greater program responsibilities and imposed greater mandates but with limited funding. In response, voters have approved constitutional measures protecting local government finances from further legislative actions (see Chapter 16). As a result of the combination of shifts of traditionally local revenues to the state combined with voter approved measures inhibiting further take-aways, the financial health of local governments in California is not critically contingent on intergovernmental revenues passed through by the state—unlike the situation in many other states. That said, it should be recognized that California counties have much more limited revenue-raising authority than cities and remain, by their nature, highly dependent on state budgetary actions. Evaluating Financial Condition Is Not Just an Accounting Exercise. Many oversight agencies, watch-dog groups, and academics have attempted to measure the condition of local government finances based on a set of financial trends (such as debt service to revenue ratios and reserve levels) or even socio-economic statistics (such as community poverty levels and crime rates). But these sorts of analyses are inevitably incomplete and inaccurate for a number of reasons: •

• • •

Published data are not complete nor timely. Data regarding municipal finances may be found in budgets, financial reports, and reports filed with the State Controller. But this data takes time to compile, file and publish and is not complete enough to make reasonable determinations about long-term financial condition.

Trends and comparative statistics are used to imply outcomes without strong causality. Even with solid data, the analyst needs to be able to interpret the numbers properly.

Comparisons among local governments are often misleading. The many ways local governments differ may explain some differences in financial measures. An evaluator must be careful not to make snap conclusions.

An adequate evaluation of financial condition must look forward, not just backward. Historic trends and current conditions are only a part of the picture and do not necessarily reflect the future.

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Diagnosing the Financial Health of a California Local Government. There are several key indicators, measured over time, of financial condition in a government agency. These include the net operating deficit/surplus of revenues versus spending, and the reserves (unrestricted fund balance or working capital) of the agency.

Net Operating Deficit/Surplus. The bottom-line question in financial condition is, “will the government have adequate financial resources to fund its responsibilities?” Continuing operating deficits—more total spending than total revenue—may be an indication that the government’s financial condition is unsustainably out of balance. Though an operating deficit in any one year may not be a cause for concern (because, for example, reserves or one-time remedies might be available to cover the difference), frequent and increasing deficits may indicate that the government’s activities are not sustainable within the revenues available over time. The data to compute this measure should be readily available in the financial statements of the agency, but that data must be analyzed with care and expertise. For example, a budget can be balanced and an ongoing structural problem masked if a deficit is covered by temporary solutions, such as nonrecurring revenues like limited-term grants, land sale income, or transfers from other funds. Temporary solutions such as these cannot be relied upon in the long run. A good analysis of financial health must therefore distinguish onetime from ongoing revenues and spending and forecast ongoing revenues and ongoing spending, taking into account expected changes, such as annual contributions to benefit plans. Even this may not show the whole picture if certain current financial obligations are being delayed and not expressly included in the budget or financial statements. A more complete examination takes into account “unbudgeted current liabilities” such as Other Post-Employment Benefits (OPEB); unbudgeted earned-leave cash-out liabilities; maintenance and replacement costs of vehicles, technology, buildings, streets, and other properties and infrastructure. This is the best indicator of a local government’s true long-run financial health because it reflects the level of spending actually needed to sustain current levels of services over time.

Fund Balance. Fund balance, or reserves, are the savings account of a public agency. A positive fund balance is important for any government to withstand financial risk over time. Unanticipated fluctuations in revenues may occur from economic impacts, natural disasters, or state take-aways. Reserves, therefore, are important to meet unforeseen revenue shortfalls or expenditure needs. But reserves cannot be relied upon to cover financial shortfalls that are more than temporary. An unplanned decline in unrestricted fund balances as a percentage of operating revenues over time suggests that the agency is frequently relying on reserves to cover recurring costs and, thus, is less able to withstand financial emergencies.

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The right level of fund balance varies depending on many factors, including levels of risk and revenue volatility, but, generally speaking, dropping below eight percent may be cause for concern. The Government Finance Officers Association of the United States and Canada (GFOA) recommends maintaining a minimum general fund reserve of sixty days (16.7 percent of expenditure), with higher levels warranted depending on the fiscal risks facing the agency. The GFOA has developed a structured assessment methodology in developing appropriate reserve levels based on an agency’s exposure to the following eight fiscal risks: •

•

•

• • • •

•

Vulnerability to extreme events and public safety concerns. Major extreme events the community could reasonably be subject to and the likelihood and potential magnitude of loss for each event.

Revenue source stability. Volatility of each major revenue source based on factors such as past experience and trends with that revenue, characteristics of the tax- or rate–payers, state or federal revenue take-aways, and economic factors.

Expenditure volatility. Spikes in expenditures, usually arising from special, non-recurring circumstances such as lawsuits; critical special projects without a funding source; or new state or federal spending requirements and unfunded mandates.

What Is “Fund Balance”?

Fund balance is the cumulative excess of revenues and other sources over expenditures and other uses in each governmental fund since the agency began. From a balance sheet perspective, it is the net of assets less liabilities. under Statement no. 54, the Governmental accounting Standards Board (GaSB) organizes fund balance into five categories: ●Non-Spendable. amounts that are not in spendable form, such as prepaid items or inventories; or are legally or contractually required to be maintained intact.

●Restricted. revenues where the use is subject to externally enforceable restrictions imposed by outside third parties.

Leverage. Common examples include pensions, unfunded asset maintenance, and debt: is the source of leverage very large? Does it have an off-setting funding source or asset?

●Committed. amounts that can be used only for the specific purposes determined by a formal action of the agency’s highest level of decision-making authority (governing bodies).

Other funds. Are there other funds that have a significant dependence on the General Fund?

●Unassigned. residual classification of spendable amounts available for other purposes.

Liquidity (cash flow). Intra-period cash imbalances, such as property taxes that are only received at one or two points during the year.

Growth. This factor is only relevant if significant growth is a realistic possibility in the next three to five years. It includes assessing likely potential marginal costs associated with serving new growth compared with marginal revenues and any resulting gaps.

Capital projects. Are there high-priority projects without a funding source, where reserves may be looked to as a funding source?

●Assigned. amounts that are constrained by the agency’s intent to be used for specific purposes, but are neither restricted nor committed.

reserves typically refer to the unrestricted fund balance (committed, assigned, and unassigned), since this is the amount of fund balance where the governing body has discretion as to its use.

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The GFOA methodology for assessing General Fund reserve levels is available online at: www.gfoa.org/financial-policy-examples-general-fundreserves.

Capital Asset Condition. Capital assets such as public buildings, streets, and equipment must be maintained and replaced over time. This requires annual resource commitment such that the value of assets and asset improvements does not decline.

Liquidity. A decreasing amount of cash and short-term investments as a percentage of current liabilities suggests the government is less able to pay its short-term obligations. Increasing current liabilities at the end of the year as a percentage of net operating revenues indicates liquidity problems and/or deficit spending. Liquidity measures the amount of readily available financial resources relative to immediate financial commitments (current liabilities).

The California Municipal Financial Health Diagnostic

the california municipal Financial Health diagnostic was developed following the vallejo and Stockton municipal bankruptcy filings based on the experiences of many financially distressed municipalities in california and other research and methods for measuring financial health. the tool has now been used by hundreds of cities and special districts to assess their financial condition. a version developed with the guidance of a team of california county finance officers, specifically tailored to california counties, is also available. these tools provide structured methodology via checklists and interactive excel spreadsheets for assessing an agency’s fiscal health. they are available at: http://californiacityfinance.com/#manaGinG.

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Fixed Costs and Budget Flexibility. Fixed costs are those costs over which the government has little control in the short run because of contractual agreements, charter restrictions, or state or federal law. Non-labor fixed costs include debt service, retiree health payments, lease-purchase payments, utilities, contracted goods and services, etc. Increasing fixed costs as a percentage of net operating expenditures may indicate an unsustainable financial structure where the government has limited ability to make necessary budget changes. Fixed does not mean static. Fixed costs may be changing over time but cannot be easily altered. Constraints on the budgetary discretion of the agency may also include binding arbitration or required formulas or third-party agreement to alter compensation, spending, or minimum staffing. These legal constraints impair the agency’s ability to achieve solutions when in fiscal distress and may also accelerate cost increases over time.

Subsidies of Other Funds. Some cities and counties find themselves using the general fund to subsidize golf course rates; water, sewer, transit, parking or other enterprise operations; or to pay debt service or capital improvement costs that should arguably be paid by proprietary or special revenue funds. Often this is because user fees are not sufficiently high to be self-supporting. Sometimes it is simply the result of conscious and reasonable public policy decisions. But sometimes it is due to debt obligations incurred related to those functions that now burden the general fund if the intended repayment source (development fees, enterprise fund) proves inadequate. These subsidies limit budget flexibility if they are a significant portion of the general fund net operating expenditures and/or if the trend is increasing, and could be a sign of financial problems.

chapter 7: Budgets and Fiscal Policy: allocating resources and ensuring Financial Health

Financial Practices. An agency’s financial and budgetary management practices may contribute to financial distress. Practices that should be rarely used include solving budgetary imbalances with temporary revenues or cuts (such as furloughs), internal borrowing from special funds beyond budget years (i.e. for more than meeting short-term cash-flow needs), deferring pension or other employee costs, and backloaded debt service schedules. Financial trouble is also strongly correlated with a local government’s failure to file financial reports on time. Summing Up

Budgets are how agencies allocate their resources. It is among the most fundamental and important of functions. The process of preparing a budget, if done in a way that actively engages decision-makers and the public, can require considerable time and staff resources. There are different types of budgeting approaches, and most budgets will employ elements from more than one. The most traditional and familiar approach is a line-item budget that largely compares revenues and expenses from year-toyear with incremental adjustments to match changing conditions and new organizational objectives. Increasingly, agencies are using other budgeting techniques that focus on outcomes and performance measures. Furthermore, some local governments have explored multi-year budgets and long-term financial plans. Perhaps most importantly, local government budget decisions should be based on public policies that are articulated through an open, public process. Many such decisions cannot be reached by simple, technical formulas. Rather, resource allocations and the policies upon which they are based are almost never determined strictly by technical information, but also on the consideration of values. The sorting out of these value judgments, informed by sound technical data and analyses, is the messy realm of local democracy. Evaluating a public agency’s financial health is an essential part of good financial management. Can the agency pay its bills and provide an acceptable level of service in the near term? In the long term? A good diagnostic effort asks the hard questions, the right questions, and provides a complete and fair discussion of the agency’s financial sustainability into the future by closely examining the agency’s practices, limitations, revenue trends and expenses, both budgeted and not budgeted.

For many agencies, the most significant operating budget expense is the cost of providing staff. Thus, issues related to paying for labor is the subject of the next chapter.

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Guide to LocaL Government Finance in caLiFornia NOTES Aaron Wildavsky, Budgeting: A Comparative Theory of Budgetary Processes, New Brunswick: Transaction Publishers, 2002. 2 Government Finance Officers Association of the United States and Canada. Destinguished Budget Awards Program: Detailed Criteria Location Guide, www.gfoa.org. 3 One notable exception is the City and County of San Francisco, with its unique “city/ county” governance, where the mayor coordinates and presents the budget to the Board of Supervisors. 4 In a few small counties, where they may not have a CAO, the Auditor is the Budget Officer. 5 Stephen R, Covey, The Seven Habits of Highly Effective People, New York: Simon and Schuster, 1989, 2004. 6 The NACSLB was created to provide tools for state and local governments to improved their budget processes and promote their use. It was a unique cooperative effort of elected officials and professional managers from state and local governments representing eight respected organizations deeply involved in state and local finance: • International City/County Management Association • Government Finance Officers Association • National League of Cities • Association of School Business Officers • Council of State Governments • National Association of Counties • National Conference of State Legislators • U.S. Conference of Mayors Additionally, the NACSLB also included representatives from academia, labor, and industry. 7 The 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. 8 Ibid. 9 Ibid. 10 Paul L. Solano and Marvin R. Brams, Management Policies in Local Government Finance, ed. J. Richard Aronson and Eli Schwartz, Washington D.C.: International City/County Management Association, 1996. 11 Len Wood, Local Government Dollars and Sense, Rancho Palos Verdes, CA: The Training Shoppe, 1998. 12 Ibid. 13 For an absurd example to make the point: although similar in population size, the City of South Lake Tahoe is likely to have much higher snow removal costs per capita than Seal Beach—and it won’t be due to Seal Beach’s superior snow removal programs. 1

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Murray Dropkin, Jim Haplin and Bill LaTouche, The Budget-Building Book for NonProfits: Step-by-Step Guide for Managers and Boards, San Francisco: Jossey-Bass, Second Edition, 2007. 15 Kevin Nelson, Zero-Based Budgeting, http://www.referenceforbusiness.com/ management/Tr-Z/Zero-Based-Budgeting.html. 16 Jonathan Walters, Measuring Up: Governing’s Guide to Performance Measurement for Geniuses (and Other Public Managers, Washington, D.C.: Governing Books, 1998. 17 See also www.ca-ilg.org/budgetingguide for a report on efforts by different cities in California. 18 Aaron Wildavsky (1930 to 1993) was a prolific author known for pioneering work on budgeting and public policy. He was a professor of political science at the University of California, Berkeley, from 1962 to 1993, where he served as chair of the Political Science Department (1966 to 1969) and founding dean of its Graduate School of Public Policy. 19 Wildavsky, Budgeting, op.cit. 20 Paul Steinhauser, Poll Finds Trust of Federal Government Runs Low, CNNPolitics, February 25, 2010. 21 See John Nalbadian, “Professionals and Conflicting Forces of Administrative Modernization and Civic Engagement,” in The American Review of Public Administration, 2005. 22 Ibid. 14

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M

unicipal policies and standards regarding service levels are important and obvious determinants in establishing the cost of delivering community services. What is less obvious, however, is the strong probability that even if service levels are unchanged, or even reduced, service costs may rise anyway— and sometimes significantly so. There can be many causes for this phenomenon, but the most powerful one is usually the cost of employees. Staffing is the dominant cost driver in virtually every local government agency in California (and elsewhere). Thus, processes used to determine staffing levels and employee compensation—the cost of people—must be understood in any discussion of municipal finance. For any given level of staffing, local agency leaders are under great pressure to compensate employees competitively, especially if they are to recruit and retain talented people successfully. Employee compensation is driven not only by market forces and customary public sector pay and benefit systems, but also by collective bargaining rules, regulations, and practices. Collective bargaining is strongly affected by the power of organized labor and by political decisions made in the state Capitol. Another factor affecting compensation is that a local agency’s employee groups often wield significant political clout at election time. Employee compensation and the unfunded liability associated with post-retirement benefits, particularly pension and retiree health insurance costs, present a looming fiscal (and political) issue in California that will require reform in order to bring some stability and predictability to municipal finance. This is discussed further in Chapter 17. The Cost of the Workforce

Employees as a Percentage of Municipal Costs. Most local government services can only be provided by people, whether those services are directly

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delivered by the agency or contracted out. People provide services such as police and fire protection, code enforcement, recreation, park maintenance, and land use planning. People also staff the support service functions, including human resources, finance, information technology, and general administration. Today, general fund staffing costs in full service cities typically range from seventy to eighty percent of operating costs, depending upon how services are delivered. This is not surprising, since public safety costs are by far the largest general fund cost in virtually all cities, typically accounting for between fifty percent and sixty percent of the general fund operating budget and reaching up to nearly seventy-five percent in some cities.1 Two factors have influenced this growth in public safety costs: citizen concerns about crime that has translated into political support for added staff, and the growth of union political power.

What Composes Total Employee Costs? The simple answer is “pay and benefits.” But, of course, the equation is far more complicated. In fact, establishing the estimated cost of the workforce is one of the municipality’s most important and complex calculations. This complexity results from the many differences in pay and benefits that exist among the multitude of job classifications, employee groups, and unions within most agencies. Calculating labor costs also involves accurately estimating turnover and vacancies, negotiated future pay and benefit costs, and overtime use (which can vary greatly year to year—and which can also have drastic budget impacts, especially in the public safety services). Poor projections will result in unused resources if overestimated, or “budget busting” over-spending if underestimated. Therefore, these costs must be analyzed in a comprehensive and methodical fashion.

Pay. With regard to pay, a fundamental distinction is whether or not the position is paid on an hourly basis and, thus, entitled to overtime, or if the position is a salaried “management” position. Both public and private-sector jobs are governed by the federal Fair Labor Standards Act (FLSA), which establishes standards for making this distinction. Under FLSA, employees are determined to be either “exempt” (salaried management without overtime) or “nonexempt” (hourly and, therefore, not exempt from overtime pay). Nonexempt employees in local agencies compose the majority of positions and include, for example, police officers, firefighters, engineers, most office staff, and “field” workers. Instead of overtime, nonexempt employees may, under certain circumstances, earn “compensatory time off ” (paid time off in lieu of direct overtime pay). Other special payment types may include “standby” pay for being available for emergency “call-out” during off hours or court-time pay (for police officers, for example). They may also be entitled to “incentive” pays to recognize the acquisition of various certifications or

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skills, such as completing bilingual and other specialized education programs, or paramedic or other professional certifications. Therefore, any estimate of employee pay costs must accurately capture information regarding base pay (including likely pay increases during the estimate period from merit or cost of living increases), overtime use, and other forms of “special” compensation. And then there is the rest of the cost equation—benefits. Benefits. Depending upon compensation philosophy and negotiation history, local governments will provide some level and mix of the benefits outlined below. • • • • • • • • • • •

Retirement pensions Deferred compensation “matching” contributions Health insurance (medical, dental, vision) Post-retirement health care Disability insurance Workers compensation Life insurance Time off and other leaves (holidays, vacation, sickness, administrative, family and bereavement leaves) Auto allowances or assigned “take home” vehicles Medicare (mandatory for employees hired after 1986) Social Security (if the agency has elected to participate in that system)

Two of the benefits listed above have received particular scrutiny in recent years: retirement pensions and post-retirement health care. Such scrutiny is warranted, given the huge liabilities that these benefits are projected to impose. Pension and retiree health care benefits will be discussed in more detail later in this chapter and again in Chapter 17. How Compensation and Benefit Levels Are Determined There are a variety of different ways that pay and benefit changes are triggered in the public sector—and the changes are almost always upward. Some of the triggers are customary and routine, while others may be initiated as a result of special studies or circumstances. The most influential process, however, is collective bargaining. In fact, even many of the routine pay and benefit structures have their origin in past negotiations and labor contracts.

Customary/Routine Public Sector Pay Increases. Regular pay increases are typically triggered by step increases, cost of living adjustments, promotion, longevity and annual performance awards.

When Zero Is Not Zero

during the late 2000s when municipalities were in financial distress, many unions agreed to a “zero pay increase” year in order to save money and reduce layoffs. However, in most of these cases, employees not yet at the top of their range were still allowed to continue to progress through steps in the salary range. this practice avoided inequitable situations between employees in the same or similar jobs—and also avoided protracted union negotiations during a time of crisis.

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Step Increases. Regular positions typically fall within a salary or wage range established for each job classification, and within that range there are “steps” that employees advance through. There is no set rule on how many steps may exist within a range, but among many California local governments, ranges commonly consist of five steps with five percent pay intervals between each step. Advancement from one step to the next may be based on various factors, but the most common factor is simply longevity. For example, an employee moves from Step 1 to Step 2 after passing an initial probation period; he or she then moves from Step 2 to Step 3 after another year of “acceptable” performance.

The COLA Two-Step Sometimes coLa increases, combined with step increases, can result in very large jumps in compensation. consider this example. in July, an employee earning $4,000 per month at Step 3 within a range receives a 3.0 percent coLa and now earns $4,120 monthly at the same step. in october the same employee is eligible to move from Step 3 to Step 4 and receives another 5.0 percent increase to $4,326 monthly. thus, the employee’s pay has increased by 8.2 percent in three months. depending upon the frequency of the coLas, this “two-step” increase can happen until the employee reaches the top of the range, or is promoted to a new, higher range.

Cost of Living Adjustments. A “COLA” is, hypothetically, intended to be an adjustment to pay that offsets the loss in purchasing power due to inflation. In practice, public sector COLAs are typically a negotiated annual increase that may, or may not in fact, closely track an independent measure of inflation such as the Consumer Price Index (CPI). The salary ranges are adjusted by the COLA and an employee’s relative position within the range moves in a like manner. Although exempt employees typically are not organized to negotiate COLAs, in order to maintain equity and appropriate pay differentials between supervisors and those they supervise, comparable COLAs are also typically granted to unrepresented employees (such as managers and “confidential” positions). The interplay between step increases and annual COLA adjustments is a customary aspect of public sector pay that is typically more aggressive than pay progression within the private sector (see sidebar). At the same time, private sector compensation may not be restricted by a “top of range” that is reached relatively fast. In any case, ranges and steps are customary within the public sector and public agencies that do not have a range-step system are generally at a competitive disadvantage in recruiting talent.

Promotion. Employees may be promoted from one position to another, either as a result of a structured “career ladder” that employees may rise on (perhaps based on a combination of skill and longevity, such as from Accounting Assistant I to Accounting Assistant II) or through a competitive promotional process. The latter may be either internal to the organization, that is, restricted to the existing staff, or open to any qualified candidate, whether or not they are current employees. For example, promotions to police sergeant are almost always determined through an internal competition limited to existing police officers within the agency. On the other hand, a wider net is typically cast for police chiefs, who are often hired following statewide or nationwide recruitments. Longevity Awards. In order to encourage employee retention over time, many agencies have implemented increases based on length of service with the agency

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(independent of the different jobs employees may hold during their career with an agency). For example, an employee may receive a one-percent longevity increase after ten years with an agency and a two-percent increase after twenty years.

Pay for Performance/Bonuses. Many agencies have tried to mimic private sector systems by substituting (or supplementing) COLA and/or step increases with performance-based increases tied to specific goals or measurable criteria. Usually, such programs apply after an employee reaches the top of his or her range. Where tried, these systems have typically applied to the exempt, unrepresented employees (management). Such systems can be controversial in a public setting, where “bonuses” are not the norm. Results, therefore, have been mixed. Situational and/or Periodic Adjustments. Reclassifications, “equity” adjustments and compensation studies also affect pay and benefits, but are triggered either by special circumstances or market force considerations. •

•

Reclassifications. Positions are reclassified when job duties have substantially changed over time either through some evolution in the nature of the work or as a result of changes in organizational relationships and responsibilities. Typically, either management or employees may initiate a proposed reclassification. Proposed changes are almost always for an upgrade in the classification—and thus higher pay. However, in order to maintain a rational overall classification system—and to avoid what is sometimes called “grade creep”—changes are usually only made after studies confirm the legitimacy of the request.

Equity Adjustments. Local government organizations, especially medium- to large-sized agencies, involve a complex hierarchy, with many departments, layers, and diverse position classifications. In such hierarchies, a pay range change to one position classification may alter relationships horizontally and/or vertically (such as creating pay “compression” between supervisors and those they supervise). Equity adjustments are, therefore, occasionally necessary. For example, if the reclassification of a code enforcement officer to senior code enforcement officer created only a three-percent differential with the supervising code enforcement position, the supervising position could receive an equity adjustment of seven percent to maintain a ten-percent differential between supervisor and subordinate.

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accountable for delivering such services. If citizens perceive something amiss in the performance or decisions of cities, counties or special districts, they can usually effectively access officials. Because so many local services are provided by people, quality service delivery depends heavily on a local government’s ability to attract and retain quality employees. This is especially so when resources are scarce and employees are expected to “do more with less.” Therefore, local elected officials and managers have a powerful incentive to hire the best employees possible in order to satisfy their citizens’ expectations. Although the conventional wisdom may be that government jobs are prized and, therefore, job applicants and choices among candidates are plentiful, in practice, recruitment for many positions is a highly competitive process within the “marketplace.” The competitive labor market will differ depending upon the job to be filled. For example, the recruitment area for entry level positions like office assistants or street maintenance workers is usually local because people with the skills, experience or capacity to learn such jobs are likely to be available. On the other hand, more specialized positions like civil engineers, information technology specialists, chief building officials and fire marshals typically require a statewide recruitment. And for the highest level positions (department heads, special district general managers, city managers, and county executives), nationwide recruitments are common. And while many studies have shown that satisfaction with a job involves far more than the level of compensation (including factors such as interesting work, “making a difference,” working for a good boss, working in an organization with a healthy culture and promotional opportunities) in almost all cases, competitive compensation—pay and benefits—is still essential. There are many related factors that determine competitive compensation for a given job in a particular labor market, and a discussion of proper methodology in this regard would be lengthy and involve such factors as housing prices and demographics. For purposes of this book, however, it is enough to say that the most common way of judging appropriate and competitive compensation is by surveying “comparable” agencies. Such surveys may also be used to help set annual COLA increases or for other compensation determinations. Agreeing on a list of ten to twelve comparable agencies is usually both a technical and a negotiated exercise. Management will advocate to include agencies that offer lower pay and benefits while still comparable in terms of population, scope of services, and other variables. Unions, on the other hand, will typically negotiate to include “richer” agencies in the comparison list. In recent years, there has been pressure to also compare agency positions to analogous ones in the private sector. Such comparisons can be very difficult to make because of the proprietary nature of private business

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information and the difficulty of finding positions that validly compare with many municipal jobs, such as police officers and firefighters. Labor Relations and Collective Bargaining

No matter the financial circumstances they face, or how strongly agency leaders may want to alter past compensation habits and practices, local governments in California cannot take unilateral action to institute changes. Not only should changes be carefully evaluated in terms of the possible advantages and disadvantages before implementation (such as the impact on employee recruitment and retention), but state law requires that local governments negotiate in “good faith” with employee organizations regarding all matters of pay, benefits, and working conditions.

California Laws Governing Public Employee Unions. The Labor Relations Act was established in 1935 and prescribes how employers must engage with labor unions in collective bargaining. Interestingly, when President Roosevelt signed the new law, public employees were not organized nor included in the act (in fact, they were expressly excluded). However, in the years that followed, as government expanded and the public sector grew, government employees became a prime target for union organizing. Some people argued that public employees did not need the protection of unions because they had civil service protection. However, the more successful arguments were that civil service protection did not encompass such things as “fair pay,” benefits, safe working conditions, or political “power plays” against categories of employees (the contention was that civil service protection covered only individuals). Government employees, including local government workers, now constitute some of the most significant and powerful sectors of unionized labor. In 1961, California passed the George Brown Act, which allowed public employees the right to join unions. In 1968, the pivotal Meyers-Milias-Brown Act (MMBA) was passed that required cities, counties, and special districts to meet and confer “in good faith on all matters relating to employment conditions and employer-employee relations, including but not limited to wages, hours, and other terms and conditions of employment.”2 Although the law allows local agencies to implement it in different ways (through employee relations resolutions or ordinances), the law clearly prescribes a process that must be followed based on a principle of “good faith.” In California locally organized public employee unions are granted many rights, including the right to strike (except for certain public safety workers). Employers retain certain rights, known as “management rights,” which include determining agency mission, setting priorities and directing work. The respective responsibilities and the process for determining pay, benefits, 99

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and working conditions are highly prescribed and cannot be legally ignored or curtailed.

General Approach. Because agencies may adopt their own employee relations ordinances and resolutions, there are different approaches to the required meetand-confer process. In addition, communities, managers, unions, and union leaders all bring their own personalities and histories into the mix, and, thus, the nature and nuance involved in agency negotiation may differ in a myriad of ways. However, at the broadest level, the process involves five major stages: •

• • • •

A request to begin negotiations is sent by one of the parties, or the parties mutually agree to open negotiations; The parties conduct negotiations; The parties reach tentative agreement; Union members ratify the tentative agreement; The governing body approves the agreement.3

Of course, the process is far more complicated and can go in a number of different directions at any stage. The above five steps also anticipate that the parties will negotiate to agreement. However, that does not always happen.

The Negotiators. Each party—the local agency and the employee organization (or “union”)—will appoint negotiating teams to represent their interests in the process. For the agency, these teams will typically include the human resources director, a finance department representative, and a staff person from the city manager, county administrator or general manager’s office (and maybe even the top executive, depending upon the profile of the negotiations). One representative will typically have the role of “crunching the numbers” to estimate the cost of various proposals. The employee group team will usually consist of some union board members and others who represent the varied interests of the group. For example, the police union may also include a dispatcher or records manager on the team if it also represents non-sworn employees. Both teams will often include, and even be led by, a labor relations consultant who may be a trained negotiator or an attorney—or both. These hired professionals not only bring specialized expertise into the process, but they provide emotional buffering during the often contentious negotiation process. This can aid the representatives in preserving a long-term working relationship.

The Decision-makers. Each negotiating team is guided by their respective policy boards—the union board for the employee group and the governing body (such as the city council or board of supervisors) for the agency team. Ideally, each team will work to assure that their respective decision-makers are

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kept abreast of the status of negotiations, but not directly involve them in the day-to-day talks. Decision-makers are also expected to maintain strict confidentiality regarding team consultations and direction and avoid any ex parte (that is, “side”) discussions with the other negotiating party.4

The Process. The process starts in earnest after these decision-making bodies are consulted and provide the broad goals, proposals and parameters for their teams. Much work must be done prior to these consultations in order to review past history, outline the likely issues and establish financial goals and limits. A city council, for example, will usually be asked to set a “cost parameter.” For example, that the final agreed upon contract should cost no more than three percent of total compensation for the group. In other words, an “uplift limit” is set based on a percentage of the present costs of all salaries and benefits for the particular employee group. In setting parameters, decision-makers should be mindful of equity in comparison to other groups. As the negotiations proceed, management must be aware that the cost of most proposals is multi-dimensional. For example, a change in how vacation is accrued or used by firefighters could trigger additional overtime costs. Therefore, management will need to estimate not only the cost of the vacation proposal, but the cost of the secondary overtime impact as well. Today, there are two fundamental approaches to bargaining: positional bargaining and interest-based bargaining. Using an interest-based bargaining approach, the respective teams approach the talks from a more collaborative perspective and seek “win-win” solutions. In positional bargaining, the groups generally pursue fixed (and often opposing) viewpoints to either achieve a specific goal or to force a compromise. Whichever style is used, negotiations will typically start before the current labor contract ends—and usually start slowly. In a first session, such topics as the process and schedule, respective roles, and agreed upon negotiation ground rules are discussed. General interests and initial proposals may be tentatively laid out, but primarily for purposes of clarification. Data may be shared, such as proposed CPI indexes or “comparable agency” surveys. As the negotiation process progresses, the parties will begin to tackle the specific issues each has put forward, with periodic consultation with their respective decision-makers. Proposals can vary widely in scope and number, but will typically include goals related to such matters as: •

•

•

Pay (such as across-the-board COLA increases and special adjustments for certain classifications) Health benefits (such as the agency’s cost share versus the employees’ cost share) Retirement benefits (such as benefit levels and employee contributions)

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• •

•

•

Vacation and/or other forms of time-off (such as sick leave, number of paid holidays, or administrative leave) Career ladders and promotional opportunities Incentives (such as those for bilingual skills and specialized education incentives) The grievance procedure whereby employees can protest that the contract provisions have been violated (and other terms and conditions of employment) Length of the contract

The negotiation process can take a matter of days, weeks, months, or even years. Each is highly idiosyncratic to the agency and is affected by such factors as the participants’ personalities, labor relations history, organizational culture, past practices and the fiscal environment. The specifics of the process may also vary depending upon the adopted rules within a jurisdiction. However, there are certain steps for ultimately resolving differences and reaching a conclusion.

Getting to the End. If a negotiation goes well, a “tentative agreement” will be reached before the current agreement has expired. If the negotiation is more difficult, the parties may need to agree to extend the existing agreement by some period of time in order to conclude negotiations. If agreement still cannot be reached after further negotiations, either party may formally declare “impasse.” When impasse is declared, the California State Mediation and Conciliation Service may be contacted and a mediator provided. If this approach is used, the mediator will try to bring the parties together but cannot force a settlement. If mediation does not work, the next step is “fact finding” whereby each party formally presents its issues to a neutral third party hearing officer, who will ultimately recommend a settlement.

Final Decision-Making—and Accountability—When All Else Fails. If the parties have exhausted the impasse procedures without settlement, then the governing body may unilaterally implement its “last, best and final offer.” The ability to unilaterally implement may seem like the scale is heavily weighted in favor of “management,” but there are constraints against unilateral implementation. First, the legal bar is high in terms of judging whether or not all efforts have been exhausted to reach agreement5 (with recourse for review before the National Labor Relations Board). In addition to the legal standard, there are human and political considerations that discourage unilateral action. For example, after investing much time (and money) in the negotiation process, most elected officials and managers will want to show a positive outcome. In addition, most elected officials and managers will want to preserve a good working relationship with their own employees. Unilateral implementation almost always is instituted in a climate of high conflict resulting in tensions that can linger for many years. 102

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And there is a powerful political motivation: unions have more freedom to argue—and financially support—their case publicly and politically; and law enforcement and fire unions are particularly skilled and successful in marshalling public support. Public safety employees also often gain the backing of high profile federal and state officials and other locally prominent figures. Conversely, “city hall politicians and bureaucrats” are far less likely to garner public sympathy and unqualified acceptance. Local elected officials, therefore, will typically make every effort to achieve settlement with their employee groups. But whether they succeed or fail, they are ultimately accountable for their decisions to the citizens who elect them and who pay for the workforce and services they provide. For these reasons, the vast majority of California local governments conclude negotiations successfully, without resorting to unilateral implementation.

The Exception: Binding Arbitration. Some California cities and counties have adopted charter amendments to provide public safety unions with a different way to resolve labor differences after impasse. The process is called “binding arbitration.” While the process may differ somewhat in each of the agencies, there is one major difference from the process followed in all other California cities and counties: rather than elected officials possessing the final authority to make a decision, irresolvable differences are taken to an independent third party who hears the arguments and renders a decision that is binding on all of the parties. On the surface, binding arbitration may appear to be a fairer way to resolve differences. Since public safety employees cannot strike, unions argue that it levels the playing field between labor and management. However, there is a major underlying philosophical question involved, which goes to the core issue of accountability. Who should make a final decision on behalf of a community regarding the compensation of its employees—an outside arbitrator or the elected representatives of a community? The California Supreme Court decided that it is the elected representatives of the community when in 2003 the justices struck down a binding arbitration law for firefighters and other public safety employees. The law, referred to as Senate Bill 402, was advocated by public safety unions and would have applied to every local jurisdiction in the state. The court’s decision to find the law unconstitutional, however, exempted charter cities in recognition of the “home rule” principle underlying the charter form of government. Thus, a vote of citizens is required in order to put binding arbitration into the charter, or for it to be revised or removed from the charters of the cities that presently have the system. Interest in removing binding arbitration from charters has been growing, based on some onerous results of arbitration rulings, amplified even more during difficult economic times.

California Cities and Counties with Binding Arbitration

alameda anaheim Gilroy Hayward modesto monterey napa oakland oroville Petaluma redwood city Sacramento city Sacramento county Salinas San Francisco city/county San Jose San Leandro Santa cruz Santa rosa Stockton Watsonville

in recent years, voter sentiment appears to have turned against binding arbitration. While the city of vallejo was the first agency in california to adopt binding arbitration in 1970, its voters repealed this from the city charter in June 2010. voters in Palo alto and San Luis obispo repealed binding arbitration provisions in those city charters in 2011. charter amendments were approved in San Jose (2010) and Santa rosa (2012) limiting the scope of binding arbitration in those cities.

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Defined Benefit vs. Defined Contribution Plans

there are two basic types of retirement plans: defined benefit and defined contribution. under the defined benefit plan, the employer promises a specified monthly benefit upon retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service, and age. annual contributions are made to the plan in an amount actuarially required to fund the plan. the benefit level is defined and contributions will vary as needed to fund them. Defined contribution plans do not commit to a specific benefit, but rather, to a specific contribution amount by the employee and employer. in this case, pension benefits will vary depending on the contributions made and investment earnings on them. the contribution level is defined and pension benefits will vary. many private sector retirement benefit plans are of this nature: the employer agrees to contribute to an employee’s individual retirement account while the employee works for the organization. the retirement benefit is contingent on the performance of the account and related variables, but it is not a post-employment obligation of the employer.

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Pensions. While cities, counties, and special districts are free to create their own retirement systems, 460 of California’s 482 cities and thirty-six of California’s fifty-eight counties, are members of the California Public Employees Retirement System (CalPERS).7 Dating back eighty years, CalPERS is now the largest pension fund in the United States, serving over 1.8 million members and managing nearly $300 billion in assets.8 Members include state, city, county and special district employees. Local agencies typically contract with CalPERS for “defined benefit” retirement plans for two major groups of employees, sworn public safety employees (police and fire employees) and non-sworn employees or miscellaneous employees (all other agency employees, including non-sworn employees in the police and fire departments). As explained in the sidebar, defined benefit plans differ significantly from defined contribution programs. CalPERS defined benefit plans guarantee retired employees a regular pension payment based upon a formula factoring in retirement age, years of service, and final compensation. These three factors then determine the pension amount based on the formulas in place.

Trends Before the Public Employees’ Pension Reform Act of 2013 (PEPRA). Until the adoption of PEPRA in 2012, the state legislature had a long history of approving improved pension benefit formulas, while at the same time in many cases reducing required contributions for them. By the early 2000s, the “normal” retirement age had decreased over time from sixty to fifty-five for non-sworn employees and from fifty-five to fifty for sworn employees. The state legislature added the option of “3 percent at 50” formula for sworn employees in 2000, and the “2.5 percent at 55,” “2.7 percent at 55,” and “3 percent at 60” formulas for non-sworn employees in 2002. Figure 8-1 summarizes the various plan options that were available until PEPRA. The definition of final compensation has also evolved over the years. In the 1950s and 1960s, using an average of the five highest years of compensation was standard. In the 1970s, the current options of averaging the three highest years of compensation or using one final “single highest year” of compensation were introduced. Until PEPRA, many agencies used the single highest year option.

Funding Pension Benefits. CalPERS plans are funded through employee and employer contributions and earnings on investments; about two-thirds are currently funded from investment earnings and about one-third come from employee and employer contributions. When enhanced CalPERS retirement

chapter 8: Labor: employing People Figure 8-1. CalPERS Pre-PEPRA “Classic” Retirement Plan Options*

*these are still available to employees hired before January 1, 2013. programs were offered in the early 2000s, the stock market (and thus CalPERS investment earnings) were on a tremendous upswing. As such, many local plans had actuarial assets that were significantly in excess of liabilities. Based on CalPERS actuarial assumptions, it was projected (incorrectly) that the new benefit levels could be funded entirely from existing CalPERS surpluses and the excess assets from investment earnings—for many years into the future, if not indefinitely. These erroneous conclusions, combined with the political support enjoyed by public safety unions (enhanced to even higher levels after the 2001 terrorist attacks), made it extremely difficult for local agencies to resist upgrading to the “3 percent at 50” program for their safety employees. Very soon, this program became the standard retirement program for police officers and firefighters throughout California. This dynamic also drove a boost in the retirement programs available to non-sworn local government employees. In many communities, for example, non-safety unions argued that as a matter of fairness and equity, agencies should be open to enhancing their retirement programs, too. While the equity argument was bolstered in agencies that had significant excess actuarial assets, many nonsafety unions further encouraged political support by agreeing to pay and benefit concessions in exchange for the improved retirement programs. As a result, many local agencies in California also adopted these enhanced programs, effectively forcing others to participate and to maintain a competitive compensation position in the recruitment marketplace. And the ugly truth is that in 2008, the stock market declined severely from its unprecedented highs, drastically lowering CalPERS investment earnings and exposing the “excess actuarial assets” as illusions. Combined with 105

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other, more realistic actuarial valuation assumption changes, such as retirees living longer and lower long-term investment yields, local agencies have experienced significant increases in employer contribution rates (which are likely to continue increasing for many years into the future). For example, many local agencies saw “zero” employer contribution rates for both safety and miscellaneous employees in the early 2000s (during the so-called excess asset and “superfunded” years). Today, many of these same agencies see employer contribution rates of forty-five percent of payroll for sworn employees and thirty percent for non-sworn employees; and again, these rates are likely to increase further in the future.

Who’s a “New” Employee?

PePra only applies to “new” employees: those hired into the calPerS system for the first time on or after January 1, 2013. However, “classic employees”—those who established calPerS membership before January 1, 2013, and were hired by a different calPerS agency with a break in service of six months or less—will be eligible for the new agency’s benefit level that was in place as of december 31, 2012. in short, because PePra only affects new hires—and excludes as new hires “classic” employees—it will be many years before PePra results significantly lower employer contributions. that said, the journey of a thousand miles begins with the first step.

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PEPRA Impacts. Effective January 1, 2013, PEPRA altered many aspects of the CalPERS pension program in order to reduce costs and future liabilities for state and local agency system members. Major changes for new system members include lower-cost pension formulas, increased retirement age requirements, use of “three years of highest average compensation” (rather than single highest year) in calculating pensionable pay, and caps on maximum annual benefits. Figure 8-2 shows the revised benefit levels for new hires. Retirement benefits for local agency employees hired before January 1, 2013, are not affected by these “rollbacks”: they only affect “new” employees (see sidebar for “new” versus “classic” employees). As such, there will not be any significant short-term cost savings from these changes. PEPRA also includes provisions designed to eliminate abuses for both current and future system members, such as “pension spiking” and excessive re-employment of CalPERS retirees by member agencies. It also requires equal sharing between employees and employers of the “normal” contribution rate for current and new members. Figure 8-2. CalPERS Retirement Formulas Under PEPRA for New Hires

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Calculating CalPERS Pension Benefits. The sidebar provides two hypothetical retirement calculations for positions in an agency that contracted with CalPERS for the “2.7 percent at 55” plan for non-sworn employees and the “3 percent at 50” plan for sworn employees before PEPRA (the factors for calculating pension benefits—years of service credit, pensionable compensation, and age—are the same for the PEPRA benefits; but of course, the factors shown in Figure 8-2 are much lower). By any standard, these are generous programs. While CalPERS notes that the average annual service retirement allowance for all currently retired members is about $31,500, the actuarial concern is that it will take many years to see significantly lower pension costs, as many current employees will remain covered by the pre-PEPRA benefits for many years into the future. Figure 8-3. Benefits Are a Large Component of Regular Staffing Costs Office Assistant $42,000

Police Officer $89,000

Annual “Base” Salary (Note 1) Benefits _______________________________________________________________________________________________ Paid Benefits calPerS retirement (note 2) _______________________________________________________________________________________________

employer contribution: 35% of regular salary for $8,000 $31,200 Safty employees and 19% for miscellaneous employees _______________________________________________________________________________________________ Health, dental, vision insurance at $800 per month $9,600 $9,600 _______________________________________________________________________________________________ Workers compensation at 10.5% of Salary for Sworn employees and 2.5% for office employees $1,100 $9,300 _______________________________________________________________________________________________ Long-term disability at 1% of Salary $400 $900 medicare at 1.45% of Salary $600 $1,300 unemployment insurance at 0.4% of Salary $200 $400 _____________________________________________________________________________ Total Paid Benefits $19,900 $52,700 _____________________________________________________________________________ Leave Benefits vacation at 15 days per year (note 3) $2,400 $5,100 _______________________________________________________________________________________________ Sick at 50% use of 12 days per year (note4) $1,000 $2,100 _______________________________________________________________________________________________ Holidays at 12 per year (note 5) $1,900 $4,100 _____________________________________________________________________________ Total Leave Benefits $5,300 $11,300 _____________________________________________________________________________ Total Benefits $25,200 $64,000 Total Compensation $67,200 $153,000 Benefits as Percent of Base Salary 60% 72% Notes:

(1) in addition to “base” salary, there are other likely salary add-ons that can be significant such as bilingual pay, educational incentives, paramedic pay and uniform allowances. in most casers where benefits are set as a percentage of salary, benefit costs will be increased by these add-ons.

(2) retirement cost assume no coordination with Social Security. While rates are set by calPerS for each agency based on its own experience (or the experience of a pool of smaller agencies). these rates reflect likely contributions for a “classic” plan with the following “mainstream” features: single highest year of compensation: “3% at 50” plan for Safety employees; and “2.7% at 55” plan for miscellaneous employees. (3) this is a typical accrual vacation accrual rate for five years of service.

(4) regular employees typically accrue one day of sick leave per month. this sample assumes a sue rate of 50%.

(5) common municipal holidays in california include, new Years, martin Luther King’s Birthday, President’s day, memorial day, independence day, Labor day, columbus day, veteran’s day, two days at thanksgiving and two days at christmas. along with these, many municipal agencies provide “floating holidays” as well.

CalPERS Retirement Calculations

Office Assistant. For the “2.7 percent at 55” plan, non-sworn employees will receive 2.7 percent for each year of service credit, times their final compensation if they retire at age fifty-five or later (an earlier retirement option—but no lower than age fifty—is available at reduced percentage rates). if the plan is based on the “single highest year,” an office assistant under this plan who earned $48,000 in the highest year before retirement ($4,000 per month) with twenty-five years of service credit would receive a monthly pension of $2,700 (0.027 x 25 x $4,000) or $32,400 per year (67.5 percent of his or her final highest pay). Police Sergeant. under the “3 percent at 50” plan, sworn employees will receive three percent for each year of service credit times their final compensation, if they retire at age fifty or older. if the plan is based on “single highest year,” a Police Sergeant under this plan who earned $120,000 in the highest year before retirement ($10,000 per month) with thirty years of service credit would receive a monthly pension of $9,000 (0.03 x 30 x $10,000) or $108,000 per year (ninety percent of his or her final highest pay).

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Post-Retirement Health Care Benefits—Another Significant Liability for Many. As noted earlier, virtually all local governments provide some level of health care contributions for their full-time workforce. However, programs to provide post-employment health care (coverage during retirement) have grown much like other employee benefits, and many of these programs are now posing huge fiscal challenges. In some agencies, unfunded retiree health care costs are larger than pension liabilities. Unlike defined pension plans such as CalPERS, where agencies are required to pay actuarially determined amounts each year, local government agencies are not required to do so for retiree health care benefits. Instead of paying an actuarially determined amount (known as the Annual Required Contribution, or “ARC”), they can fund this on a “pay-as-you-go basis.” In the early years, pay-as-you-go will be less expensive than paying the ARC (also known as “pre-funding”). However, around year fifteen for most agencies, the ARC will begin to be lower than pay-as-you-go, since prefunded amounts have been invested (see Figure 8-4). Moreover, pay-as-you-go becomes infinitely more expensive than prefunding after unfunded liabilities have been paid-off (typically after thirty years): in fact, under pay-as-you-go, liabilities for retiree health care (also referred to as Post-Employment Benefits Other Than Pensions, or “OPEB”) are never paid off; they just continue to grow (see Figure 8-5). For many local agencies, the wake-up call on the true cost of retiree health care benefits did not occur until the Governmental Accounting Figure 8-4. Retiree Health Costs Over Time

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Standards Board (GASB) adopted Statement No. 45, which required state and local governments to report on the financial status of their OPEB obligations on an actuarial basis (like retirement plans) in their audited financial statements, rather than on a deceptively lower pay-as-you-go basis, which is how many local agencies fund their retiree health care costs. Disclosure requirements and accounting for OPEB will become even more stringent when GASB Statement No. 75 becomes effective for fiscal years beginning after June 15, 2017. This problem is not only an issue in California, but nationwide. Adding It Up: Estimating the Cost of the Workforce

As illustrated in the previous discussions, the cost of government is largely driven by the cost of employees, and there have been compelling forces at work to cause these costs to steeply rise—perhaps to unsustainable levels. Because pay is but one factor in the cost of a position, analysts must be sure to use methods that also capture the estimated cost of benefits. And these costs must be carefully projected into the longer-term future, too. After accounting for leave, health-related and pension benefits, Medicare and unemployment insurance, disability and workers compensation coverage, the “full cost” of a position is frequently sixty to seventy percent or more than the cost of the base salary or wage. See Figure 8-3. Figure 8-5. Unfunded Liability Trends

The Great Recession and Furloughs

the historic trajectory of municipal labor costs has been upward and will likely be so in the future as local governments extend services to accommodate growth and other service demands. However, facing the severe budget constraints resulting from the Great recession and the state’s budgetary crisis, many local governments in california were forced to reduce labor costs significantly in recent years. in most cases, the approach has been simply to cut positions (and/or leaving vacant positions unfilled). Some jurisdictions have successfully reduced these costs in ways that mitigate against further job cuts. one strategy (employed also by the state) has been to use “furloughs,” whereby the number of hours worked by staff are cut and pay reduced accordingly (for example, reducing hours and pay by two days per month). From the employee’s perspective, pay is reduced (although unpaid time off increases, which can be a boon to some people). at the same time, there is either a reduction in services to the public or, in the case of exempt employees especially, similar workloads with less time (and compensation) to accomplish them. of course, pay and benefits reductions for existing staff must be negotiated for represented employees, but sometimes employees have been willing to accept lower pay as a tradeoff for maintaining jobs in the organization. difficult times have generated difficult responses.

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In addition, there is more than pay and benefits involved in estimating full costs. Adding positions also requires added supplies and other overhead costs. For example, adding a police officer or deputy sheriff requires uniforms, weapons, radios, vehicles, and other support expenses. And if an agency wishes to add one new firefighter position, because of the twenty-four/seven nature of the fire service, the cost can actually be over three times that of a single position in order to fill all shifts and related time-off coverage requirements. Given the cost of the workforce, local government must be strategic and analytic before adding new services and positions. New ideas and efforts to reduce costs are also underway. Some examples are provided below and discussed further in the last chapter. Strategies for Containing Workforce Costs

Labor relations law governing both private- and public-sector collective bargaining has a long and deep history and, despite pressures for change, in California at least the basic protections and the right to bargain will likely prevail into the future. However, the now apparent excess in the 2000s has inspired a growing consensus that some changes and reforms are needed. There have been some cost-control strategies that have been used for many years, such as contracting out some services to the private sector (such as janitorial services and landscape maintenance). Technological efficiencies and ongoing efforts to “do more with less” have also been encouraging. The following three approaches are promising in terms of addressing the issue of pay and benefit sustainability for the longer term: the development of succession planning programs, the establishment of formal compensation philosophies, and state and local reform of retirement benefits.

Initiate a Succession Planning Program. In the early twenty-first century, “Baby Boomers” are now at retirement age. Given this demographic “bubble,” the challenge of finding suitable new employees to replace them will be strong for many years to come. Meeting this challenge by “outbidding” the competition in terms of pay and benefits will be neither successful nor sustainable. Therefore, many organizations have initiated succession planning programs to promote the development of talent from within the organization to fill higher-level jobs as they become available. Such programs recognize that pay and benefits are key elements in employee recruitment and retention, but there are other critical elements involved, too, such as a healthy culture, challenging work and promotional opportunity. Having a larger pool of talent within the organization relieves some of the upward and comparative pressures on compensation. 110

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Formal Compensation Philosophy. A formal compensation philosophy establishes a clear statement of goals and standards regarding pay, benefits, and related practices. In effect, the local government adopts policies to guide compensation decisions into the future. For example, an agency may determine that it wants to be in the top fifteen percent of comparable agencies in terms of pay and usual benefits. Another’s goal may be to be nearer the middle while also emphasizing other rewards like employee development programs, and promotional opportunities. Establishing criteria for evaluating comparable public sector agencies and the relevant labor market, considering such factors as demographics for population, median home price, median household income, median age, median education level, and unemployment, is critical. Many agencies do not formally adopt explicit policies regarding compensation. However, this step is becoming increasingly important, as the compensation issue grows in financial and political immediacy. A conscientious policy developed through an open public process is likely to yield better longterm outcomes than by “muddling through” incrementally.

Paying Down Unfunded Liabilities and Sharing Retirement Benefit Costs. There is strong consensus that pension benefits already earned by current employees and retirees are contractual obligations that cannot be impaired. However, for current employees, what about pension benefits going forward? As of 2016, the “conventional wisdom” is that unless replaced with comparable benefits, these cannot be impaired, either. This is based on the “California Rule,” created in 1955, when the California Supreme Court considered a challenge to a 1951 city charter amendment in Allen v. City of Long Beach (Cal. 1955). However, in light of staggering pension cost increases, several cities have attempted to modify benefits going forward for current employees. So far, these have not been successful. Even with the bankruptcies in Vallejo, Stockton, and San Bernardino, pension benefit levels for current employees were not impaired. That said, an appellate court decision in August 2016 surfaced the notion that benefit changes going forward may be allowable. This is likely to be appealed to the state Supreme Court. Stated simply, the ability to modify pension benefits going forward will be contentious and ultimately resolved through court actions that are beyond the control of any one local agency to resolve. That said, two strategies many local agencies have used to reduce pension costs that are within their local control include: •

Paying Down Unfunded Liabilities. As local agencies recover from the Great Recession, many are using their stronger financial condition to pay down their unfunded pension liabilities. Without directly affecting benefit levels, this has the effect of reducing annual payment obligations.

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Sharing Pension Costs. Another strategy that several local agencies have implemented is sharing employer contribution costs. While subject to “meet and confer,” this can result in significant and immediate agency cost savings.

In the case of retiree health care, these benefits are not considered subject to the “California Rule.” Accordingly, along with the strategies of paying down unfunded liabilities and sharing costs, a number of cities have been successful in reducing benefits for already retired employees as well as in increasing contributions from current employees. These and other reform efforts are revisited in Chapter 17. Summing Up At the local level, public services are mostly provided by people. Consequently, staffing costs overwhelmingly compose the biggest cost component found in the operating budgets of most California local governments. Any understanding of local public finance, therefore, must include an understanding of the forces that influence the cost of staffing. The competitive labor market is one important influence because in order to provide quality services, a talented workforce must be assembled and retained. Most local agencies, therefore, are very sensitive to the need to offer not only competitive pay and benefits, but also other practices related to compensation that are customary in the recruitment marketplace. In recent years, another very powerful (and interconnected) force has profoundly shaped compensation outcomes: the labor relations process and public employee unions. Over the years, with the support of state government leaders, employee organizations—especially public safety unions—have become extremely powerful influences over local government labor compensation and benefit levels. Enhancements in public sector compensation, particularly in the area of retirement and post-retirement health coverage, have strained local budgets considerably and portend potentially catastrophic problems, unless there are reforms. Successfully implementing reforms without undermining the ability of local agencies to hire quality employees to deliver vital public services is among the greatest challenges facing local government leaders and municipal managers.

This chapter discussed what is usually the largest single expense category in local government budgets. But, agencies also need to pay for many other things besides labor, including supplies, equipment, and services. The next chapter covers procurement practices.

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chapter 8: Labor: employing People NOTES “The Beholden State: How Public Sector Unions Broke California,” Steve Malanga, City-Journal, Spring 2010. 2 California Government Code Section 3504. 3 Pocket Guide to the Basics of Labor Relations, California Public Employee Relations Institute of Industrial Relations, University of California at Berkeley, 2009. 4 Another difference between the public and private sectors is that a corporate board or business owner clearly identifies with management, whereas a local agency’s governing board may see itself as the arbiter between employees and “management,” blurring the usual negotiation situation. 5 Pocket Guide to the Basics of Labor Relations, California Public Employee Relations Institute of Industrial Relations, University of California at Berkeley, 2009. 6 “Vallejo: Portrait of a Broke Town,” Bloomberg Businessweek, February 26, 2009. 7 Fast Facts at a Glance, CalPERS, April 2010. 8 Ibid. 9 And they are projected to rise even further over the next three years, to forty-six percent of payroll for sworn employees and twenty-three percent for non-sworn employees, an increase of thirty percent from already-high 2010 levels. 10 “State and Local Government Retiree Health Benefits: Liabilities Are Largely Unfunded, but Some Governments Are Taking Action,” United States Government Accounting Office, Report to the Special Committee on Aging, November 2009. 11 “Retaining and Growing Talent: Strategies to Create Organizational ‘Stickiness,’” Public Management Magazine, Dr. Frank Benest, pages 20-24, October 16, 2007. 1

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ocal governments deliver services through two basic types of expenditures: payments to employees and payments to vendors for goods and services (due to their responsibility for certain health and human services, counties have a third type: pass-through payments to individuals). As discussed in Chapter 8, staffing typically accounts for a large portion of local government operating costs. This chapter discusses key principles and practices related to the second type of service delivery: purchasing goods and contracting services. Placing Purchasing in Context

The portion of a local agency’s budget that is allocated to the purchase of goods and services is typically relatively modest—perhaps fifteen to twenty percent of total expenditures—after accounting for: •

• • • •

Staffing costs, which are typically the largest portion of expenditure types. Construction project contracts, which are governed by the State Public Contract Code for all local agencies except for charter cities and counties (and even then many of these adopt the Public Contract Code by reference in their charters). Debt service payments to bond holders. Pass-through payments to individuals for health and human services. Purchases like telecommunications, utilities, and insurance that can usually be purchased from only one vendor (or have a very limited market in the region).

While not a significant part of total agency costs, many organizations have put in place very elaborate and complex systems that create the dreaded “red tape”

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often associated with government business practices. On the other hand, there are many ethical and legal hazards if purchasing operations are not conducted in a prudent manner. Missteps can seriously undercut public confidence in an agency’s overall financial management in providing effective stewardship of the community’s resources. Procurement practices that might make sense in the private sector will simply not pass public expectations for transparent, open and fair governance. This makes balancing efficiency and effectiveness (“cutting the red tape”) with responsible stewardship and accountability a difficult challenge for all local governments. “Empowerment” may be the watchword of business school texts, giving employees throughout an organization authority to make decisions for the sake of efficiency and responsiveness. But in government, empowerment can conflict with organizational accountability expected from a public agency—and the undermining of public confidence that can easily follow purchasing practices that cannot pass the “headline test” in tomorrow’s newspaper (let alone viral blog). Many things can be explained—but it is always better not to have to (and in today’s e-publishing world, the misunderstanding will be in the e-ether long after any clarification or explanation is subsequently provided). This is one of the cardinal virtues of straightforward, clear and simple systems: they are less likely to go wrong and easier to explain if needed. Elected officials and staff need to be sensitive to the importance of both the substance and appearance of fair and transparent purchasing practices. Following Albert Einstein’s advice helps in developing systems that reflect this balance: “Make everything as simple as possible, but not simpler . . . Any intelligent fool can make things bigger and more complex. It takes a touch of genius—and a lot of courage to move in the opposite direction.”

In summary, the goal of local agency purchasing systems should be to develop and implement simple but prudent policies and procedures. Basic Purchasing Tasks Regardless of the type of goods or services being acquired, virtually every purchase transaction goes through seven distinct stages in varying degrees: • • • • •

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Assessing and determining resource needs. Developing specifications. Soliciting and evaluating quotations, bids or proposals. Selecting the best proposal. Awarding the contract or purchase order and authorizing work to proceed.

•

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Receiving and inspecting goods or services to ensure they conform with specifications. Paying the vendor when contract terms have been met.

Except for construction projects, local agencies have broad local discretion in setting purchasing standards, systems, and procedures.

Essence of Effective and Appropriate Purchasing: Competition. The best way of assuring that stewardship and accountability goals are met is to provide for as full and open competition as possible on all purchases. This means ensuring that procurement opportunities are widely provided to all vendors; and that “open specifications” are used to avoid limiting bidding opportunities to a few (or just one) supplier or brand.

Roles and Responsibilities. Ensuring that purchasing roles and responsibilities are clear to elected officials and staff, and that they make sense, is essential in developing and implementing “simple but prudent policies and procedures.” A key part of “simple” is making sure that “who’s responsible for what” can be easily articulated to all actors in the process; and that roles assigned to the actors in the process are in alignment with their policy significance. For example, it doesn’t make sense for the elected governing body (Board of Supervisors, City Council or Board of Directors) to be directly involved in the purchase of a $2.50 screwdriver; on the other hand, governing body members should be involved in very expensive purchases, especially where significant discretion may be involved in selecting the best firm to do the work. While the ordinance or resolution that establishes the purchasing policies and procedures may necessarily be long, it should be possible, nevertheless, to effectively summarize “who’s responsible for what” on a single page (see the sidebar). Policies and procedures that are not reducible to a clear and simple picture may reflect a purchasing system that is unduly complex. Emerging “Best Practices” In balancing efficiency and effectiveness with responsible stewardship and accountability, the following are emerging “best practices” for local government purchasing systems:

Governing Body Award of Contracts. At some point in the purchasing process, governing body involvement is warranted for significant purchases. In many organizations, this means governing body approval of the award of contracts for amounts above a specified limit after the staff has prepared the bid package and solicited proposals. Several agencies have found that it makes 117

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more sense for the governing body be engaged earlier, requiring them to approve the bid package and solicitation process first, then authorize the staff to award the contract if it is within the approved budget. With this approach, the governing body is meaningfully involved in the key policy issues: exactly what is being purchased, the criteria for determining the best proposal, the amount the agency is willing to spend, and the sources of funding. With these issues explicitly addressed by the governing body, determining who then provides, for example, the lowest price for a back hoe becomes an administrative, not a policy, action.

Invitations for Bids (IFB) Versus Requests for Proposals (RFP). Some purchases, such as vehicles and other mechanical equipment, lend themselves to clear definitions of what is required from the supplier and manufacturer. In these cases, an “IFB” approach where price is the primary factor in determining the best proposal makes the most sense. However, there are many circumstances, such as technology purchases, consultant services (like attorneys, architects, and engineers), and specialized operating and maintenance services, where it makes more sense for the award to be made based on other factors as well. In this case, an “RFP” approach makes more sense. While the agency still needs to define its needs as clearly as possible, an effective RFP clearly articulates to vendors that the award will not be solely on price, but other factors will be considered as well (such as those in the sidebar). The RFP should also be clear on proposal contents and the criteria that the review team will use in determining the best proposal.

Centralized Versus Decentralized Purchasing Approaches. Many local agencies—especially larger ones—have established centralized purchasing organizations, through which a purchasing agent and buyers procure goods and services on behalf of the operating departments. This is based on the concept that the agency will see reduced prices and greater efficiencies through expertise, specialization and economies of scale. On the other hand, many agencies have purposely decentralized decision-making, consistent with prudent review and internal control procedures, as a way of reducing overhead and implementing leaner, more streamlined purchasing, while also fostering department responsibility, initiative and flexibility. With clear guidance and adequate resources, either approach can work well. However, successful centralized operations require a strong customer-oriented organizational culture; and successful decentralized ones require simple yet effective internal control procedures that are broadly communicated, readily accessible standard templates and bid packages, and an effective system of administrative review.

Sample Proposal Evaluation Criteria

● understanding of the work required by the agency. ● Quality, clarity, and responsiveness of the proposal. ● demonstrated competence and professional qualifications necessary for successfully performing the work required by the agency. ● recent experience in successfully performing similar services. ● Proposed approach in completing the work. ● references. ● Background and related experience of the specific individuals to be assigned to this project. ● Proposed compensation

as reflected in this sample criteria, the contract award will not be based solely on price, but on a combination of factors as determined to be in the best interest of the agency. When an rFP process is used, the agency should make it clear to vendors that, after evaluating the proposals and discussing them further with the finalists or the tentatively selected contractor, it reserves the right to further negotiate the proposed work and/or method and amount of compensation.

Electronic Issuance of Bid Documents and Receipt of Proposals. Until recently, fair and open competition required preparing and issuing “hard copy” 119

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bid documents that were costly and slow in getting out to prospective vendors. However, with advent of electronic documents, web sites and email “list serves,” bid packages can be broadly and cheaply distributed, reducing staff costs and improving competition. And while it continues to be essential that sealed bids be received by the deadline to avoid the substance or appearance of collusion or favoritism, a number of agencies have successfully implemented prudent “e-bid” systems, which replace “hard copy” bids.

Sole Source Purchases. Few situations will truly require “sole source” vendors. While staff may have preferred suppliers, there are rarely circumstances when only one business can provide the needed goods and services. Even in cases when there is a preferred manufacturer, the product is often available from several sources. In ensuring fair, open and transparent practices, organizations should limit when competitive bidding yields to “sole sourcing.” When a sole source is being considered, agencies should fully support and justify this exception from competitive bidding. Along with the benefits from acting as an open, transparent government, competition almost always results in better prices.

Cooperative Purchasing. Agencies can significantly reduce their purchasing efforts—“cut the red tape”—while meeting their stewardship responsibilities and receiving competitive pricing—through cooperative purchasing with other agencies. Both the federal and state governments have cooperative purchasing systems in place under which local agencies can “piggyback” their purchases. The League of California Cities and the California State Association of Counties jointly have put in place an excellent cooperative purchasing program through the California Statewide Communities Development Authority.

“Just-in-Time” Inventories. At one time, bulk purchasing of supplies was a key strategy for lowering costs. However, bulk purchases require storage facilities, careful inventory controls, and higher ongoing staff costs related to the distribution of inventory from the centralized storage. Today, there are many suppliers that will “warehouse” needed inventories at agreed upon unit prices and deliver them “just-in-time” for the agency’s use. This can often occur at no added cost to the agency, and result in deliveries to the site faster than the agency’s warehouse can deliver them. Progressive agencies proactively seek these “just-in-time” inventory opportunities. E-Purchasing. Often in conjunction with “just-in-time” purchasing arrangements, many agencies have moved to “e-purchasing” over the Internet. By more easily accessing a wide variety of possible manufacturers and suppliers, agencies can realize opportunities for lower prices, better products and faster delivery. E-purchasing, however, is most effective with some level of decentralization and usually requires staff to use agency credit cards.

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Credit Cards. One of the banes of purchasing and accounting staffs is the use of “open purchase orders.” These often undermine internal controls, and make processing and accounting for purchases a staff-intensive process. When properly designed, the use of credit cards for modest purchases in lieu of petty cash can significantly reduce both processing costs and prices while ensuring appropriate internal controls. The “Cal-Card” program provided to local governments through the state General Services Department provides cities with an excellent tool for assuring appropriate authorizations and detailed reporting on use. Purchase Orders, Agreements, and Encumbrances. Under the “standard purchasing model,” there are three main steps with distinct “actors” in the process: • •

•

Order placement by Purchasing. Delivery of the ordered goods by the vendor to Central Receiving, which matches the delivered goods to the Purchase Order to ensure that they have been correctly delivered. And then disbursement of funds by Accounting when it matches the vendor’s original invoice (which must be sent directly to Accounting and reference the Purchase Order Number) to the Purchase Order from Purchasing and the “receiver” sign-off from Central Receiving that the order has been correctly filled.

This model makes sense in a manufacturing environment and has the desired internal control goal of “separation of duties.” However, very few purchases in local government actually look like this. The most significant purchases are typically for services, which are usually not “physically” delivered anywhere; and most tangible “goods” purchases are typically of a low unit value and either delivered to the site or picked-up by the field staff. Nonetheless, many local governments have put in place traditional systems based on the “order, receive and disburse” approach developed for manufacturing firms. This results in very high processing costs. For example, many agency purchasing ordinances require the issuance of a Purchase Order for all purchases. If one assumes even a modest processing cost of $50.00 per purchase order, this approach is very expensive for small purchases, and engenders a significant duplication of effort (and slower process) for most large purchases where there are formal agreements also in place. This also makes credit card payments, e-purchasing over the Internet, and other electronic payments virtually impossible. Smart agencies only issue purchase orders for “mid-cost” items, where a lower cost “over-the-counter” purchase process would be inappropriate, and where a formal agreement exists for higher cost purchases. Many agencies have found that taking this approach results in simpler, lower cost purchasing systems, since very few purchases fall into the “mid-cost” range where a purchase order really makes sense. 121

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Local Preference. It is understandable that a local agency would want to support their local economy and community-based businesses by providing them with opportunities to sell their goods and services to it. However, when this becomes a formal policy of local price preference over other vendors, agencies cross into a “free trade versus protectionism” conundrum. Two issues arise: ● Local agencies may begin to experience a lack of competition—and higher prices as result—if non-local vendors choose to opt out of the process because of the advantages given to their local competitors.

● And the logical reaction to local purchasing preferences in one community is the adoption of them in others. When this happens, local vendors lose business opportunities in other places, resulting in greater losses than may be offset by winning more local bids.

One form of local preference that works but does not devolve into the problems cited above is to give local vendors credit for any sales tax revenues that they may generate for the agency. In most cases, this is a very modest preference (one to 1.5 percent for most cities and counties). Where the agency has adopted a local preference, the parameters of the policy should be clearly identified in the bid documents.

Register of Warrants. The preparation and placement of any item on the governing body’s agenda, no matter how seemingly routine or simple, by its nature requires significant staff effort. Despite this, many agencies continue to require governing body approval of its “Register of Warrants” (which is just a check register), even though this has not been required for many years: charter cities and counties have always been able to establish their own procedures for the payment of vendor invoices; and under Government Code Section 37208 (adopted in 1979 and amended in 1986), most local agencies that formally adopt their budget by ordinance or resolution—and all local agencies that prepare a comprehensive annual financial report—are not required to receive governing body approval before issuing checks to vendors. Continuing to present the Register of Warrants for governing body approval wastes resources and limits the agency’s ability to issue checks on a timely basis, considering that in many cities, particularly, councils meet regularly only twice per month. By using the Register of Warrants for its intended purpose—to serve as an internal control check register—local agencies can move to more frequent payment cycles. This results not only in more timely payments but greater staff productivity, as paying vendors becomes a continuous process, rather than a semi-monthly project. This allows both the governing body and staff to put their limited resources to higher-value uses. 122

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Appropriate internal controls need to be in place for the administrative approval of the check register; and of course, the check register should be available to anyone who asks to see it. Summing Up While the purchase of goods and services is a relatively modest component of costs for many local agencies, there are many ethical and legal hazards if purchasing operations are not conducted in a prudent manner. There is significant potential for missteps of substance or appearance that can undercut public confidence in the agency’s ability to manage its fiscal affairs—or any of its affairs, for that matter. On the other hand, local agencies need to balance their responsibility for good governance with efficient and effective purchasing practices that cut “red tape” and free up organizational resources for higher priorities.

In addition to providing public services by employing staff and purchasing needed goods and services, local governments frequently build or buy public facilities, or “capital improvements,” the subject of the next chapter.

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apital improvements are things that municipalities buy or build that have long lives and are expensive. Examples include fire stations, water treatment and sewer plants, parking structures, and roads, among others. There is no absolute definition as to how expensive or long lived a facility needs to be to qualify as a capital expense. For example, in some places, various vehicles may be considered capital items; in others they might be considered an operational expense. Some jurisdictions further differentiate between “major” and “minor” capital projects. In such cases, the former are usually reported and tracked in a Capital Improvement Plan (see below), while the latter are part of the agency’s operating budget. Capital Improvement Plans Most public agencies develop Capital Improvement Plans (CIPs) as part of their budgeting process.1 A CIP lists foreseeable capital purchases and other improvement projects in various stages of planning, acquisition, design, and construction over a multi-year timeframe. Many capital improvements simply involve buying products or undertaking routine construction projects. But others may be much more complicated and could include some or all of the following steps from concept to completion: • • • • • •

Study and feasibility analysis Environmental review Design Real property acquisition Site preparation Construction

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Guide to LocaL Government Finance in caLiFornia Illustrative Information for a CIP Project

For each project, the ciP should provide a description, objectives and policy nexus, phases, timelines, cost estimates, and funding sources. consider this hypothetical example: Sewer Lateral Replacement at a Police Station

CIP Project Summary replacing the sewer lateral at the police station to eliminate repeated clogging will cost $50,000 in 2009-2010. Project Objectives 1. eliminate repeated sewage intrusion to the building. 2. minimize police operations disruptions. 3. reduce needed emergency responses. 4. reduce exposure of staff to raw sewage. 5. maximize building service life. 6. maintain a positive image for the city. Existing Situation the building age of the police annex building is estimated to be eighty years old. Street tree roots have infiltrated the sewer lateral, requiring repeated emergency repairs for pipe clogging. replacing the sewer lateral will prolong the life of the building and reduce frequent emergency line clearings that sometimes disrupt police operations. Goal and Policy Links 1. adopted city goal: maintain infrastructure 2. adopted city policy: provide proper work environments for employees 3. adopted city policy: maintain buildings to maximize facility service life 4. Planning commission has found this consistent with the General Plan Project Work Completed to Date an evaluation of the problem and determination of possible solutions has been done by staff. Environmental Review categorical exemption; no further environmental review is anticipated. Project Constraints and Limitations no constraints or limitations are anticipated. Key Stakeholders Staff and visitors using the building Project Phasing and Funding Sources Funding: General Fund Phasing: Project will be done in a single phase in the current fiscal year

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• • •

Construction management Equipment acquisition Building commissioning

All capital improvements should be clearly linked to an agency’s goals and policies, and a good CIP will articulate this nexus between projects and adopted policy. State law explicitly requires cities and counties to find that anticipated land acquisitions and capital projects are consistent with their adopted general plans. A CIP will also include cost estimates for each phase of a project as well as available or expected funding sources. Figure 10-1 illustrates how some CIPs are summarized to help decision-makers and the public better see the scale and scope of pending major projects. For each major capital project, however, more detailed information is usually provided. See the sidebar for an example. Paying for Capital Improvements Like most individuals and businesses, public agencies build or purchase large, expensive items either by paying with cash or by borrowing money.

Pay as You Go. Using cash is often called the “payas-you-go” method. For example, a city may require developers to contribute traffic mitigation fees into a special fund to help pay for a new traffic signal; when the fund reaches sufficient size, the city can install the needed improvements. Public agencies may also use revenues from the general fund or from enterprise funds. In the latter case, the money can only be used to pay for capital projects associated with that particular enterprise function. Other sources of cash for specific capital improvements include grants and donations.

Development Impact Fees and Exactions. As discussed in Chapter 5, municipalities may charge fees on new development to raise money for infrastructure improvements needed to address impacts from that new development. There are specific requirements for

chapter 10: capital improvements and debt Financing: Building things Figure 10-1. CIP Summary Table

adopting such fees and they must be treated as special funds (usually capital project funds) to ensure they are used in a timely way for the intended purposes. (See Chapter 5.) Common development impact fees address water, sewer, transportation, drainage, recreational open space, and parks facilities, although other kinds of capital projects may be included. In all cases, the municipality’s fee program must show a reasonable relationship connecting the project to the resulting impacts on infrastructure and between the amount and uses of the fee and the mitigation of those impacts. Court cases clarify that the costs imposed on the developer must be roughly proportional to the project’s impacts for which the fee is meant to mitigate. Sometimes a municipality when approving a new development project will require the developer to install infrastructure that is especially needed to support the project as a condition of approval. Common examples are curbs, gutters, sidewalks, street trees, street lights, transit stops, water meters and laterals, and many others. The developer typically submits improvement plans to the local agency for review and approval, and then installs the required facilities in accordance with the approved plans. When requiring exactions, local agencies should meet the nexus, reasonableness and general proportionality standards required for impact fees.

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Alternatively, in some situations, local governments can borrow money for capital improvements.

Debt Financing: Federal and State Low Cost Loan Programs. For certain types of capital facilities, the state or federal government may be able to offer low-cost loans. The most common such loan programs are the U.S. Environmental Protection Agency’s Clean Water Act (CWA) State Revolving Fund and Safe Drinking Water Act (SDWA) State Revolving Fund. The CWA fund provides favorable financing for projects that address non-point source water pollution, certain watershed and estuarine protection projects, and for municipal wastewater systems. The SDWA fund is targeted to upgrading public or private water systems to comply with safe drinking water standards. Competition for these loans is often acute.

When Does Borrowing Make Sense for Capital Projects?

Local government agencies should refrain from long-term debt financing except when the following criteria are met:

• • • •

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the money will be used for a one-time capital expenditure. the capital facility’s life exceeds the term of the borrowing. the borrowing won’t adversely affect the agency’s credit rating. the source of repayment is clearly identified and reliably available.

Debt Financing: Municipal Bonds. Public agencies typically borrow money for capital projects by issuing “bonds”—conceptually, a bond is an IOU that promises a lender that the local government will pay back the loan principal, at a specified interest rate, within a specified timeframe. These are called “municipal bonds” or sometimes “muni” bonds. The total amount that the agency needs to borrow is broken down into smaller “chunks” or denominations that constitute the most appropriate size for the investors that are targeted as most attracted to offering loans. For example, a city may issue ten million dollars in bonds, each priced at $5,000. The investors buy the bonds that can be cashed in at maturity for the face value (principal) plus the specified interest. When individuals buy the bonds it is called a “retail sale.” However, most municipal bond purchasers are institutions or large pooled mutual funds. These purchasers may hold the bonds or they may re-sell the bonds to other investors. There is a significant global secondary market for municipal bonds. Bonds issued by local government agencies are evaluated by private ratings companies, principally, Moody’s, Standard and Poors, and Fitch. The rating companies assess municipalities in basically the same way that credit agencies look at individuals: what is the agency’s ability to pay back the loan and what is its record regarding its willingness to pay back loans. To gauge ability to pay back the loan, the rating company will consider the strength of the local economy, the health of the agency’s finances, generally, and the source of revenue that the agency will use to pay off the particular loan. They evaluate willingness to pay by looking at the agency’s past performance; for example, has the agency ever defaulted on a loan? They will also consider the political stability of the agency; for example, does the agency have a history of political or legal turbulence that might affect the debt? The rating system labels vary from company to company. For example, Standard and Poors rates the highest quality bonds as AAA. These are considered the safest: the agency is almost surely going to make good on the loan. The ratings

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indicate progressive levels of risk from AAA to AA to A to BBB to BB, and so forth. Frequently “+” or “-” or other notations are appended to the letters to indicate more subtle variations in quality or safety. Bonds that are below the BBB range or its equivalent have some significant risk associated with them and are usually considered “non-investment grade,” sometimes called “junk bonds.” They are deemed to be vulnerable to changes in the economy or the future circumstances of the issuing agency. Naturally, bonds that are the most likely to be paid back—the highest quality, the safest ones—will enjoy lower interest rates. Certain investors want the safety of those bonds, so they are willing to accept lower returns. On the other hand, if a bond is rated as risky, lenders expect the prospect of higher returns to induce them to loan the money. The lower the rating, the higher the interest rate the agency is going to have to pay to attract buyers of the bonds. Most municipal bonds issued in California are considered “tax free.” That means that the interest that the lender earns on the bond is not subject to federal or California income taxes. Thus, local governments can generally borrow money at lower rates than private corporations. Investors who are seeking tax-free income are especially attracted to municipal bonds.

Issuing Bonds: the Process and the Players. The process for issuing municipal bonds is complex, and may vary depending on the type of public agency, type of project to be financed, type of bond instrument used, and other factors.2 That said, the following describes the general process and the typical specialists involved. The public agency that wishes to sell the bonds is called the issuer. Once the legislative body decides to pursue debt financing, it assembles a financing team composed of key staff members and several outside consultants. A financial advisor—who may be an independent consultant or investment banker—assists the issuer develop a financing plan including a feasibility analysis, and provides expert information on market conditions, appropriate rates and terms, and helps represent the issuer when submitting materials to the ratings agencies. A critical member of the team is the bond counsel, who provides specialized legal advice regarding the proper process, required disclosure and the overall legality of the bonds. Perhaps the most critical function of the bond counsel is to assure investors that the bonds meet state and federal requirements so that interest earned on the bonds is exempt from income taxes. Bonds can be sold through “negotiated” sales or through “competitive” sales. In the case of the former, the issuer and a bond underwriter negotiate the terms and price and enter into an exclusive agreement. The underwriter will purchase the bonds and re-sell them to other parties. In a competitive sale, the issuer solicits sealed bids from underwriters and then selects the best one. In

Short-term Borrowing

Local governments in california are generally prohibited from borrowing money for any purpose except for capital projects. unlike the federal government, cities are prohibited from borrowing to cover operational costs. the one type of exception is when a city is waiting on money (anticipating funds) due to it from a specific source. consider property tax revenues: the tax is distributed to the various agencies receiving a share twice a year. Local governments may take out short-term loans, called tax and revenue anticipation notes (trans), that provide cash immediately in amounts up to a certain percentage of the tax revenues they expect to get when the annual property tax proceeds are distributed. the local agencies pay back the lender, with interest, when the tax revenues arrive. Similar short-term loans are Bond anticipation notes (Bans) or Grant anticipation notes (Gans). in all cases, the source of money to pay back the short-term borrowing is clearly identified. the term for these notes typically cannot exceed fifteen months.

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some cases, such as General Obligation bonds (discussed further below), the agency must use a competitive sale pursuant to state law. The financial team submits its financing plan and supporting materials to an independent ratings agency, typically located in New York, that evaluates the quality of the bonds; that is, it assesses how likely the issuer is to pay back the loan, on time, with the specified interest. Often the financing team visits the offices of the ratings agency, presenting information supporting the creditworthiness of the issuer. Besides strictly financial data, the team may provide information about the experience and expertise of the team itself, the political stability of the issuer, the long-term viability and vitality of the community, and the issuer’s expertise in delivering the capital project to be funded through the bond sale. Credit ratings can be enhanced by the purchase of a bond insurance policy that guarantees the payment of principal and interest on the bonds, or by other types of assurances by third parties. In certain cases, bond insurance is simply required by law or as a condition of assuring investors of the creditworthiness of the issuer.3 The issuer may also select a trustee or agent, such as a bank or other financial institution, that actually administers the collection of bond proceeds and the repayments. The agency is responsible for complying with federal arbitrage regulations. Arbitrage is the ability to obtain tax-exempt bond proceeds and invest the funds in higher-yielding taxable securities, resulting in a profit. Generally, such arbitrage must be rebated to the federal government. A special fiscal advisor may be hired for this purpose. The financial advisor and bond counsel also assist the issuer with meeting federal regulations that mandate the governing body’s approval of an official statement and that require continuing disclosure of information by the issuer to enable investors to make informed decisions.

Debt Policies. Many agencies that regularly access the debt markets find it useful to have a formal, written debt policy. This approach helps ensure that decisions on particular proposals are not made hastily because of immediate political pressures. Guidelines and sample debt policies are available from the GFOA. Major Types of Debt Instruments for Local Agencies in California The following summarizes the major ways public agencies in California can borrow money for different kinds of capital projects. These are sometimes referred to as debt or financing “instruments.”

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General Obligation Bonds. In California, cities and counties can use General Obligation or “G.O.” bonds to finance capital projects, including the acquisition of land. Various state statutes also authorize special districts to issue G.O. bonds. When issuing G.O. bonds, the local agency pledges its “full faith and credit” to repay them, and property taxes are usually increased to cover the obligation. These bonds are considered low risk to investors and generally garner high ratings and favorable interest rates. However, use of G.O. bonds and the attendant property tax increase by cities, counties, and special districts requires that the issue be placed before the local electorate and must be approved by a two-thirds supermajority. School districts may also issue G.O. Bonds. A constitutional amendment approved in 2000 lowered this hurdle to fifty-five percent for school districts as part of a strategy to lower development impact fees imposed by school districts on new housing projects. Another consideration relevant to G.O. bonds is the municipal debt limit. The combined outstanding debt of a city secured by property taxes generally cannot exceed 3.75 percent of the combined assessed property value of the city. For counties, the debt limit is generally 1.25 percent (with some exceptions). In determining the limit, however, the outstanding general obligation debt among all local public agencies (school districts and special districts) must be tallied and not just the debt issued by the city or county. In some locations, this limit may be an insurmountable hurdle to issuing new G.O. bonds.

Revenue Bonds. Public agencies may issue bonds to finance facilities for enterprise functions using revenues from those functions to pay the debt service. Common examples include financing sewerage and water facility upgrades, parking structures, toll roads, and bridges. Revenue bonds do not need the two-thirds voter approval because they are not repaid by taxes but by the enterprise income. They may require voter approval, however, in some cases, depending on the type of revenue or specific authorizing laws.

Certificates of Participation and Lease Revenue Bonds. A certificate of participation (COP) is a debt instrument similar to a bond that, in certain circumstances, has advantages over more traditional bond financing. A COP is an undivided interest in future lease payments made by a public agency for use of some facility. For example, a city desires to build a new fire station. The city creates a non-profit corporation (or the city may partner with a Joint Powers Authority, bank, or property leasing company). The non-profit sells COPs to finance the station. The city then leases the station from the non-profit, and the lease payments cover the debt service. The portion of the lease payment that goes toward interest payments is tax-free. Because lease payments, not taxes, are used to pay for the financing, voter approval is not required. When the debt is retired, the city usually assumes ownership of the station. 131

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The ratings agencies analyze COPs similarly to how they would more traditional bond issues, recognizing the close relationship between the issuing entity and the lessee. Lease revenue bonds are similar to COPs in that the lease income is pledged to offset the debt obligation. After the passage of Proposition 13 and restrictions on general obligation bonds, many agencies turned to COPs to finance projects. As experience with these types of instruments has increased, lease revenue bonds, rather than COPs, are more commonly used today.

Assessment District Bonds. Property owners may be “assessed” to pay for certain public facilities that afford special benefits specifically to the affected properties. Examples include sewer, water, road and sidewalk improvements, among many others. The public agency first defines an “area of benefit” or district, and assigns a share of the benefit (and commensurate cost) to the property owners in the area based on an engineering analysis. After notice and a public hearing, the property owners in the district vote on the proposed assessment. But unlike a vote of the general electorate, the votes are weighted to reflect the cost borne by each property. For example, if the analysis indicates that a commercial parcel will benefit twice as much as a residential parcel, the commercial lot would be required to pay double what the residential lot would pay. However, the commercial lot owner also gets two votes in the assessment election, while the residential lot owner would only get one. Similarly, owners of multiple lots are entitled to multiple votes. If approval of the district fails, the public agency must wait at least another year before taking up the issue again. If the district is approved, the agency may issue bonds for the facilities, using the assessment fees to retire the debt. The most commonly used provisions for forming assessment districts are contained in California laws from the early part of the twentieth century and they are referred to by the year of their adoption. The 1911 and 1913 Acts provide for the establishment of assessment districts and for the issuance of bonds. The 1915 Act also enables the use of bond financing, but requires the agency to use other statutes to actually form the district. Later statutes, including Proposition 218 and its subsequent clarifying legislation, have further refined the requirements for establishing districts and for issuing debt.

Tax Increment Financing. Tax increment financing uses the growth in property tax revenue that results from property development to pay for the financing of that property development. “Tax allocation bonds” are issued, backed by all or a portion of the incremental growth in property tax revenues that occurs as property values increase over time. The basic concepts of tax increment financing have been used effectively for hundreds of years throughout the world, including in California until 132

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recently. With the elimination of California’s redevelopment agencies in 2012, California was left without a means to use tax-increment financing for economic development or public facility construction until, in 2014, the legislature produced two new tools authorizing the use of tax-increment financing. However, both tools allow the use only of tax increment of consenting cities, counties, or special districts and do not allow the use of property tax increment from the school portion of property tax share. Consequently, the state of California (through the school share of property tax) provides no financial support and the capacity and viability of these tools is quite limited. An Enhanced Infrastructure Financing District (EIFD) may be established to use property tax increment of those taxing agencies in that area that consent (cities, counties, special districts, but not schools). To issue tax allocation bonds backed by this tax increment, an EIFD must receive the approval of fifty-five percent of registered voters within the proposed district, or—if there are twelve or fewer persons registered to vote—a majority vote of landowners (one vote per acre or partial acre). EIFDs can finance the construction or rehabilitation of a wide variety of public infrastructure and private facilities, including: •

• •

• • • • •

• • • • •

•

Highways, interchanges, ramps and bridges, arterial streets, parking and transit facilities. Sewage treatment, water reclamation plants, and interceptor pipes. Facilities for the transfer and disposal of solid waste, including transfer stations and vehicles. Facilities to collect and treat water for urban uses. Flood control levees and dams, retention basins, and drainage canals. Parks, recreational facilities, open space, and libraries. Brownfield restoration and other environmental mitigation. Projects on a closed military base consistent with approved base reuse plans. Industrial structures for private use. Transit priority projects. Projects which implement a sustainable communities strategy. Mixed-income housing developments. Facilities constructed to house providers of consumer goods and services. Child care facilities.

A Community Revitalization and Investment Authority (CRIA) may be used where at least eighty percent of the property located within the revitalization area can be characterized by: 133

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An annual median household income that is less than eighty percent of the statewide annual median income; and three of the four following conditions: a) A nonseasonal unemployment rate three percent higher than the statewide median unemployment rate; b) Crime rates five percent higher than the statewide median crime rate; c) Deteriorated or inadequate infrastructure, such as streets, sidewalks, water supply, sewer treatment facilities, and parks; or d) Deteriorated commercial or residential structures.4

CRIAs are empowered to used eminent domain and are generally authorized to plan and fund the: •

• • • • •

Rehabilitation, repair, upgrade, or construction of public infrastructure; brownfields cleanup; low- and moderate–income housing; seismic retrofits of existing buildings; owner or tenant improvement loans; assistance to businesses for certain industrial and manufacturing uses.

CRIAs may issue long-term debt, backed by property tax increment. Voter approval is not required. At least twenty-five percent of tax increment collected by a CRIA must be used to increase, improve and preserve the community’s supply of affordable housing.

Mello-Roos Special Tax Districts. Property owners in a prescribed “special tax district” can vote (two-thirds majority) to impose a special tax to pay for capital improvements (as well as various public services). There is greater flexibility in what kinds of facilities can be funded than with many of other debt instruments. Mello-Roos financing has been most frequently used by developers who are required by the local jurisdiction to install public facilities supporting the new development. Often there is only a single property owner (who may also be the developer); thus, the two-thirds vote is easy to obtain. The special tax is passed on to the future owners (usually homeowners) of the development. The city or county proposes the formation of the special tax district and subjects the proposal to a vote. If fewer than twelve registered voters live in the district, then a two-thirds majority of the property owners can approve the special tax. The votes are weighted by the size of each property-owner’s holdings. In cases of twelve or more registered voters residing in the proposed districts, then the two-thirds majority must be garnered from them. 134

chapter 10: capital improvements and debt Financing: Building things Figure 10-2. Features of Capital Financing Methods

Special tax districts became quite unpopular in the late 1990s as residents realized that they were paying higher taxes than others outside the districts, often for the same or similar levels of service.

Other Infrastructure Financing Tools. Two types of bonds are used by Joint Powers Authorities (JPAs). Sales tax bonds are used primarily for transportation related improvements; usually, a county-wide Transportation Authority is formed among the county and its various cities. A sales tax increase is presented to the voters, usually a one-quarter or one-half cent increment. If approved by a two-thirds majority, the sales tax increase can be dedicated to repay bonds. Marks-Roos bonds are also used by JPAs. They have been most often used by jurisdictions that wish to issue relatively small amounts of debt. Through the JPA, they can combine the small amounts into larger issues, resulting in efficiencies and sometimes more favorable rates. 135

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One other type of bond is available to local governments. With conduit bonds, the public agency passes through the debt obligation to a private party who thereby gains favorable tax status for the bonds. The funding can be used to build public infrastructure required to support private projects, usually large scale commercial or industrial developments favored by the community. Summing Up Local governments buy and build a wide variety of expensive, long-lived facilities to serve their communities, which are referred to as capital improvements. Municipal budgets should include a Capital Improvement Plan that forecasts the costs of planning, designing and building capital projects over several years. Good CIPs are always closely linked to a community’s expressed goals and policies. Cities and counties are required by state law to find their CIPs consistent with their adopted general plans. Capital projects can be undertaken through a “pay-as-you-go” process, which is paying for the facility in cash, or through debt financing. Most large projects are debt financed. Local governments sell bonds to borrow money. There are numerous types of bonds local governments can use in California. The major types of instruments and some of their key characteristics are summarized in Figure 10-2.

The last three chapters discussed the major ways public agencies spend their money. Local governments will have unexpended money, for example, tax or other revenue proceeds being held until needed, or simply reserves to smooth cash flow requirements and for emergencies. The next chapter discusses how this “surplus” money is invested.

NOTES California Government Code § 65403 lays out guidance for special districts regarding CIPs but does not require them to use that particular approach when planning capital improvements. 2 The California Debt Issuance Primer by the California Debt and Investment Advisory Commission is an excellent source of additional introductory information about debt financing and the various debt instruments available to public agencies in this state. 3 However, in turbulent credit markets, bond insurance may not be available. 4 Alternatively, a revitalization area may be established within a former military base with largely deteriorated or inadequate infrastructure and structures. 1

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ocal government budgets typically involve collecting and spending many millions of dollars each year. Some of these revenues come in large “chunks” rather than continuous or even streams over time. In addition, many agencies hold substantial reserves in case of unexpected emergencies or other contingencies. That means local agencies will be responsible for managing that money, including properly investing surplus funds until actually needed. Municipal investment practices are often unfamiliar to most people until a crisis occurs such as the bankruptcy of a local public agency due to inadequate reserves, unwise investment decisions, or poor accounting controls. This chapter discusses investment strategies, and outlines some of the principal pitfalls of local government money management and approaches to avoiding them. Fundamental Principles for Investing Public Funds The overwhelming consensus among public investment managers is to follow the “SLY” principles, in priority order: • • •

Safety Liquidity Yield

A local agency should only consider yield in making investment decisions after assuring that safety and liquidity needs have been met. These concepts are so basic to the investment of public funds that they are clearly set forth in California Government Code Section 53600.5: When investing, reinvesting, purchasing, acquiring, exchanging, selling, or managing public funds, the primary objective of a trustee shall be to safeguard

They May Be Clichés, But They Are Fundamentals

• if it’s too good to be true, it probably is. (When it comes to the investment of public funds, the “probably” modifier should be stricken.) • never put all your eggs in one basket (no matter how strong and attractive that basket may seem). • the only way to sustain above market yields is to take above market risks. • only invest funds in instruments you fully understand and can easily explain to others, including the governing body.

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Financial Management Calamities

there have been no failures in local government financial management in california as serious and pronounced as investment losses that resulted from either the lack of clear and prudent policies, or the failure to follow them. the inappropriately aggressive quest for higher yields with public monies has sometimes led to enormous financial losses for the local government, has at times cost professionals their positions, and in rare cases has even resulted in criminal prosecutions. While there are (unfortunately) many others, the following are three illustrative examples of california investment fiascos in a ten-year span from 1984 to 1994:

•

•

•

in 1984, the city of San Jose lost $60 million in its investment of bond proceeds. While this was a relatively modest portion of the city’s overall portfolio at the time, it was, nonetheless, a big hit on its finances. as mayor tom mcenery noted

at the time: “We lost enough money to pay for 100 cops for ten years.”1 along with the investment loss, certain top administrators in San Jose were fired or resigned in the wake of these events. three years later, the city of camarillo lost $30 million in investments. While less than San Jose’s investment loss, it was proportionately a much greater one. it wiped out camarillo’s entire investment portfolio—all of its funds as well as employee contributions to its deferred compensation program. Several top administrators lost their jobs in this case as well. even with the two cases serving as recent cautionary tales, in 1994 orange county suffered $1.6 billion in investment losses. this not only affected orange county, but almost 200 other cities, special districts, and school districts that had placed funds in the orange county investment pool (several of whom had borrowed funds in order to make even larger investments in the pool). it also resulted in felony convictions and jail terms for several senior officials, including the county treasurer, due to attempted cover-ups as losses began to surface.

in each of these cases, the inappropriate investment actions were not taken for personal financial gain, but rather to achieve higher yields for the public agency. While the pursuit of high yields may be an appropriate gamble in certain private sector situations, there is— and should be—a different and more conservative standard for the investment of public funds. and in each of these cases, the problem was not necessarily the investment instruments per se (for example, many were u.S. treasuries or similar, highly rated governmentsponsored enterprise securities), but with inappropriate uses of those investment instruments. Such troubling uses included risking long-term investment funds on shortterm interest rate changes or leveraging investments by using money not readily in hand. the problems generally related to “market risk”—the loss of value due to changes in interest rates. as discussed further in the text, if the investment term had been based on cash flow needs with the intent to hold the investment instruments until maturity, the most catastrophic losses would have been avoided.

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the principal of the funds under its control. The secondary objective shall be to meet the liquidity needs of the depositor. The third objective shall be to achieve a return on the funds under its control.

The following summarizes the concepts underlying these principles, and possible approaches for prudently addressing them.

Safety. The safety of principal should be the foremost objective of an agency’s investment program. This means making investments in manner that seeks preservation of capital in the overall portfolio. The most common strategy is to diversify investments so that the impact of potential losses from any one type of security or from any one individual issuer will be minimized. Diversifying an agency’s portfolio by issuer, type of investment, and maturity terms is the primary tool available in minimizing investment risk and capital losses. Of course, there is some level of risk in any form of investment, even those considered the safest. And being overly cautious is not a prudent policy either as it will lead to unreasonably modest returns. Accordingly, the public portfolio manager’s goal is not absolute avoidance of risk, but to mitigate risk in pursuing a reasonable level of return. Two types of risks are especially germane to investing public funds.

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Credit Risk. This is the risk that an investment will lose some or all of its value due to a real or perceived change in the ability of the entity receiving the investment funds to actually make good on the agreed upon returns. This is most common when investing in debt instruments and assessing the actual ability of the issuer to pay back the debt. The degree of credit risk depends on the type of investment instrument. Common strategies for mitigating credit risk include 1) limiting investments to the safest types of securities;2 2) pre-qualifying the financial institutions, broker/dealers, intermediaries, and advisors that the agency will do business with; and 3) diversifying investments within the portfolio by instrument type, issuer and maturities.

Interest Rate Risk. Interest rate risk (or “market risk”) is the risk that the portfolio will decline in value due to changes in the general level of interest rates. Generally, longer-term portfolios usually achieve higher returns; on the other hand, longer-term portfolios also have higher volatility of return, and thus greater interest rate risk. The market value of virtually all portfolios is likely to change over time, both up and down, based on the yield of the investment at the time of placement versus current interest rates. For example, a very safe U.S. Treasury bond purchased with a remaining life of three years with a four-percent yield will be worth more than its original par value one year later if interest rates fall to three percent. On the other hand, it will be worth less than its par value one year after this if interest rates rise to five percent. However, if the intent is to hold until maturity, the agency will be unaffected by these fluctuations over time, since it will have received the interest earnings and return of principal at the time of maturity that it planned on at the time of placement (original purchase). Whatever the change in its market value up and down over the threeyear term, its market and par value will be the same at maturity. However, if the agency is forced to sell the otherwise very safe Treasury bond before its maturity when interest rates are five percent, it will suffer a significant investment loss, since the security will have to be sold at less than its book value (at a discount) in order to compensate investors for a yield that is lower than market rates. The most common (and common sense) approach to mitigating interest rate risk is to base the maturity term of investments on cash flow needs. This means providing adequate liquidity for shortterm cash needs and making longer-term investments only with funds that are not needed for current or pending cash flow purposes. Interest rate risk can be largely mitigated if investments are placed at the time with the intent (and ability) to hold them until 139

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maturity. That said, investments may be appropriately sold before maturity for several reasons, including: • • •

Meeting unexpected cash flow needs. Improving the quality, yield or target duration in the portfolio. Realizing capital gains that better positions the overall portfolio in achieving articulated investment goals.

However, public fund investments should not be bought with the sole intent of speculating on the future direction of interest rates. Failure to follow this fundamental premise has been the primary cause of the significant investment losses in some agencies. For this reason, in response to these losses due to interest rate risk, the state adopted Government Code Section 53601, which precludes local agency investments of greater than five years, except under specific circumstances approved by the governing body.

Liquidity. This means ensuring that the investment portfolio will remain sufficiently liquid (readily convertible to cash) to meet all operating requirements that may be reasonably anticipated. This can best be accomplished by structuring the portfolio so that investments mature in accordance with cash needs to meet anticipated demands (“static liquidity”), for example, by investing a portion of the portfolio in money market mutual funds or local government investment pools that offer same-day liquidity for short-term funds. However, since all possible cash demands cannot be anticipated, the portfolio should also consist largely of securities with active secondary or resale markets (“dynamic liquidity”).

Yield or Return on Investments. Return on investment is of least importance compared to the safety and liquidity objectives described above. The core of investments should be limited to relatively low risk securities in anticipation of earning a reasonable return relative to the risk being assumed.

The pursuit of a reasonable return on investments that recognizes the need to minimize the potential for capital losses arising from market changes or issuer default is an appropriate goal; pursuing above market yields that by their nature require taking above market risks is not. As the unfortunate experiences of many agencies show, when it comes to public accountability, no matter how successful an aggressive approach may seem in the short run, it will never be sufficiently high to offset the public controversy (or worse) that results from investment losses.

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chapter 11: investments: managing the Public’s Portfolio Surplus Funds: Why Do They Exist? In order to make investments, local agencies must first have “surplus funds” to invest. Where do these surplus funds come from? There are several sources: •

• •

• • •

•

•

Short-Term Cash Availability. Agencies that are largely dependent on property taxes must be able to operate from the beginning of the fiscal year (that typically begins in July) until revenues are received from the county in December. In planning for this six-month period, agencies will have cash that is available for investments at certain points in the fiscal year. Reserve Policies. Agencies may also have money resulting from minimum fund balance requirements in the general fund or working capital policies in the general fund and enterprise funds.

Pay-As-You-Go Capital Project Funding. In many cases, agencies may set funds aside in order to accumulate sufficient money to undertake future projects. (This is especially likely to be the case for projects funded by development impact fees.)

Equipment and Facility Replacement Funds. Money may be available when agencies set funds aside annually to pay for future equipment and facility replacements.

Bond Proceeds: Construction Fund. When agencies sell bonds for capital projects, the proceeds for construction and acquisition are likely to be drawn-down over several months or even years.

Bond Proceeds: Debt Service. Many bond issues require establishing a bond reserve that is equal to one year of debt service payments. These reserve funds will need to be invested in some fashion during the life of the bond issue.

Internal Service Funds. Many agencies maintain internal service funds that may generate cash balances in fully recovering costs like depreciation. Additionally, general liability and workers compensation funds may also have significant cash balances in funding actuarial liabilities where cash disbursements will be made in the future.

Trust Funds. Funds may be made available by donors where the intent is to fund programs from the investment earnings on the initial principal amount (or some combination of interest and principal). Pension and retiree health contributions also fall into this category. 141

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Cash Flow Projections Are Essential. As reflected above, there are a variety of reasons that agencies may have “surplus” funds available for investment. For this reason, to best meet liquidity needs and mitigate interest rate risk, agencies should prepare cash-flow projections that take into account the timing of receipts, disbursements, and resulting cash balances. Based on this analysis, they can appropriately structure the amount of the portfolio that should be placed in short-, medium- and longer-term investments. Investment Authority

Elected or Appointed Treasurer?

From time to time, the pros and cons of an elected versus an appointed treasurer surfaces in city governments. in recognition of the needed expertise for the position, there has been a recent trend away from elected to appointed treasurers. a 2010 San Luis obispo county grand jury concluded that:

City councils in Arroyo Grande, Atascadero, and Paso Robles should consider trying again to convince the electorate to make . . . the position of treasurer appointive, while educating the electorate about the qualifications needed in a treasurer and committing the city to require appointed treasurers to possess those qualifications . . .4

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Ultimately, the governing body is accountable for the agency’s investment policies and practices. However, the agency’s treasurer is the official that is responsible for serving as the local government’s investment officer and, thus, for managing its portfolio. This position may be elected (as it is in about forty percent of cities3 and almost all counties in California) or appointed (as they are in sixty percent of cities in California and most special districts). For cities and counties, voters determine whether the treasurer will be elected or appointed (in the case of appointment, this is usually by the governing body but in a few cases by the chief administrative officer). Except in larger cities, elected treasurers are often part-time, “honorific” positions, with the day-to-day responsibilities assigned to the finance department or division. While this is also the case for many appointed treasurers, an approach used in many cities in order to assure accountability and avoid “turf battles” is for the city council to appoint as city treasurer whomever the city manager has appointed as finance director. Evaluating Investment Officer Actions. As set forth in Government Code Section 53600.3, investment officers are held to the “prudent investor” standard of care: When investing, reinvesting, purchasing, acquiring, exchanging, selling, or managing public funds, a trustee shall act with care, skill, prudence, and diligence under the circumstances then prevailing, including, but not limited to, the general economic conditions and the anticipated needs of the agency, that a prudent person acting in a like capacity and familiarity with those matters would use in the conduct of funds of a like character and with like aims, to safeguard the principal and maintain the liquidity needs of the City. Within the limitations of this section and considering individual investments as part of an overall strategy, investments may be acquired as authorized by law.

Where investment officers act in accordance with written procedures and adopted investment policies and exercise due diligence, this means that they should be indemnified from personal responsibility for an individual security’s credit risk or market price changes, provided deviations from expectations are

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reported in a timely fashion and the liquidity and the sale of securities are carried out in accordance with the adopted policies. Investment Management Effective investment management follows three basic steps:5 • •

•

Developing investment policies and related strategies. Making individual investments in accord with the adopted policies and strategies, considering economic and market conditions and cash flow requirements. Making adjustments as needed in light of changed circumstances. Figure 11-1. Effective Investment Management

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The importance of clear investment policies and strategies in this management system is discussed in greater detail later in this chapter.

State Investment Policies and Reporting. In responding to the local agency investment losses that occurred from 1984 through 1994, the state adopted a series of requirements for the preparation of investment policies and reports. However, to avoid mandated cost reimbursements to comply with these requirements, the state subsequently repealed them and made them voluntary. In the case of counties, the state has set forth specific policy, investment oversight committee and reporting requirements, if the county chooses to have them. However, while no longer required, it is clearly a “best practice” for agencies to adopt clear investment policies and to follow them, to review and update them on a regular basis, and to report investment activities and results on an ongoing basis. In fact, these three actions—clearly articulating appropriate policies, following them, and then reporting on results—are the most effective way of avoiding investment losses and the serious erosion of public confidence that comes with them.

Allowable Investments. Government Code Sections 53601 and 53635 set forth limits on the investment vehicles available to local agencies in California. Figure 11-2 summarizes allowable investments for all local agencies.6 (See also the Glossary for brief descriptions of these investments.) As discussed above, while these are allowed investments, this doesn’t mean that they are appropriate for all agencies. Just because agencies may make these types of investments doesn’t mean they should. Each agency needs to determine suitable investments based on variables including the size of its portfolio, local circumstances, and staff resources and capabilities. The assessment of which investments to undertake is best made in the context of clear, adopted investment policies. Investment Policies

While a “Statement of Investment Policy” is no longer required by the state, it remains one of the key tools available to a public agency in appropriately managing its portfolio. While each agency needs to address for itself policies that make the most sense, the Government Finance Officers Association of the United States and Canada (GFOA) has prepared a sample investment policy, which is available on its web site at www.gfoa.org. It recommends that policies cover the following topics:7

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•

•

•

•

•

• •

Governing Authority and Responsibility. What are the legal constraints based on federal, state or other requirements? Who is responsible for what?

chapter 11: investments: managing the Public’s Portfolio Figure 11-2. Allowable Investment Vehicles

Scope. What investments does the policy apply to? For example, does it apply to all funds, or are there exclusions, such as bond proceeds, deferred compensation or pension funds? Are funds pooled, and, if so, how will earnings be apportioned among funds? Objectives. What are the goals of the investment program regarding safety, liquidity, and yield? How will the agency know whether goals and objectives have been achieved? What is the methodology for this evaluation?

Standards of Care. What is the standard of “prudence” to which investment officers will be held? What are the ethical standards and how will conflicts of interest be avoided? Authorized Financial Institutions, Depositories, and Broker Dealers. How will these types of advisors or agents be selected?

Safekeeping and Custody. What internal controls are in place to ensure protection of investments? What provisions are in place to ensure proper delivery of investments and for third-party safe keeping?

Suitable Investments and Parameters. What types of investments—and what portion of the overall portfolio and maturities— are appropriate? As noted above, the state has limits on allowable investments: the issue here is not what the agency may legally invest 145

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•

in, but what it should invest in, considering variables such as the size of its portfolio, local circumstances, and staff resources and capabilities.

Reporting. How often will reports be made, to whom will they be presented and what information will they contain?

Additionally, the California Municipal Treasurers Association (CMTA) has examples of investment policies from California cities, counties, and special districts on its web site at www.cmta.org. In some cases, agencies may prefer to formally adopt investment policies that are very broad in scope, which are then supplemented by a more detailed investment management plan.10 However, regardless of approach, the key principles and strategies that an agency will use in guiding its investment decisions should be clearly articulated, reviewed by the chief executive officer and governing body, and made publicly available.

Key Policy and Strategic Considerations. While the general contents of an effective investment policy are outlined above, local agencies should pay special attention to issues: Investment Goals and Evaluation. Investment policies and strategy commonly set forth broad goals, for example,

The primary investment objective is to achieve a reasonable rate of return on public funds while minimizing the potential for capital losses arising from market changes or issuer default. In determining individual investment placements, the following factors shall be considered in priority order of safety, liquidity and yield.

However, to effectively evaluate whether this goal is being met, agencies should consider setting benchmarks in evaluating how they are doing in achieving their “primary investment objective.” For example, a benchmark for effectiveness evaluation might read:

In evaluating the performance of the city’s overall portfolio in achieving this objective, it is expected that yields on city investments will regularly meet or exceed the average return on three-month U. S. Treasury Bills. It is also expected that the portfolio managed by investment advisors will meet or exceed the Merrill Lynch 0-to-5 year U.S. Treasury Bond Index.

Maturities: Matching to Cash Flow. As discussed above, it is essential that investment policies and strategies clearly articulate how maturities are determined: failure to set clear guidelines in this single

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area (or if set, failure to follow them) has been the greatest source of public scandal in the management of local government funds.

Local Agency Investment Fund (LAIF). Created in 1977 by Government Code Section 16429, the Local Agency Investment Fund (LAIF) is an attractive, voluntary investment vehicle for California’s local governments. It offers local agencies the opportunity to participate in a large, diversified portfolio (See Figure 11-3) that uses the investment expertise of the state treasurer’s investment staff. As of 2016, there were 2,640 agencies participating in LAIF with a combined portfolio of about twenty-two billion dollars. There are several significant advantages to investing in LAIF, including: Safety. Managed by professional, well-qualified staff in the State Treasurer’s Office, it has a highly diversified portfolio. With an average portfolio maturity of about 170 days, LAIF is part of the State’s Pooled Money Investment Account (PMIA), which as of 2016 manages an overall portfolio of $75.4 billion. The portfolio is very diverse, with about sixty percent invested in United States Treasury or other public agency securities. Liquidity. Funds can be deposited or withdrawn on a daily basis (although LAIF requests twenty-four hours notice for withdrawals of

Figure 11-3. State of California Pooled Money Investment Account (PMIA) Portfolio Composition

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ten million dollars or more). LAIF is also very flexible on the amount of investment: there is a nominal minimum of $5,000, with a maximum investment of $65 million per agency (as of 2016).

Reasonable Rate of Return. Given its portfolio policies and strategies for safety and liquidity, LAIF consistently offers very competitive rates of returns.

Use of Investment Advisors. Many local agencies have contracted with investment advisors to assist in managing part or all of their portfolios. Contracting for portfolio management services provides specialized professional expertise, risk management and continuity in the investment function even if individual staff members leave the organization. Contracting with an investment advisor can also free-up agency staff to perform functions where they may be able to better use their expertise and add value. Depending on an agency’s staff resources and abilities, in today’s volatile and global markets and considering modern complex investment instruments, a professional investment manager may be best suited for achieving an agency’s investment goals while minimizing portfolio risk. An investment advisor’s knowledge of securities and access to the markets should also result in enhanced investment earnings. Because of their greater expertise, investment advisors are held to a higher standard of responsibility: the “prudent expert” standard, rather than the “prudent investor.” As discussed earlier, many agencies may find investing largely (or wholly) with LAIF the safest, easiest and most efficient strategy. But while LAIF is a secure investment that yields market earnings, an over-concentration of the agency’s portfolio in LAIF may not meet diversification objectives. Turning to the expertise of an outside professional may allow the agency to better diversity its portfolio, using various investment strategies and instruments as appropriate. On the other hand, agencies should be wary of investment advisors who offer significantly greater yields than reasonable market benchmarks or those that are available elsewhere in the market (such as LAIF), or who propose fees based sharing “profits” from investments, or who “guarantee results.” There is only one way to consistently sustain above market yields, and that is to take above market risks. Portfolio management by investment advisors falls into two broad categories: discretionary and non-discretionary. Discretionary managers have the authority to execute investment transactions for their clients under the guidelines of governing law, policy, and written instructions. The advantage of discretionary management is that it limits the amount of time agency staff must spend on the investment function on a daily basis, freeing their time for other duties. It may also result in higher yields without sacrificing safety or liquidity. However, for this approach to be effective, the parameters for action by the 148

Why Not Simply Use LAIF Only?

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if LaiF is such a good deal, why not invest all agency funds with it? as noted, LaiF’s investment policies and strategies provide a high degree of safety from both creditor and market risks; and within this context, it provides very competitive yields. diversification also may suggest that, for many local agencies, especially those with smaller portfolios,8 investing most or all of their entire portfolio with LaiF as a way of reducing the risks associated with finding alternative safe vehicles. there are, however, two reasons why an agency should consider not placing its entire portfolio in LaiF:

•

•

Cash Flow Needs. as discussed above, agencies should consider their cash flow needs when reviewing investment maturities. the average weighted maturity of LaiF’s portfolio typically

ranges from 180 to 200 days (although there have been times when it was greater than this). under normal market conditions, investments longer than this will earn higher yields. as such, if an analysis shows that the agency can reasonably place some (or perhaps a large portion) of its portfolio in investments for periods longer than this, it is likely to earn yields greater than LaiF on that portion of the portfolio. However, in the absence of such an analysis that results in a high level of confidence that a portion of the portfolio can safely be placed for longer terms, LaiF is likely to be the investment vehicle of choice for most (and perhaps all) of the portfolio.

Protected from State Raids by Statute—But . . . While LaiF is very safe and very liquid from a structural standpoint, the “risk” in investing in LaiF may be an institutional one: the potential (real or perceived) that the state might access or freeze LaiF accounts—even if only temporarily—in tough fiscal times. this risk, however, is likely a limited one given legislation and court decisions.

LaiF deposits are fully protected by statute9 from state borrowing, impoundment or seizure, regardless of the state’s fiscal circumstances. in the thirty-one-year history of LaiF, the state has never frozen or limited access to LaiF accounts, even in the toughest of its budget years. that said, local agencies should avoid putting all their eggs in one basket—even a LaiF one. While LaiF itself is highly diversified, local agencies—especially those with large portfolios—should avoid relying solely upon it. While LaiF deposits may be clearly statutorily protected, they are not as clearly constitutionally protected, although Proposition 22 passed in 2010 added constitutional protection to a broad range of local revenues. it is reasonable to assume—absent countervailing political or legal forces—that what the state legislature statutorily protected, it can statutorily unprotect. and even if local government lawsuits ultimately prevailed in forcing the state to release LaiF funds, this could take many months (or years) to resolve—with the state, in the interim, able to achieve its cash flow goals in limiting or prohibiting LaiF withdrawals. For this reason, while fully investing in LaiF might otherwise make sense, local agencies with larger portfolios should consider placing at least some of their portfolio in investments outside of LaiF to mitigate “institutional risk.”

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investment advisor must be clearly articulated. For example, one city’s investment management plan states: The investment advisor must act in accordance with the City’s primary investment objectives and within the guidelines set forth in the Investment Management Plan. The initial configuration of the portfolio will be approved by the City Treasurer before placement.

The investment advisor will consult with the City Treasurer before selling investments at a capital loss, which may be appropriate in repositioning the portfolio for better gains in the future in meeting the City’s performance goals.11

Non-discretionary managers work in a similar way to discretionary managers, except that they must contact the client with their recommended transactions prior to their execution. The client then may give or withhold authorization to execute the recommended transactions. While this approach requires greater staff involvement (and may result in lower yields due to greater time constraints in making trades), many agencies may be uncomfortable delegating this level of discretion to an outside party. Regardless of the approach, agencies considering the use of an investment advisor should make the selection through a competitive request for proposals (RFP) process. Fortunately, there are several well-qualified firms that specialize in this type of service with offices in California. The California Debt and Investment Advisory Commission (CDIAC) provides a sample RFP for this purpose in its “Investment Primer” (available on its web site at www.treasurer.ca.gov/cdiac/ invest/primer.pdf) and the CMTA has sample RFP’s from several cities, counties and special districts on its web site at www.cmta.org.

Critical Importance of Third-Party Custodial Agreements. In 1992, a private investment firm managed a portfolio of $1.2 billion for sixty-four agencies in thirteen states as well as Micronesia.12 The firm reported yields of up to seventeen percent when other “SLY” investments were earning six percent.13 In accordance with the principle of “if it’s too good to be true, it is,” over $120 million in funds were found missing after an audit by the U.S. Securities and Exchange Commission. California public agencies that suffered losses included the cites of Torrance, Orange, Loma Linda, Grand Terrace, Beaumont, Palm Desert, Indio, Big Bear Lake, and La Quinta as well as the Coachella Valley Joint Powers Insurance Authority.14 On the surface, virtually all of the purported investments made by the firm were in highly safe U.S. Treasuries. However, what may have started as legitimate investments quickly turned into a large-scale “ponzi” scheme, with investments by new clients used to pay interest earnings to earlier ones. 150

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This was only possible because the investing agencies did not place their investments in third-party custodial safekeeping: they depended solely or the private firm to hold their investments and report on them. Instead of wiring funds to a third-party custodial account for settlement, they wired them directly to the firm. Agencies could have protected themselves through simple safekeeping arrangements. For example, the County of San Diego Retirement System had invested over fifty-million dollars in securities with the firm, yet they did not lose any funds because they were held in safekeeping by a third party.15 There are several banking institutions that specialize in third-party custodial safekeeping. The use of such “third-party” custodians—institutions other than the party that sold the investment to the agency—ensures that no funds are at risk in the transaction, since funds are not released until the actual securities are delivered. The “delivery versus payment” aspect of these transactions means that the agency will be holding either money or securities at all times during the transaction. Investments purchased through advisors should be held in safekeeping and the records of the custodian reconciled to those of the investment advisor on a regular and timely basis. The Governmental Accounting Standards Board (GASB), which sets generally accepted accounting principles for U.S. states and local governments, believes that holding securities in safekeeping is so important that how and where they are held—and the level of risk associated with this—must be disclosed in audited financial statements. Investment Oversight Committees

Establishing an investment oversight committee is optional for all local agencies. For counties, Government Code Section 27131(a) states that the Board of Supervisors may establish a treasury oversight committee. If they do, then the Government Code (in Sections 27131 and 27132) is very specific about the purpose, membership, and structure of this committee. For cities and special districts that choose to have investment oversight committees, their purpose and membership is at the agency’s discretion. Factors that local agencies should consider in assessing whether such a committee is desirable include the oversight and internal control procedures in place, the complexity of its portfolio, the frequency with which it purchases securities, and the skill level of its staff. Even where this assessment might lead to the conclusion that an oversight committee is not necessary, given the high profile of investment losses where they have occurred, agencies may want to consider establishing oversight committees to better assure transparency and instill public confidence. 151

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It is essential to clearly articulate the committee’s scope of responsibilities and membership. How broad and detailed is its role? Will its members be from internal staff or from the public (or some combination of the two)? And if it includes members from the public, are there specific qualifications for membership? The following is an example of the responsibilities and membership of an oversight committee as expressed in a city’s Investment Management Plan: The City will form an Investment Oversight Committee whose membership consists of the City Manager, Assistant City Manager, Director of Finance & Information Technology/City Treasurer, Finance Manager, and the City’s Independent Certified Public Accountant. The Investment Oversight Committee is responsible for 1) reviewing the City’s portfolio at least quarterly to determine compliance with the Investment Management Plan; and 2) reviewing and making recommendations as appropriate regarding the City’s investment policies and practices at least annually.

Regarding the role of the independent auditors on the committee, the policy is clear that the committee’s oversight function is consistent with the scope of the auditors’ engagement duties, which include reviewing compliance with City financial policies and procedures; and for making recommendations for improvements in the City’s fiscal operations. However, in this oversight context, the auditors retain their independence from responsibility for managing any aspects of the City’s operations: this responsibility lies solely with the City’s elected leadership and staff.16 Reporting The primary tool for ensuring that investment policies are being followed is the ongoing and timely reporting on the status and performance of the agency’s investment portfolio. While the state once required a minimum of quarterly reports, reporting is now optional—but still recommended. Monthly reports should ideally be presented to governing bodies and senior management that include the following information for each investment or security: • • • • • •

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Issuer or broker/dealer (financial institution) Type of investment Certificate or other reference number if applicable Percentage yield on an annualized basis Purchase date Maturity date for each investment and the weighted average maturity of all the investments within the portfolio

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Current market value Total cost and market value, including source of this valuation, of the agency’s portfolio Rating of security

The report should be introduced by a summary that highlights the following subjects: •

• •

•

•

Portfolio overview comparing the current month with the prior month Explanation of any significant changes from the prior month Description of compliance with the investment policies and plans Ability of the agency to meet expenditure requirements in the following six months Other information regarding the agency’s portfolio as appropriate

Reports should include all agency investments, including those held by trustees or managed by investment advisors (any exceptions should be clearly noted). Summing Up There is no public policy or professional upside to chasing yield in ways that are inappropriately aggressive given that public money is entrusted to the agency—but there are huge downsides. Investment officers should be prudent—and they shouldn’t try to be budget-balancing saviors. When investment earnings reflect a significant portion of an agency’s revenues (more than around ten percent), it would be most appropriate to ask “why?” Investment earnings accounted for thirty-five percent of Orange County’s General Fund budgeted revenues just before it began incurring its huge losses.17 The key to success in prudently managing the investment of public funds is to articulate policies and plans clearly that are appropriate for the agency—and to follow them.

Clearly, collecting, spending and managing public funds demands a high degree of professional care and ethical behavior. Perhaps the strongest safeguard of this public trust is the accurate, timely and transparent reporting of an agency’s finances. Reporting and audits are the topics of the next chapter.

“Marking to Market” Accounting as Required by GASB 31

in the aftermath of the orange county investment losses, GaSB adopted “Statement no. 31,” which requires that the value of a local agency’s portfolio must be “marked to market” in its financial statements. this means that if the “book value” of an investment of $1.0 million increases to a market value of $1.1 million, the unrealized gain of $100,000 must be recorded in the agency’s financial statements as an increase in assets on the balance sheet and as added revenue in the income statement. conversely, if the market values fall by $100,000, the unrealized loss of $100,000 must be recorded in the agency’s financial statements as a decrease in assets on the balance sheet and as reduced revenue. For an agency that intends to hold investments (such as u.S. treasuries or other public agency securities) to maturity, these changes in market value are irrelevant: at maturity, the agency will receive exactly the interest and return of principal that it expected. in the interim, however, it is possible for an agency’s investment earnings to fluctuate significantly from year to year solely due to this factor, which can mask underlying adverse or positive trends in interest rates or cash balances that could be invested. in the private sector, this is better accounted for by segregating the portfolio into investments intended for trading (which are “marked to market”) and those intended to be held until maturity (which are reported based on book value). Given the potential for widely skewed results under GaSB 31, why do local agencies report investment gains, losses, and interest income in this fashion? Because it is required in order to receive a “clean” audit of the financial statements.

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Guide to LocaL Government Finance in caLiFornia NOTES Len Wood, Local Government Dollars and Sense, Rancho Palos Verdes, CA: The Training Shoppe, 1998. 2 Caution regarding ratings of investment instruments has always been important but the need for care in understanding the nature of the underlying basis of any investment regardless of the ratings bestowed by a ratings agency has been emphasized in the financial “meltdown” in the late 2000s when many billions of dollars in supposedly AAA rated instruments turned out to be junk. 3 Coleman, Michael. “Appointed and Elected City Treasurers in California.” at http://www.CaliforniaCityFinance.com. 4 2009-2010 San Luis Obispo Grand Jury, Electing City Treasurers and Clerks, Wise or Otherwise? San Luis Obispo Superior Court, 2010. 5 California Debt and Investment Advisory Commission, California Public Fund Investment Primer, Sacramento: State of California, 2016. 6 Ibid. 7 Government Finance Officers Association of the United States and Canada, GFOA Sample Investment Policy, http://www.gfoa.org/downloads/SampleInvestment Policy.pdf, 2010. 8 For example, this is the approach taken by the City of San Luis Obispo: its Investment Management Plan—which includes the formal but broader investment policy, is available on its web site at: www.slocity.org 9 City of San Luis Obispo. 10 $10 million or less. 11 Government Code §§ 16429.3 and 16249.4 12 Wood, op. cit. 13 Ibid. 14 Sharyn Obsatz, The Press-Enterprise, “Con Taught Hard Way to Invest,” http://www.press-enterprise.com/newsarchive/2000/08/06/965528790.htm, Accessed October 2010. 15 Wood, op. cit. 16 Modeled on a policy described in the City of San Luis Obispo, Financial Plan, 2009-2011. 17 Public Policy Institute of California, When Government Fails: The Orange County Bankruptcy, A Policy Summary, Sacramento: 1998. 1

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ocal government finance is essentially about the collection and use of public money. Therefore, careful and transparent accounting and open public reporting are both moral and legal obligations. Effective reporting means telling an agency’s financial story accurately, completely, and in an understandable way. Furthermore, if budgets are truly to be used to frame and then implement public policy, then the reliability, accessibility, and usefulness of financial data are all certainly critical. Such information is essential to the organization for achieving goals, avoiding financial problems, and improving resource efficiency. Fund Accounting Concepts

The core concept underlying local government accounting is the use of different funds, which was introduced in Chapter 3. Funds segregate monies from different sources that will be used for different purposes. Each fund lists its revenues and expenditures but also has its own general ledger and balance sheet accounts. Under GAAP (see Chapter 3), the fund type determines the basis of accounting. For example, the accounting for governmental funds (see Chapter 3) focuses on the status of current financial resources: money that is available for appropriation, and, as such, “budget versus actual” statements are typically prepared for them. Financial statements are prepared using the modified accrual basis under which revenues are recognized as soon as they are both measurable and available.1 Proprietary funds (such as enterprise funds) focus on the flow of economic resources, that is, the net assets in the fund and changes to them. Financial statements use the accrual basis of accounting. Under this method, revenues are recorded when they are earned and expenses are recorded at the time liabilities are incurred.2

Two Practical Ground Rules

communicating what are often complex numbers to the public, governing bodies, senior managers, and agency staff can seem an intimidating if not impossible task. that said, there are two basic ground rules:

• •

Know the fiscal story you want to tell—and tell that one. don’t communicate complex numbers: communicate what they mean.

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While the financial reporting model required for enterprise funds in accordance with GAAP does not provide for “budget versus actual” comparisons, as a practical matter all local governments are equally concerned about “budget versus actual” in their enterprise funds. This leads to a disconnect between GAAP and the budget and policy information decision-makers typically use. A strategy for bridging this gap is discussed later in this chapter. The conceptual differences between the emphases of the two financial measurement focuses and the related bases of accounting are illustrated in Figures 12-1 and 12-2. They each assume a similar set of underlying transactions, but the resulting financial statements look significantly different. Figure 12-1. Governmental Fund Statement

Restricted Assigned

Unassigned

Annual Reports

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There are two basic kinds of financial reports: annual and interim. Certain annual reports are also audited, that is, reviewed by independent certified public accountants to ensure compliance with standard procedures, the inclusion of information required by regulators, and transparency. There are generally accepted accounting principles (GAAP, see Chapter 3) for how audited annual financial reports should be prepared and presented. Annual financial reports include the following:

chapter 12: reporting accountability and telling the Financial Story Figure 12-2. Proprietary Fund Statement

Change in Net Position

$300,000

Total Net Position, Beginning of Year Total Net Position, End of Year

•

• •

Audited Basic Financial Statements, which provide the minimum level of detail required to meet GAAP . Comprehensive Annual Financial Reports, which provide additional information about financial operations for the year and long-term trends. Annual Financial Transactions Reports, which must be submitted to the State Controller.

Basic Financial Statements. This is the minimum financial information necessary to receive an independent auditor’s finding that the agency’s financial statements “. . . present fairly, in all material respects, the respective financial position . . . [of the agency] . . . and changes in financial position . . . in conformity with accounting principles generally accepted in the United States of America.” This is often referred as an “unqualified opinion” because there are no conditions or limitations—“qualifications”—on the opinion (other than those standard to the independent auditor profession that are clearly identified in the opinion letter). Along with the auditor’s opinion, there are three key elements to the Basic Financial Statements: •

Government-Wide and Fund-Based Statements. The Governmental Accounting Standards Board (GASB) establishes two distinct

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Guide to LocaL Government Finance in caLiFornia Do the Two “Views” Make Sense?

When GaSB introduced the governmentwide statements in 1999, it identified three goals for the (then) new financial reporting model :

• • •

improve financial reporting. enhance awareness of fiscal issues facing states and local governments. recognize the importance of adequately maintaining infrastructure.

even after many years of experience with the “two views,” many municipal finance professionals are skeptical of the value. most agencies continue to focus their budgeting and financial reporting efforts on the fund statements. in the real world, funds matter: in short, water fund revenues can’t be used to pay for police services, and street maintenance funds can’t be used to pay for park maintenance. as such, presenting a consolidated picture of an agency’s finances without regard to funds may result in a grossly misleading one. However, at this point, making the added entries and preparing the worksheets needed to produce the government-wide statements are part of each agency’s standard year-end closing process. the huge initial efforts to prepare fixed assets record-keeping systems and develop values for infrastructure assets likes sidewalks, bridges, roads, and storm drains are behind them. So, while, at best, the jury is still out on whether the government-wide statements are useful, they are a required component in preparing financial statements in accordance with GaaP. For this reason, agencies are well-served from a stewardship and community trust perspective to prepare government-wide statements along with the fund-based ones.

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•

•

types of financial statements: government-wide and fund-based. The former were introduced in 1999, while fund-based statements have a much longer history. Government-wide statements treat the local government as a single entity and consolidate all of its operations across different functions and funds into a single report. Rather than using funds as the basis for presentation, this approach organizes financial operations into two major activities: governmental and business-type. In combining all activities, the government-wide statements use the full accrual basis of accounting for all financial operations; record infrastructure such as streets, sidewalks, curbs, gutters, bridges, storm drains, street lights, traffic signals, and stop signs as capital assets; and expenses capital assets through depreciation. The fund-based statements present financial information on a traditional fund basis, using the modified accrual basis of accounting for governmental funds and the accrual basis of accounting for proprietary and fiduciary funds. This approach is often more helpful to decision-makers as it more clearly shows the status of individual funds and treats them as separate pools of money.

Notes to the Financial Statements. These help explain the financial statements by providing narrative information about the agency’s significant accounting policies and detailed disclosures on key financial matters such as investments, pension and other post-employment benefit obligations, long-term debt, interfund transactions, joint ventures and significant commitments and contingencies. While “notes” have long been an integral part of audited financial statements, GASB requirements3 have led to longer and more complicated notes to meet disclosure requirements. As such, the notes are typically longer than the financial statements themselves.

Required Supplementary Information (RSI). There are three key components to the “RSI” (and there could be more depending on the agency’s circumstances). 1. Management’s Discussion & Analysis (MD&A): This added feature requiring analysis on specified issues was introduced in 1999 in GASB Statement No. 34. While perhaps counterintuitive because it is referred to as “supplemental” information, the Basic Financial Statements begin with the MD&A.

chapter 12: reporting accountability and telling the Financial Story

2. Budget Reporting. GASB Statement No. 34 also requires comparisons of “budget-to-actual” results for the major governmental funds in the RSI. Both the original and final budget must be presented.

3. Retirement Obligation Funding Progress. When there are unfunded liabilities for pension or other postemployment benefit obligations (such as retiree health care benefits), agencies are required to provide schedules and explanatory notes disclosing their progress in funding them.

From the reporting perspective, just what is the “local government” that needs to be included in its financial statements is less clear than it might seem. For example, a city may have a housing authority and be a member of a joint powers agency. Which, if any, of these should be included in the city’s financial statement? The answer depends on several factors including: whether or not the local government exercises oversight and management control over the entity; whether or not the local government is responsible for fiscal losses should they occur in the subject activity; and whether or not the entity adopts its own budgets and policies without review or approval by the local government. Once it is determined that a component entity (such as a housing authority) should be included in the local government’s report, there are two approaches for integrating them into the municipality’s financial statements. In a blended approach, the entity’s financial operations are incorporated into the overall financial statements and grouped appropriately into the special funds, capital project funds, debt service funds or fiduciary funds. The alternative is to provide a discrete presentation, where the financial activities of the component entity are presented in the same statement but apart from the other local government fiscal activities. While there are some guidelines for determining which approach may make the most sense (such as whether the governing boards are substantially the same as the primary government and whether the component unit largely serves or benefits the primary government), the decision to use a blended or discrete presentation largely rests with the reporting entity’s judgment as to which approach best tells its fiscal story.

What Are Audits and When Are They Required?

Preparation of annual financial statements is the responsibility of the agency’s staff. the purpose of external audits conducted by an independent certified public accountant is to provide users of the statements with assurance that the agency’s financial statements fairly present its financial condition in all material aspects in conformity with generally accepted principles. this “assurance” (if, in fact, the auditor can provide it) comes in the form of the auditor’s opinion letter, which is included with the Basic Financial Statements. along with detailed reviews of an agency’s financial transactions, the auditor also conducts a thorough evaluation of the agency’s accounting and internal control systems. Based on their evaluation, the auditor prepares and issues a “report to management” that identifies any material internal control weaknesses (or, less serious but nonetheless significant, internal control deficiencies) that were found during the audit. management’s responses to the findings are typically incorporated directly into this report. along with distribution of the report to all governing body members, the auditing Standards Board requires that the auditor meet with someone (or a group) who represents the governing body—without management staff present— for a candid discussion of any concerns that may have arisen in the course of the audit and to answer any questions that the representative(s) may have about the report. (this requirement, known as Statement on auditing Standards no. 114, applies to external audits of both private and public sector organizations.) although agencies may require audits as part their policies, ordinances or charter, there are no state requirements that an annual audit of all agency funds be prepared. However, the state does require financial and compliance audits on focused areas of an agency’s operations, such as transportation development act funds and gas tax funds. additionally, if an agency spends more than $750,000 annually in federal funds, it is required under the Single audit act of 1984 to have a financial and compliance audit conducted by an independent certified public accountant in accordance with federal audit standards.

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Guide to LocaL Government Finance in caLiFornia Award Programs Both the GFoa and cSmFo have developed award programs for financial reporting to assist local agencies to improving their reports. more information about the programs is available in the GFoa’s web site at www.gfoa.org; and on the cSmFo’s web site at www.csmfo.org.

Comprehensive Annual Financial Report (CAFR). Many agencies go beyond the minimum and issue Comprehensive Annual Financial Reports (CAFR). Preparing a CAFR is not required to meet generally accepted accounting principles and to receive an unqualified auditor’s opinion, but it will provide valuable information in presenting a clear picture of an agency’s financial condition. The recommended contents (including extensive examples) for a CAFR is provided in what is often referred to as the “Blue Book”—Governmental Accounting, Auditing and Financial Reporting (also known as GAAFR), published by GFOA.4 The principal elements are: • a transmittal memorandum that summarizes the report; • the local government’s basic financial statements, including the auditor’s opinion; • supplemental fund statements for all the “non-major funds;” and • statistical information such as ten-year financial, economic and demographic trends. Except for the statistical section, the auditor’s opinion also includes the supplemental financial information in the CAFR, with the finding that (if it can do so) that the added schedules and information “in our opinion, are fairly stated in all material respects in relation to the basic financial statements taken as a whole.” One of the problems with CAFRs is that they can become too comprehensive, burying the fiscal story in piles of information. The solution is to use the transmittal memorandum to focus on key issues using a format and approach that make sense for the agency and to provide a financial over view of results at the beginning of the report. The transmittal memorandum also provides an opportunity to provide budget versus actual information for the enterprise funds based on changes in working capital (current assets less current liabilities, which is a similar concept as fund balance in the governmental funds).

Annual Reporting to the State. Cities, counties, and special districts are required to report annually to the State Controller on the financial results of their operations (special reports are also required for transit operators and the status of gas tax revenues and expenditures). There is a common format for all reports and firm due dates, but the results are not required to be audited. As noted in Chapter 2, these reports classify revenues and expenditures as either general (unrestricted) or functional (restricted in some way to particular purposes). These reports provide a wide range of useful infor mation.5 Interim Financial Reporting Interim reports are unaudited and may be issued during the year as deemed appropriate or useful to the agency. Examples include monthly and quarterly 160

chapter 12: reporting accountability and telling the Financial Story

financial status reports; focused reports on key financial areas like investments, sales tax or TOT; and mid-year budget reviews. The budget itself usually includes estimates for the remainder of the current year as well as for the upcoming year and, thus, is an “interim” financial status report, in addition to prescribing future appropriations. There are no common standards, comparable to GAAP, for the preparation or presentation of interim financial reports. However, from a financial management perspective, interim reporting is more important than annual reporting. While audited financial statements provide a reliable fixed point for subsequent analysis, they usually lag behind the end of the fiscal year by six months in most agencies. Without effective interim reporting, the agency could, therefore, be unaware of adverse trends or problems for up to a year and a half if it relies solely on annual financial statements. This underscores the importance of timely and accurate interim reporting that concisely presents what the data mean. Examples include monthly or quarterly updates on budget versus actuals, investment perfor mance, the status of taxes and other revenues, and other information deemed important to tracking the fiscal conditions of the local government. See Appendix C for ideas on effectively analyzing and presenting financial information. Summing Up

Effective financial reporting, both in the form of annual audited financial statement as well as interim reports during the year, is an essential component of responsible fiscal stewardship. Preparing CAFRs that meet high professional standards helps assure the community and elected officials that the agency’s fiscal operations are well-managed in compliance with adopted polices and plans. And preparing timely, accurate interim reports that concisely present the agency’s financial condition on an ongoing basis is singularly important in protecting an agency’s fiscal health by identifying any adverse trends and allowing for appropriate corrective actions as needed.

In the next part of the book, the important relationships between development and municipal finance in California are examined.

California Committee on Municipal Accounting

created in 1953, the california committee on municipal accounting (ccma) is comprised of representatives of the california Society of certified Public accountants (calcPa) and the League of california cities. While GaSB is the authoritative body in setting generally accepted accounting principles for state and local governments, the ccma complements this by providing issuers, auditors and other interested parties with guidance on accounting and financial reporting issues that have unique circumstances to local governments in california in implementing generally accepted accounting principles. ccma “white papers” may be found on the california Society of municipal Finance officers website at cSmFo.org.

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Guide to LocaL Government Finance in caLiFornia NOTES In modified accrual basis accounting capital outlays are recorded as expenditures in the period incurred and not depreciated. Proceeds from debt are recorded as a financing source in the current period (rather than as a long-term liability with a fully offsetting increase in cash, resulting initially in no net change in equity); and principal payments are shown as expenditures when due (rather than as balance sheet reductions to long-term debt); interest payments are shown as expenditures when due, and not accrued based on when incurred. 2 Capital purchases are reflected as balance sheet transactions, where cash assets are simply offset by capital ones; and depreciation is recorded on capital assets to allocate their economic use over time. 3 There are, as of 2016, now eighty-two “statements” issued since GASB was created in 1984 as the authoritative body for setting generally accepted accounting principles for state and local governments in the United States. The statements articulate specific requirements. 4 Available (for purchase) at: www.gfoa.org. 5 These reports are available on-line at no cost from the State Controller at: www.sco.ca.gov. 1

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Development and Municipal Finance Part IV

Local Economic Development: Fostering Business Vitality Chapter 13

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ocal economic development refers to the efforts of local governments to improve or grow the community’s economy; that is, policies and projects to increase the money coming into the community through, for example, new or better jobs for residents, new retail sales, or tourist spending. Surely the provision of public services to local businesses is an important and appropriate local government function. Economic development, however, involves a more active role by the public agency in stimulating investment and growth. There is debate in some quarters about the extent to which the public sector should support private economic endeavors. The discussion becomes particularly lively when the topic is the use of public monies to assist businesses or the use of eminent domain to assemble land for sale or lease to private parties. However, strong links between the general community welfare and a healthy local economy have been recognized and economic development has been legitimized as appropriate public policy by legislation and case law. Perhaps most importantly, most communities have recognized the value of economic development and consider it among the expected roles of their local governments.

Economic Development as a Public Purpose: Kelo v. New London

the debate about whether or not economic development constitutes a legitimate public purpose has resulted in numerous court cases, including the u.S. Supreme court’s decision in Kelo v. New London.1 Kelo owned a house in an area of new London, connecticut, that was the subject of a large-scale economic development plan. the city attempted to assemble land as part of its plan to encourage revitalization of this area. When Kelo and others refused to sell their properties, the city used eminent domain to take the land and houses. Kelo sued, making various arguments that the use of condemnation violated the “takings clause” of the Fifth amendment. one argument was that economic development is not a legitimate public purpose. the court, citing other cases, found that economic growth resulting from economic development is, indeed, a public purpose. Writing the majority opinion, Justice John Paul Stevens noted that the city had found that the subject area was “significantly distressed to warrant a program of economic rejuvenation” that would result in new jobs, tax benefits, and revitalization of the downtown. the opinion further stated “petitioners urge us to adopt a new bright-line rule that economic development does not qualify as a public use.” However, the court concluded that “promoting economic development is a traditional and long accepted function of government.” thus, while the genesis of the case focused on the appropriate use of eminent domain, the court did state clearly that economic development for purposes such as job creation, municipal revenue enhancement, and the general improvement of distressed areas are clearly legitimate government activities. the Kelo decision, specifically with regard to the use of eminent domain, triggered a number of reactions across the country including in california. in 2006 Proposition 90 would have (among other things) made the use of eminent domain for economic development more difficult. the proposition was defeated. in 2008 the electorate did pass Proposition 99 that excludes the use of eminent domain to take single family residences when the land is then conveyed to a private entity.

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Guide to LocaL Government Finance in caLiFornia Reasons for Economic Development The relationship between economic vitality and the more general community welfare is reflected in the various reasons that local governments2 have adopted economic development policies and programs. •

•

•

•

•

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They may be hoping to improve their fiscal position, trying to increase tax and fee revenues. In California particularly, attracting retail sales outlets and visitor accommodations has direct and often substantial benefits for a city or county general fund. A more robust general fund, in turn, allows more and improved public services for the overall community.

Communities may be trying to generate more or better jobs for their residents; this is particularly true in areas with high unemployment, underemployment or with concentrations of low-skill residents. Obviously, better employment benefits a community in many ways.

A public agency may hope to diversify its local economy when that economy is based on only a small number of businesses or sectors. Diversification can reduce impacts on the community if those particular businesses or sectors suffer a downturn.

They may be trying to bring to the community new services that are not economically viable under current conditions. For example, in many smaller cities outside metropolitan areas, residents may find themselves driving to other places to find doctors, sit-down restaurants, full-service supermarkets, or other retail opportunities. In such cases, economic development may be closely tied to housing development because population growth creates the market to support the desired services.

There may be underutilized or “run down” sections of a city or county that can be improved and revitalized with government help. The resultant benefits include lower crime, more jobs and commerce, higher fiscal revenues and an overall improvement in the quality of life. Until 2012, when the state eliminated redevelopment agencies, many cities and counties used redevelopment to address blighted areas.

Often, these different goals of economic development are mutually reinforcing. For example, increasing employment also puts more money into the community, thereby improving the municipal tax base. However, this mutually

chapter 13: Local economic development: Fostering Business vitality

reinforcing effect does not always hold. For example, encouraging tourism may result in improved municipal revenues, but may not address underemployment concerns. A good economic development program will clarify the community’s goals so that specific actions can be better directed to those purposes. Thinking about the Local Economy

Just what is the “local economy” that economic development tries to improve? One might conceptualize it as all the activities that 1) bring money into, and 2) circulates money within, a community. The simplest model of a local economy differentiates the numerous and diverse activities into these two broad types or “sectors.” Businesses, non-profits, and government agencies that bring money into the local area from outside are sometimes called the economic “base” or “primary” sector; those that focus on providing goods and services to local residents and businesses, can be called the “non-base” or “service” sector. This approach is not suitable for a rigorous analysis of the complex web of activities that comprise an economy, but it is a useful way of simplifying and thinking about that complexity.3 Probably the most common example of a business that is part of the base would be a manufacturing firm that sells its products in other areas and then uses its revenue to pay its local workers (as well as pay local taxes and buy locally provided goods and services needed directly by the business). The workers then use their paychecks to buy groceries, go to movies, get haircuts, pay taxes and so on, distributing (at least part of) the money they earned throughout the local community. Thus, the money brought into the community from outside and earned by the manufacturing workers supports, in turn, local businesses like stores, doctors, restaurants, and so on. Of course, the people who work in those businesses also take the money they earn and spend part of it on other local goods and services. The impact of the original money earned by the manufacturing workers on supporting local businesses, whose employees in turn also help support local businesses, is the so-called “multiplier effect.” As a conceptual tool, this is a useful way of understanding a local economy: the base sector imports money into the community, which is then circulated around the community as people pay for goods and services in the local service sector. The growth or loss of base economic activities will have direct consequences on the service sector activities. And while the actual local or regional economy is more complex and confusing, focusing on what brings money into a local community makes it easier to see what really underlies that community’s economic growth or decline. In the example above, a manufacturing firm was the source of money coming into the community from outside. Increasingly, in today’s economy, firms may not be exporting a particular physical product, but may be providing specialized services: management, finance, marketing, software, technical 167

Guide to LocaL Government Finance in caLiFornia The Multiplier Effect

the multiplier effect is perhaps most easily visualized in terms of jobs, although it can be expressed in terms of dollars generated or other economic factors. Say twenty people work in a firm that sells a product outside the community; perhaps they develop software that is then sold throughout the world. on payday, those twenty people spend at least part of their money on groceries, clothes, entertainment, etc. their spending may effectively support the wages of a clerk at a store, a ticket-taker at the movies, a chef in a restaurant. the clerk and the ticket-taker and the chef also buy things locally with the money they earn, helping to pay the wages of still other local workers, and so on. if the twenty software firm employees make enough money, and spend enough of it locally, so that after that money is circulated around the community, twenty other local jobs are supported, then twenty jobs really turns into a total of forty jobs (the original twenty plus twenty more). the economic multiplier would be considered in such a case as 2.0; that is, if two new jobs are generated at the software firm it really means more than two new jobs in the community . . . it actually results in four new jobs: the two at the software firm plus two more in the local community at a store, theater, restaurant, and such. of course, the multiplier works both ways. in this example, if the software firm laid off twenty workers, the total effect on the local economy would not be just the loss of those twenty jobs, but the twenty others in the stores, theaters, and restaurants that were supported by them for a total loss of forty jobs. Some examples of employment multipliers reported by the u.S. Bureau of economic analysis for california include 4.3 for computer and electronics manufacturing; 2.5 for Professional, Scientific and technical Services; and 1.7 for administrative and Support Services.4 one should always be careful when applying multipliers derived for a larger area to any particular community. Smaller jurisdictions, especially, will likely find that the local multiplier effect is weaker because businesses and workers will spend more of their money outside the local area, both by necessity and by choice. also, it is important to be sure the jobs or other economic factors are truly new, additional ones to the community; if they simply are replacing existing ones, then no new multiplier effect should be expected.

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writing, design, planning, etc. But sources of money creating an economic base can be even more varied than firms that export goods or services: tourist accommodations and related facilities bring outside money into a community; in retirement areas, pensions and savings accrued elsewhere may underpin the local service sector; offices or other facilities of federal or state agencies may support local employment paid largely with money collected by and paid out of Sacramento or Washington; on-line businesses can sell goods or services throughout the world generating income that is spent locally. Perhaps the most difficult problem with using this simple two-sector conceptualization of an economy is setting the boundaries. For example, a hospital may provide services not only to the people that live in the surrounding community, but also to many others outside the area in need of these kinds of facilities and services. Whether that hospital is conceived of primarily as part of a community’s economic base or its service sector may largely depend on the size of the community and where one draws the line around an economy. The same is true of a regional shopping center or automobile mall. Part of the sales in each is simply providing for the needs of local residents, but part (perhaps the greater part sometimes) comes from people outside the local community. Economic activity has little respect for political boundaries. This becomes even more complicated in metropolitan areas where numerous jurisdictions are seamlessly connected. Someone working at a movie studio in Culver City, for example, may live in Santa Monica or Los Angeles. In such areas, economic analysis and development strategies at the strictly local jurisdictional level must almost always be supplemented by and coordinated with regional perspectives. Another important point regarding local economic development is that sometimes money that could be spent within the local service center may be “leaking” to other areas because of a lack of locally available services. Thus, local economic development efforts in that situation may involve stemming the service-sector money leaking from the community, in addition to growing its base sector. Economic development planning must, therefore, include an assessment of money that is leaving the local area that might be retained locally under different circumstances. This most frequently occurs in cases of retail sales “leakage” when local businesses do not or cannot provide the full range of desired goods and services (see Chapters 14 and 15).

chapter 13: Local economic development: Fostering Business vitality Business Attraction Concurrent with developing a clear picture of the local economy, the local government contemplating economic development needs to appreciate the forces that attract desirable businesses to an area, and the factors that might keep them away. The study of business location decisions has been a rich field for urban economists for a long time.5 Traditional location theory focused a lot on proximity to factors of production and transportation costs. More recent research has looked at the benefits of certain clusters of businesses locating near one another. Certainly at the local level, a wide range of considerations factor into the decision to choose one location over other potential sites of comparable cost or the decision to pay more for certain locations because of economic or social reasons. Some of the key variables discussed in the literature include the following: • • • • • • • •

•

•

• • • •

At the regional level

Access to factors of production (examples: labor, raw materials, energy) Major transportation facilities/centers (examples: ports, major jet ports) Clusters of related businesses that provide specialized services (examples: movie industry in Southern California or high-tech businesses in the Silicon Valley) Access to large markets Availability and cost of land and the availability of public services

Input-Output Models

more sophisticated models of an economy will divide various economic activities into many more specific sectors based on a more refined categorization of businesses. the sectors are arranged in an econometric model that estimates how much a particular sector inputs from other businesses in order to produce its outputs. the result is a complex spreadsheet that estimates the change throughout the economy resulting from changes in any particular sector. Such econometric modeling is rarely conducted below the regional level and likely has limited value when assessing strictly local activities.

At the local level

Availability and cost of land/space Size of spaces or parcels; age and features of buildings Local transportation facilities/centers (examples: smaller airports, freeway interchanges, urban transit stations) Visibility (examples: freeway visibility, street frontage on highways or major arterials, a main street in an attractive, high-volume downtown) Proximity to amenities (examples: ocean or mountain views, a vibrant downtown with nearby eating establishments and personal services) Proximity to needed business services Convenient location for customers and employees Proximity to institutions/facilities important to the function of the business (examples: law offices near court houses, marine services near ports or harbors; research firms near universities) Availability of public services (examples: parking structures, good fire and police protection, good schools for children of employees)

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Business Attraction vs. Business Retention

it is also worthwhile to analyze not only business attraction but also business retention. the latter is sometimes downplayed in economic development plans, but keeping a community’s existing businesses in the face of competing locations can be vital. in fact, several studies have indicated that most jobs are created by existing businesses and that only few significant employers actually change locations each year.6 increasingly, contemporary local government economic development focuses on keeping existing businesses and helping them thrive. in most cases, the same factors favoring business attraction generally help existing businesses. But this is not universally true. the most common potential conflict arises when newer, large-scale retail centers locate in communities with older commercial districts. new retail simply replacing existing businesses is sometimes referred to as the “transfer effect.” more colloquially the swallowing of sales from older outlets by new ones is sometimes called “cannibalization.” developers of new retail centers usually prefer large, relatively inexpensive parcels, with good freeway or highway access. the older districts usually are no longer along the major highways and are typically comprised of smaller parcels and buildings with less convenient parking. even when the older district is attractive, existing businesses there fear, often with considerable justification, that they are at a competitive disadvantage relative to the new shopping centers. Public policy that simply prohibits large-scale centers may not be an effective strategy if other nearby cities (or unincorporated areas) are willing to accommodate such uses. obviously, then, the community not only loses out on the benefits of the new retail center, but its older commercial district may still be adversely affected by the new development built within the market area but outside the local jurisdiction. in such cases, the economic development plan will need to investigate different niches that can realistically support different types of business districts. For example, most older downtowns today simply cannot support a contemporary hardware store simply because those kinds of products are less expensively provided with greater variety at big box centers. However, the big box center has a more difficult time providing an attractive pedestrian ambience with cafes, restaurants, and specialty shops. thus, many municipalities have successfully used a strategy of developing their older commercial districts as eating and entertainment areas, while accommodating the large-scale retail outlets on larger parcels near highways or major arterials.

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• • • • •

Local taxes and business climate “Prestige addresses” (some firms select certain sites because the location is thought to communicate success, quality, or competence) “CEO effect” (especially with smaller firms, location decisions may be based on quality of life perceptions by the owner or upper management). Opportunities for joint marketing/promotions (examples: malls, downtown association, visitors bureau) Proximity to appropriate work force

Economic Development Strategic Planning Engaging in some kind of strategic planning is essential in order to assess the strengths, weaknesses, and opportunities thoughtfully for economic development in a community and to target efforts accordingly. For example, a city may envision itself as an ideal location for the recruitment of large high-tech companies, but may find upon careful examination that the location criteria typically used by such companies does not match up well with the city’s assets. It would be good to know this before investing in potentially expensive, but futile, business recruiting. Economic development strategies, therefore, should be aimed at targets that are not only desirable, but within reach (and, thus, the emphasis in many places on retention rather than recruitment; see sidebar). At the same time, other considerations go into a successful economic development program besides market assessments and other technical analyses. A city or county, for example, must also consider its identity or self-image and the kind of economic development program that will be compatible with its culture and vision for the future (and thus also achieve acceptance by the community). A well-designed strategic planning process can methodically bring these two vital ingredients together— the “what can we do” (the analytics) and the “what should we do” (the local cultural and political issues). Such a community-based process can also have the collateral benefit of demystifying some of the many complexities

chapter 13: Local economic development: Fostering Business vitality

Myth: Reality:

Myth: Reality:

Myth: Reality:

Myth:

Reality:

Common Myths about the Local Economy and Land Use

Cities can determine the specific stores that fill vacant space or occupy new development. this belief, which citizens seem to attach only in relationship to national chain store prospects (and mostly in smaller growth sensitive communities) triggers questions like “Why is the city allowing a Staples office Supply when we already have office max?”

cities can establish land use and zoning designations, but it is up to the building owner or developer to attract the tenant and, in a larger development, to judge and assemble the best tenant mix. However, city officials can make their interests known and, if the developer shares the same interest, support the recruitment of tenants by being responsive to their questions and concerns and expressing a welcoming attitude. it is possible, of course, to limit certain types (or even sizes) of businesses from various districts if those businesses are deemed to have adverse impacts on nearby land uses or the community more generally.

Cities “make money” from housing development. When some citizens express concerns about population growth and/or the construction of “too much housing,” they often couple their concern with an assumption that it is “all about more property tax money for the city.”

in the aftermath of Proposition 13, which restrained the growth of property tax and limited increases in property tax rates, most housing became a net fiscal loser to california cities, with the cost of providing service to residents exceeding the added revenues from them. therefore, cities today develop housing to meet other policy objectives, but not to “make money.” However, as population and residential areas grow, cities must rely on revenues from non-residential land uses in order to meet its added service obligations. Cities can unilaterally control what happens on undeveloped land, even if the city does not own the land. many citizens like open space (or don’t like change or, say, oppose a certain proposed development) and assume that the city can simply decree that the land shall remain open and/or underdeveloped for a very long time (if not forever).

Private property owners have rights and privileges that partially depend upon the land use and zoning designations assigned by the city to their property. While cities are under no obligation to alter land use and zoning designations to increase the development potential of private land, cities cannot arbitrarily “down zone” land without potentially confronting a legal requirement to pay for the land value it has “taken.” and while public opposition can often delay project on lands designated for development, unless the land is publicly owned, the potential for development will remain, and with a change in politics, it can eventually happen. Cities can annex and control property at will. the integrity of city borders in communities that have clear boundaries with separation from neighboring communities is understandably an important goal for many citizens and city officials. therefore, when development is proposed by a land owner near a border, but just outside the city limits, opponents of the development may exhort the city to “just annex the land and zone it open space or agriculture!” But it’s not that simple.

Land annexations are presided over by Local agency Formation commissions (LaFco) and certain standards and rules must be met prior to annexation, in order to discourage “urban sprawl” and promote “orderly development.” Within this process, property owners maintain strong rights. For example, they cannot be annexed against their wishes, unless an annexation is large and involves several property owners who formally agree to annex based on a blended weight of majority vote and land valuation. therefore, if a property owner believes that a city wishes to annex his land to enforce a disadvantageous land use, under most circumstances, the property owner can just say “no.”

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Most local economic development strategic plans will incorporate the following: •

• • • •

•

•

• •

Articulation of the reasons why a particular local government wants to encourage economic growth and the connection to overall community goals, policies, and plans. Engagement with the public, including key stakeholders such as existing businesses and property owners, potential partner organizations that can provide technical and financial assistance, and citizens who can represent the community’s broader identity and hopes. Analysis of the nature of the local economy. Assessment of the local strengths and weaknesses regarding business attraction and retention, including a realistic appraisal of the agency’s roles, capacities, and culture. Identification of the types of economic activities it would like to retain and attract through its economic development efforts. Identification of locations that should be the focus of economic development efforts. Understanding what makes target businesses thrive in particular places. Evaluation and strategic selection among a wide range of economic development tools that may be effective in retaining and attracting targeted businesses and investment. Statement of goals, policies, and programs/projects that best match a community’s strengths, character, and goals. Programs and projects should include a breakdown of steps or phases from concept to implementation, the specific departments or partners responsible for those steps, cost estimates, and potential funding sources.

Most communities will choose to select outside experts to assist local government officials and staff in this type of planning work; however, many agencies also have economic development departments and/or staff that may manage the formulation of such plans. A local economic development plan can be a stand-alone effort, but must be thoughtfully linked to the community’s other priorities and goals, and especially to the area’s adopted general plan (which, among other things, formally articulates a community’s values). Although optional under state law, a 2010 survey found that over 230 cities and counties have, nevertheless, chosen to include economic development or similarly titled elements in their general plans.6 Besides local government, there are a number of other “players” that support or deliver economic development programs, including federal, state and regional agencies, and non-profit organizations. Examples are provided in the sidebar. 172

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Economic Development “Players” and Partners

there is a seemingly countless number of public entities and non-profit organizations that exist to promote economic development at the national, state and/or local levels. an exhaustive list would go on for hundreds of pages (if it could be assembled at all). outlined below are some of the most common players and partners in local and regional economic development.

LOCAL AND REGIONAL ECONOMIC DEVELOPMENT AGENCIES AND ORGANIZATIONS

Local Government. economic development has become institutionalized as a legitimate activity of local government, with most california cities and counties supporting some level of investment in economic development programs and goals. Programs typically include business attraction and retention, permit assistance, tourism promotion, and strategic economic planning.

Chamber of Commerce. these non-profit organizations promote a positive business climate and to advocate on behalf of the business community and their members. With the growth of municipal economic development programs (often due to chamber advocacy), many chambers have partnered with local government to deliver a variety of services.

Downtown Associations and Business Improvement Disctricts. cities that have defined downtowns often have associations of downtown businesses and property owners. these associations exist to promote downtown interests, including advocacy, beautification, marketing, events, and other support programs. many of these entities are structured under california law as formal “business improvement districts,” which allows businesses in a defined area to pay special assessments to fund improvements and promotional activities within the district's boundaries.

ECONOMIC DEVELOPMENT CORPORATIONS (EDCS).

Tourism Related Organizations. organizations that represent the tourism industry may have many names—convention and visitors bureaus, hotel associations, travel associations, and so on. regardless of the name, these local and/or regional entities exist to serve the same purpose: to promote the tourism industry by attracting visitors to an area to fill hotel rooms and support the local economy.

Other Organizations to Support Special Industries. depending upon the nature, mix, and needs of the local economic environment, there are a number of other organizations that may exist within a region to promote the unique interests of various industries. For example, there may be entities to support manufacturing, technology, retail, agriculture, real estate, housing, restaurants, and banking.

Private Industry Councils (PICs). established under the federal Job training Partnership act in the early 1980s, Pics are nonprofit corporations that receive federal money to support local education, testing, counseling, and job training to place unemployed or underemployed residents in jobs. Pics are governed mostly by private sector board members and work in partnership with local employers to place individuals in jobs and offset initial employer training costs.

STATE OF CALIFORNIA AGENCIES AND STATEWIDE ORGANIZATIONS

State of California Economic Development Programs. the state has dozens of economic development programs housed across a range of departments, including the Housing and community development department, the trade and commerce agency, the office of Planning and research, the employment development department, and the Governor’s office of economic development.

Other State-Level Organizations. each economic development player and partner at the local and regional levels noted above is affiliated with an organization that represents their interests on a statewide level. a few examples include the california chamber of commerce, the california downtown association, the california association for Local economic development, the california travel industry association, the League of california cities and the california State association of counties.

Colleges and Universities. many community colleges, public universities and public and private colleges partner with local and regional economic development entities to assist with such things as research and development, business incubators, small business assistance (such as a Small Business development center (SBdc) or Business assistance center (Bac) often operated under the aegis of a community college), and job training and education.

U.S. GOVERNMENT AGENCIES AND NATIONAL ORGANIZATIONS

U.S. Economic Development Agency (EDA). the eda is an agency of the u.S. department of commerce and is the lead national agency for economic development policy and programs. its stated mission is “To lead the federal economic development agenda by promoting innovation and competitiveness, preparing American regions for growth and success in the worldwide economy.” eda supports numerous programs, including ones to promote jobs creation, economic planning and research, and technical assistance in economically distressed areas.

Other Federal and National-Level Organizations. other federal departments and agencies support economic development programs, including the u.S. department of commerce office of travel and tourism industries, the u.S. Small Business administration, and the department of agriculture Farmers Home administration. in addition, each economic development player and partner at the local and regional levels is also affiliated with an organization that represents their interests on a national level or even international level. a few examples include the u.S. chamber of commerce, the national main Street center (downtowns), the national association of Housing and redevelopment officials, the international economic development council, the u.S. travel association, the national League of cities, and the national association of counties.

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Paying for the program. Funding for local economic development efforts comes from many potential sources, depending on the magnitude and nature of the specific programs undertaken. Some typical sources include the general fund and grants or loans from regional, state or other local government agencies or non-profits (see sidebar). Many cities and counties have set up Business Improvement Districts; under state law, a city or county may collect special assessments and allocate those revenues toward financing improvements or other economic development efforts in that district. Similarly, some communities have approved TOT increases or special assessments in order to direct the additional revenue toward tourism promotion and other projects to enhance visitor-serving areas. . Tools of the Trade The following briefly describes some of the more commonly used local economic development practices7:

Adequate land zoned for desired uses. The city (or county) pursuing economic development should assess its land availability and zoning/general plan to make sure there are, in fact, locations for the activities the community is trying to attract or grow.

Special land use plans. Cities and counties often prepare specific plans, downtown plans or special area plans to provide particular guidance for the types of development they wish to attract and that encourage investment by expressing a vision for the future of the affected area, along with appropriate policies and implementation programs. In addition, specialized land use planning, such as business and industrial parks, can attract firms seeking the amenities such places afford. Many special districts, too, may develop plans to attract new businesses or to accommodate and support existing ones.

Land banking. This refers to local governments owning and holding land in anticipation of desirable uses. Such parcels can then be offered to the targeted uses, sometimes even at prices or leases below market rates provided there is evidence that non-priced public benefits would result from the project. A common land banking technique, sometimes unintentional, is the maintenance of single level (surface) municipal parking lots that can be converted to more beneficial uses, sometimes through public-private development partnerships (see, however, Chapter 14 for cautions about such partnerships). Incentive zoning. Cities and counties can shape their zoning regulations to encourage land uses that are deemed especially valuable to the community. The

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most common examples are density bonuses and similar incentives available for affordable housing projects. But similar incentives can be used to attract desirable businesses or to facilitate the expansion of existing ones; examples include relaxed parking or setback standards, and height or lot coverage bonuses. Of course, any alteration from usual standards must be thoughtfully applied so as not to cause deleterious impacts on nearby uses.

Speculative buildings. The development of buildings by local governments that are then offered at reduced lease rates to targeted firms is relatively uncommon in California. In some instances, however, a municipality seeking a preferred firm (usually one that brings many jobs) offers to build or otherwise subsidize the needed facilities if the business agrees to locate there, rather than constructing a truly speculative building without committed tenants.

“Incubation” centers. The failure rate among start-up businesses is notoriously high. The major issue is often the lack of capital. Through an incubation center, a public agency can help provide space for start-up firms at lower than market rates, helping to cut cash costs during what is usually the most tenuous phase of business development. Frequently, the “incubation” period is specified, after which the business must re-locate or pay full market rents to continue in the space. As in any case where the government is subsidizing private enterprises, care must be taken to articulate the public benefits generated by the program, to avoid circumstances that could result in gifts of public monies, and to address issues of equity that may arise regarding the eligibility requirements of participating businesses. Financing. Local governments can provide favorable financing to businesses as an incentive to choose sites in their jurisdictions. Perhaps the most common examples are “conduit” bonds that reduce borrowing costs for targeted business (see Chapter 10).

Tax reductions. Reducing taxes may be similar to discounting fees, but as noted earlier, local governments in California do not exercise sole control of the major taxes including the property and sales taxes. Although taxes are frequently cited as an important factor in business decisions, the most significant local taxes, property and sales taxes, are largely or entirely determined by the state. Business license taxes and TOT are more easily controlled by the local city or county but are generally either not significant in overall business decisions or vary little from place to place in a competitive market area. Furthermore, important legal and equity issues arise if tax reductions are offered to only certain businesses or locations. Note, too, that voter approved tax measures are often difficult to modify. 175

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Fee reductions or waivers. Although difficult in recessionary periods, waiving or reducing development-related fees are relatively common ways of trying to attract businesses to local areas or to encourage or accommodate expansion of existing ones. An upfront fee reduction may result in short-term costs, but greater long-term fiscal benefits. On the other hand, it is often very difficult for a local government to measure and justify the public benefit of a fee waiver. For example, waiving fees that fund needed infrastructure improvements can undermine other important elements of economic development. Also, granting benefits to some but not to others raises equity concerns and possible charges of favoritism. Subsidies. Cities and counties sometimes develop programs to subsidize private investment in targeted areas, or to attract targeted industries. The subsidies can take the form of grants, loans, fee or tax reductions (see above), or the provision of infrastructure that might ordinarily be required of the business. The cautions noted earlier with regard to clarifying the public benefits, avoiding inappropriate uses of public monies and addressing potential equity issues among participants apply here as well.

Diverse housing opportunities. Communities that do not provide a variety of housing opportunities can inadvertently limit the labor pool available for certain businesses. Diverse housing opportunities can better support a wider range of workers with different skill types and levels. Plans and policies that encourage such housing complement, in most cases, other economic development measures.

Providing good public services and facilities. Businesses, like households, are attracted to places that have good public services including strong police and fire protection; an effective circulation system; reliable utility services, including efficient and dependable water delivery, sewage treatment, and solid waste pick-up and disposal; and, especially, schools.

Creating public amenities. Local governments can attract businesses to specific areas or help existing business succeed in various places by investing in public amenities including street trees, parks or plazas, street furniture, landscaping and lighting. Public investment frequently triggers private expenditures as people believe that the local government values a location sufficiently to warrant investment. This is sometimes referred to as “townscaping.”8

Locations of municipal facilities. Local governments make “business” location decisions themselves. For example, keeping or building a city hall or government center (or developing libraries or cultural centers, and maintaining court houses and county facilities) in a downtown even when less expensive land is available elsewhere, not only brings employees and users of the facilities

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into the area, but also attracts other ancillary or support activities such as restaurants, offices, tech support services, and so on. Municipal parking and other transportation nodes. The development of public parking lots or structures can obviously facilitate access to an area for workers and customers. Transit stops or centers, park-and-ride facilities, and even bicycle facilities can also improve access essential to successful businesses.

One stop permit center and permit expediting. Perhaps among the most common economic development tools is to provide specialized assistance to new or expanding businesses to work through the local planning and regulatory process, including sometimes, expedited permitting. Start-up firms particularly may find the process daunting and confusing. Use of an ombudsman or similar staff position to help coordinate among departments can help streamline the process and also communicates to the applicant that their business is important to the community.

Business organizational support. Particularly in distressed areas needing help and locations that can provide a shared, recognizable identity to businesses (for example, a downtown, a tourism area, or special retailing district), the local government can assist with organizing those businesses to assist with promotions, area maintenance, or special events that might be difficult for any one business to undertake. A common example is the creation of a Business Improvement District whereby funding is made available for organizing and promoting the district. Another common example is participation in established programs like Main Street USA that can provide structure and guidance for the maintenance and development of downtowns or similar business areas.

Small business assistance center. Small businesses and start-ups, particularly, need help with concerns such as planning, accounting, labor regulations, taxes, insurance, and legal issues. A local government can help foster this type of entrepreneurship by developing or supporting assistance centers where professional advice, often by retired volunteers, is available at low or no cost. Private Industry Councils, community colleges and SCORE9 often offer similar services (see sidebar on partners).

Existing business visitation. Existing businesses have already committed to the community and are most likely to maintain and grow the local economy through their own success and expansion. Thus, cities are directing greater attention toward supporting their existing businesses. A business visitation program involves city staff meeting with the owners and managers of extant business at their sites to better understand the challenges of those businesses and to solicit ideas about how the local government can contribute toward their success. 177

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“First source” agreements and “skill banks”—matching jobs and people seeking employment. Some jurisdictions require businesses that avail themselves of such government benefits as subsidies to enter into “first source” agreements whereby when certain jobs are open in those businesses they must consider qualified local residents first. Of course, there then must be a roster of local people seeking employment and the qualifications they possess. Such a list is sometimes called a “skill bank.” Under a typical first source agreement, businesses may hire outside the local community only after demonstrating that there are no qualified local job-seekers available.

Customized training or education programs. In some jurisdictions underemployment is linked to a mismatch of educational or skills requirements of employers with the capabilities of the local labor pool. Specialized training programs may help; common offerings include English as a second language and computer software use. Cities usually do not provide these services directly but, more frequently, partner with the local community college or school districts. There are also federal and state job-training programs that might complement a municipality’s efforts. Community “prospectus” and promotion. With a prospectus, whether printed materials or website, the community has a venue for promoting itself to the businesses, touting the advantages of the place. Sometimes, local agencies will attend trade fairs, contact specific businesses, and do more targeted outreach.

Shared marketing (including tourism promotion). Local governments can help subsidize promotions and marketing that attract customers to retail districts. Frequently, cities and counties in tourism-dependent areas will contribute toward a visitors bureau or similar industry group for the general promotion of the area. Sometimes, a portion of the TOT is used for this purpose. Shared marketing can help in other situations such as promoting a major shopping district or a downtown area. Redevelopment For many decades, California cities and counties used “redevelopment” to address physical and economic blight; it was, arguably, the most powerful economic development tool available to local governments. Under the California Redevelopment Act, first adopted in the 1940s and amended several times thereafter, cities and counties could form redevelopment agencies (RDAs) to develop and implement plans to alleviate problems in distressed areas. RDAs were legally separate local governments from the parent city or county, but in

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most cases, city councils or boards of supervisors sat as the governing boards of their RDAs, thus assuring close coordination with redevelopment activities as well as accountability to the local electorate. The principal advantage afforded by redevelopment was tax increment financing. The idea was that the blighted area was economically depressed and stagnant. Redevelopment efforts would improve the affected area. As that improvement occured, investment would increase, projects would be built, and property values—and property tax revenues—would rise. The increase in property tax revenue that occured after the redevelopment area was formed was called the “increment.” Usually, the total property tax collected was divvied up among the city, county, schools, and special districts. Redevelopment law allowed more of that increment to go to the redevelopment agency for use in addressing blight in the subject area (as well as creating affordable housing throughout the community). The projected income stream from the tax increment was typically used to repay tax allocation bonds (see Chapter 10), thus providing a very significant source of funding. Redevelopment became especially popular among cities facing growing financial stresses because the captured increment provided a substantial source of money that could be directed to local improvements and services. Redevelopment was used to build infrastructure and civic improvements, to provide loans and grants to encourage business upgrades and other investments, to assemble land and repackage the new parcels for private development, to help pay for code enforcement and graffiti abatement, and for many other purposes. In addition, a portion of the tax increment was required to be used for affordable housing; in 2006, the California Redevelopment Association reported that over 350,000 units had been created through redevelopment.10 The manifest benefits of redevelopment led to the formation of over 400 RDAs by 2010. Especially after Proposition 13, local governments saw redevelopment as a way of recapturing some of their lost property tax revenue. This led to some abuses where jurisdictions used redevelopment, for example, to provide infrastructure for vacant land (as opposed to existing blighted areas) and to find blight where little or none existed in order to enlarge the project areas in which tax increment could be garnered. In the mid-1990s reforms were adopted that addressed some of these problems. During the 1990s, too, the legislature reallocated RDA funds to schools to help address budget problems at the state level. In 2010 voters overwhelmingly approved Proposition 22 that was intended to prevent further state “take-aways” from local governments, including RDAs. In 2011, Governor Jerry Brown and the state legislature, facing huge state general fund deficits, proposed ending redevelopment agencies, arguing that the tax increment supporting redevelopment efforts was needed for essential services such as schools and public safety. To work around the

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restrictions imposed by Proposition 22, the legislature passed two measures: the first would eliminate all RDAs, but the second would allow them to avoid dissolution if they voluntarily paid out a certain portion of their tax increment to be distributed mostly to schools, thus offsetting a part of the state’s general fund obligation. The California Redevelopment Association and League of California Cities filed suit to have these actions deemed unconstitutional as violating the clear intent of Proposition 22. The California Supreme Court’s decision, however, was a double blow to RDAs. The court found that the legislature could dissolve RDAs, but could not offer the alternative to RDAs of avoiding dissolution by paying out a portion of their increment. The effect was the end of RDAs as of early 2012. This, of course, raised considerable problems related to outstanding debt obligations, the status of employees of the RDAs, and the continued administration of affordable housing functions. Cities and counties were given the option of becoming a “successor agency” to their RDAs. For those that did not, a separate successor agency was created by the state. Successor agencies would then develop Recognized Obligation Payment Schedules (ROPS) that were subject to state approval that would enumerate the ongoing obligations of the former RDA; tax increment funds would continue to go to the successor agency to cover its approved ROPS.11 With the elimination of California’s redevelopment agencies in 2012, California was left without a means to use tax-increment financing for economic development or public facility construction until 2014, when the legislature produced two new tools authorizing the use of tax-increment financing. However, both tools allow the use only of tax increment of consenting cities, counties, or special districts and do not allow the use of property tax increment from the school portion of property tax share. Consequently, the state of California (through the school share) provides no financial support. Enhanced Infrastructure Financing Districts (EIFD) were authorized by SB628 (Beall) in 2014. Once created within a city or county, an EIFD may use property tax increment of those taxing agencies in areas that consent (cities, counties, special districts, but not schools). To issue tax allocation bonds backed by this tax increment, an EIFD must receive the approval of fifty-five percent of registered voters within the proposed district, or—if there are twelve or fewer persons registered to vote—a majority vote of landowners (one vote per acre or partial acre). EIFDs can finance the construction or rehabilitation of a wide variety of public infrastructure and private facilities, including: •

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Highways, interchanges, ramps and bridges, arterial streets, parking and transit facilities. Sewage treatment, water reclamation plants, and interceptor pipes.

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Facilities for the transfer and disposal of solid waste, including transfer stations and vehicles. Facilities to collect and treat water for urban uses. Flood control levees and dams, retention basins, and drainage canals. Parks, recreational facilities, open space, and libraries. Brownfield restoration and other environmental mitigation. Projects on a closed military base consistent with approved base reuse plans. Industrial structures for private use. Transit priority projects. Projects which implement a sustainable communities strategy. Mixed-income housing developments. Facilities constructed to house providers of consumer goods and services. Child care facilities.

Community Revitalization and Investment Authorities (CRIAs) were authorized by AB2 (Alejo) in 2015. CRIAs may be used in a revitalization areas in which at least eighty percent of the property located within the revitalization area must be characterized by: •

An annual median household income that is less than eighty percent of the statewide annual median income; and three of the four following conditions: a) A nonseasonal unemployment rate three percent higher than the statewide median unemployment rate; b) Crime rates five percent higher than the statewide median crime rate; c) Deteriorated or inadequate infrastructure, such as streets, sidewalks, water supply, sewer treatment facilities, and parks; or d) Deteriorated commercial or residential structures.12

CRIAs are empowered to use eminent domain and are generally authorized to plan and fund the: • • • • • •

Rehabilitation, repair, upgrade or construction of public infrastructure; brownfields cleanup; low- and moderate–income housing; seismic retrofits of existing buildings; owner or tenant improvement loans; assistance to businesses for certain industrial and manufacturing uses.

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CRIAs may issue long-term debt, backed by property tax increment. Voter approval is not required. At least twenty-five percent of tax increment collected by a CRIA must be used to increase, improve and preserve the community’s supply of affordable housing. Summing Up Economic development is generally recognized as a valid, and expected, function of cities and counties, as well as certain special districts. Local governments undertake economic development to generate more or better jobs, increase their fiscal positions, diversify their economies, attract services to their communities and to revitalize underperforming areas. Economic development planning requires a thoughtful analysis of what different businesses need to succeed, and the local area’s strengths, weakness. capacities, and opportunities with regard to those variables. Careful articulation of goals, overlaid on this analysis, can help avoid fruitless efforts toward unrealistic or unfocused outcomes. Many economic development efforts involve inducing businesses to develop new or to expand existing facilities in the community. Real estate development is often closely linked to successful economic development. The next chapter provides an overview of real estate development feasibility, generally, as well as a discussion of the roles local governments may play as “partners” in desired development projects.

NOTES Kelo v. New London (545 U.S. 469 (2005)) Among local governments, cities and counties most frequently engage explicitly in economic development. That said, many special districts (consider, just as examples, airport and water port districts) are also active in local economic development efforts. 3 For a more detailed description of economic base theory and alternatives as they relate to local economic development, see, for example, Understanding Local Economic Development, by Emil Malizia and Edward Feser, Center for Urban Policy Research, Rutgers, New Brunswick, 1999. 4 U.S. Bureau of Economic Analysis for California: accessed at www.bea.gov. 5 See for example, Urban Economics by Edwin Mills, Scott, Foresman and Company, Glenview, IL, 1972, among many other textbooks on urban economics. 1 2

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California Governor’s Office of Planning and Research, The California Planners Book of Lists, 2011. 7 For more detailed discussion of commonly used economic development practices, see, for example, Edward J. Blakely and Nancy Green Leigh, Planning Local Economic Development, 4th Edition, SAGE Publications, Thousand Oaks, 2010. 8 Blakely, Planning Local Economic Development. 9 SCORE (Service Corps of Retired Executives) is a nationwide non-profit association that provides technical assistance to businesses, funded in part through the U.S. Small Business Administration (SBA). 10 www.calredevelopment.org, 2010. 11See California State Association of County Auditors, “Uniform Guidelines for the Implementation of ABx1 26: Redevelopment Dissolution” (Draft, January 24, 2012) and League of California Cities, “ABx1 26 Timeline as Modified by CRA v. Matosantos (January 9, 2012).” 12Alternatively, a revitalization area may be established within a former military base with largely deteriorated or inadequate infrastructure and structures. 6

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T

he previous chapter discussed why many local communities pursue economic development. Often, such efforts entail encouraging private real estate developers to build new commercial outlets, offices, or industrial projects on vacant land planned for growth and/or to rehabilitate or replace older structures so that they can be put to more productive purposes. Sometimes local government itself is the developer, usually of public facilities desired by the community. Several projects, such as municipal parking structures, public office buildings, and affordable housing, have important secondary benefits by stimulating additional private investment and development. Sometimes, too, the public sector and private sector formally partner in ways to create the kinds of projects a community desires. Local government officials can benefit from an understanding of real estate development, whether in their roles as planners and regulators, as economic development managers, or as developers themselves of public facilities. The Developer’s Perspective

Developers are, of course, in the business to make money. However, developers are by no means the same and their style, motivation, and standards will differ.1 Therefore, in considering the developer’s perspective, it is important to qualify upfront that perspectives will vary and developers may use different standards of judging project feasibility, depending upon the situation and their motivation. This chapter, however, will focus on the customary way that a developer will assess the merits of a possible development. One can think of developments as either a project looking for a location or a location looking for a project.2 For example, a developer may 185

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conclude that an apartment complex near a university might be an attractive project and will then evaluate available locations for such a project. Or, a developer may hold a piece of land and explore what kind of project makes sense for that parcel considering its size, location, and many other variables. The development process always starts with ideas . . . often lots of them. The initial steps in the process involve weeding out the ideas that have potential from those that don’t. This means testing ideas to see if they are feasible. The level of detail and research that goes into that testing increases so long as the project continues to appear feasible. The process is usually not linear or sequential, but, more often, iterative and recursive: information uncovered at one level of analysis will be used to modify the idea, leading to another round of testing and the discovery of new information, so that the developer continually refines the project characteristics that are likely to succeed. If a project doesn’t look promising, that is, it “fails” a feasibility test, it is then either modified and re-tested, or simply rejected. Several ideas are usually considered before one is found sufficiently feasible to warrant detailed analysis, and very few actually advance to design and construction. Different Kinds of Feasibility

Private developers construct buildings with the intent of making money. Even in the case of non-profit developers, the project must generate enough return to cover the costs of development (apart from outright grants and donations) and ongoing operations and maintenance. Financial feasibility refers to whether or not a project seems likely to return enough money given the developer’s cost and risk and compared to other investment options. Experienced developers typically use some “rules of thumb” or simple calculations to quickly decide if an idea is likely to be financially feasible or not. This is sometimes referred to as a “back of the envelope” type of analysis or described as something “drawn up on a napkin”—expressions that imply simple, brief and very conceptual assessments. At some point, a potentially feasible project will be subject to much more formal analyses. One typical evaluation uses a discounted cash flow model; that is, a spreadsheet that estimates the costs a project incurs over time versus the income it produces. A developer can get a good idea as to whether or not a project is likely to generate enough return on her investment to be feasible, considering the risk involved and alternative investment. A discounted cash flow model is often referred to as a pro forma, which means roughly “according to the form” or “according to the model.” Pro formas can be simple, summarized on a single page, or quite detailed, involving pages and pages of assumptions and other inputs. This modeling will be discussed further in a later section. 186

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bility.

However, financial analysis is only one aspect of development feasi-

Physical and environmental feasibility assesses whether or not the site is physically suitable for the contemplated project, considering the parcel’s size, configuration, topography, and other environmental characteristics. This often involves professional assessments of soils and geologic conditions, biological resources, creeks and hydrology, potential contamination, and many other factors. An experienced developer usually has a good idea about what environmental features may need more detailed assessments. If the site is found reasonably suitable for the project, the developer will undertake a legal or regulatory analysis: is the site zoned properly for the kind of use and intensity that the developer has in mind? What regulations will likely be imposed by local, state and federal agencies? Will any of them likely raise unacceptable obstacles to development of the site as contemplated? Next is the political analysis. If the current plans, zoning, or regulations will make the project difficult or impossible, how likely is it that those constraints will be changed by the respective public agencies? For example, if the zoning needs to be modified, how receptive will the local planning commission and city council (or board of supervisors) be to amendments? Will the local community, including neighboring property owners, support the change or will protests be likely? Even if the contemplated project is nominally allowed by the zoning, it often requires some type of “discretionary” approval by the local government or other regulatory agency. Such approvals might include variances, use permits, subdivision maps, environmental assessments, or other permits. Local elected officials will be considering more than the efficiency of the prospective project, that is its technical or fiscal merits. Other political values will enter the equation, such as if their support would be viewed as properly representing the will of constituents and as equitable treatment in comparison to other applicants. Projects that meet strong opposition from a local community often face delays or onerous conditions, if not outright denials. The intensity of support or opposition is best tested early on, before too much money is spent. Therefore, experienced developers will gather information on possible community reactions to their proposals by meeting with agency staff, elected officials, and others in the community. Another type of feasibility consideration that is closely linked to the financial analysis is market feasibility. A market study considers the demand for the type of development proposed and the existing or pending supply of the type of development that the new project will compete against for buyers or renters. A market study forms the basis for some of the key assumptions or inputs into the discounted cash flow model.

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Guide to LocaL Government Finance in caLiFornia Players in the Development Process Real estate development is frequently a complex undertaking. Therefore, the developer usually relies on a “team” of people to help him with different specialized tasks. Usually, the more complicated the process, the more special talents will be called upon by the developer.

Role of the Developer. The developer directs and coordinates all the factors needed to make the project actually happen. The developer is involved with every aspect of the project and is responsible for the coordination and successful completion of all the steps in the process. Often the developer will have special talents, experience, or interests that he will bring to bear on the project. For example, a developer may be trained as an architect and so has a special interest or skill in design. However, every developer must be a generalist to some extent, able to navigate with knowledge and competence within the fields of real estate acquisition, local government permitting and politics, architecture, environmental issues, banking and financing, construction, advertising and marketing, contracts, tax law, and business management, among others. No one can be fully expert in all these fields. Thus, the developer typically assembles a “team” of consultants to assist with specific aspects of the project. The following lists some of the professionals who may comprise the development team.3

Realtor. A licensed real estate professional can help with the identification, optioning and acquisition of suitable parcels of land for the project. A realtor will also be involved in the eventual lease or sale of the completed project.

Planners and Landscape Architects. Private sector planners and landscape architects often assist with the site planning: where the buildings and related features should go on the parcel considering the goals of the project, local regulations and environmental constraints, and the surrounding physical and social contexts. Increasingly, planners are also retained to help assess the regulatory and political framework of the development. In many jurisdictions the applicable zoning and subdivision codes, as well as specific and general plans, directly affect the feasibility of development projects. Experienced planners can help the developer find his way through these complex constraints. In some special circumstances, more complicated social context analyses may be warranted. For example, some developers retain cultural anthropologists to help understand not only the legal and political environment, but also the sensitivities of the community, sometimes critical to successfully engaging local support. 188

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Architects. Architects actually design the buildings, striving for an aesthetically pleasing appearance, functionality for the developer and eventual user of the building, and compliance with codes and standards, while meeting the budget for construction costs set by the developer to make the project financially feasible.

Engineers. A wide variety of engineers may be retained on the team, including structural engineers who work closely with the architects on the building design, civil engineers who design the infrastructure and “offsite” improvements, and soils and geologic engineers who are involved with the design of foundations and advise the building designers regarding seismic hazards. Traffic engineers are sometimes included on a team if circulation and parking issues are especially important. Contractor. The contractor assembles the labor and materials and builds the project. Often a contractor will have several “subcontractors” or “subs” who specialize in particular trades such as electrical work, plumbing, finishes, and such.

Construction Managers. Construction managers oversee the building of the project on behalf of the developer, helping to ensure the efficient process.

Market Analysts and Appraisers. The market analysts assess the economic environment into which a new project will emerge; they specifically consider the existing supply and demand conditions for the real estate project being proposed. They evaluate the competition and help with the realistic pricing of the project if it is to be sold or leased. They also help the designers know what features should be included in the project to make it more competitive in the market place. Appraisers do similar work in order to establish a value on the project for financing and other purposes.

Attorneys. Lawyers will be called in to help with all the various contracts and agreements among investors, buyers and sellers, and the developer and his team of experts. They may also be involved in evaluating the legal and political feasibility of a project in the context of the local community’s adopted plans and ordinances.

Accountants. Certified Public Accountants (CPAs) will help track the costs versus incomes, the financing, and tax implications for the developer and investors.

Investors and Lenders. These parties provide the cash needed to undertake a project. They all will expect some return from the developer to compensate for the use of their cash or equity. 189

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Property Managers. If the developer continues to own the project after it is built, then property managers are often retained to handle building maintenance, tenant relations, rent collection, and many other responsibilities that go with owning a building. Owner. Many developments are built speculatively; that is, without a particular end user or owner in mind. (For example, a retail mall can be designed without knowing the precise businesses that will be located there.) In other cases, developers may construct a “build to suit” project that has direct input from the future owner or occupant about their specific needs and objectives.

Others. Of course, many other people may be involved in a development project, depending on its size, nature and complexity. Examples would be security firms to protect the site while under construction, marketing and public relations firms to help advertise the project to potential buyers or renters, and insurance agencies to provide protection from problems during and after the construction.

Government Agencies. Government agencies are key players in the sense that they can affect the design and costs of a project. In addition to the elected decision-makers and planning commissions, in many cities and counties there is a design review or architectural review commission that must approve development projects. A number of federal, state and regional entities may play a review and regulatory role, too—for example, the U.S. Army Corps of Engineers, California Department of Fish and Wildlife, the State Department of Transportation (Caltrans), the regional air pollution control district, and the area Regional Water Quality Control Board. Anticipating the role and interests of the many governmental agencies that often get into the mix can help address requirements that could affect the marketability of a project or the financial feasibility from the developer’s standpoint. Therefore, experienced, sophisticated developers understand how governmental agencies can significantly affect their projects, and try to build relationships with those agencies and to address their concerns early in the process, if possible.

The Public. Last, but certainly not least, the public will be involved in a project—sometimes heavily—depending upon the circumstances. The developer must be sensitive to potential public involvement at every significant step along the way. For complex or sensitive projects, developers may develop community outreach and information plans. Such plans may include public meetings, focus groups, newsletters, websites, emerging social media, and other methods to proactively address and influence public sentiment and project support. 190

chapter 14: real estate development Feasibility and the city as developer: Perspectives and roles Capital Requirements Obviously, many elements must come together to develop a project successfully. The following summarizes the major capital (that is, cash) requirements for any development.

Land and optioning land. A developer may already own the land on which the project will be built or he may need to purchase the land necessary for his project. In other cases, however, the developer may want to have control over the site, but not actually pay the full amount to buy it until it is clear that the project will actually go forward. For example, a developer may want to build houses on a farm on the edge of a growing city. The developer could approach the owner and buy the land outright. He could also, however, try to buy an “option” to purchase the land. In such a case, the landowner receives some money, but only a fraction of the full cost. In exchange, the landowner promises the developer not to sell the property to anyone else for some period of time. During that time, the developer tries to get all the necessary permits for the project and to arrange the necessary financing, etc. At the end of the option period, the developer must pay the owner the rest of the land cost and actually buy the land, or the landowner is released from the obligation and can sell the land to other parties. The advantage to the developer is that he can control the land and make sure no competitor can build on it ahead of him without paying the full sale price. The option also allows the developer to test the various types of feasibility without fully investing in a piece of land that may turn out to be infeasible to develop. The advantage to the landowner is that he can get some cash early on and still has ownership if the development project doesn’t actually proceed and can then try to sell it to another party. Sometimes, the landowner becomes a partner in the project with the developer. If the project is successful, the landowner shares in the profits in exchange for providing the land needed for the project. There are many variations on these types of arrangements, all of which can be negotiated between the developer and a landowner and memorialized into a legal contract.

Design. The design of a project includes the site planning, landscape architecture, architecture, and engineering needed to develop plans that can be submitted to the permitting agencies for approval. As noted above, the design is not solely up to the developer, but the government agencies will often require adjustments to the design before they will approve the plans. After the schematic plans are accepted by the agencies, the developer’s design team prepares construction plans that will be reviewed for consistency with adopted building codes. In the early stages of feasibility analyses, the overall development cost is frequently expressed as a percentage of the estimated construction cost. If 191

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a proposed project continues to look financially feasibility after these early analyses, the developer will frequently do a much more detailed estimate of design-related costs given the specific circumstances of the project and continue to refine the financial modeling accordingly.

Exactions/Permits/Fees. In many jurisdictions, new development is expected to pay for the installation of public infrastructure needed to support the project. Sometimes, the developer must actually do the public improvements: install the street or sidewalk or water lines, for example, to the specifications and approval of the local agencies. In other instances, the developer is required to contribute money toward the construction of the infrastructure. In a growing number of jurisdictions, development impact fees are significant elements in a project’s total cost. Other fees will be charged to cover the cost of planning and environmental reviews, plan checks, and inspections. Cities and counties frequently apply conditions of approval and environmental impact mitigation measures to the permits that they issue for development projects, and those conditions can affect the physical design of a project as well as its cost and, thus, its financial feasibility.

Construction costs. When one begins to enumerate all the items needed to actually build even the most simple real estate project, it becomes quickly evident that such a list will be long and complicated. Indeed, project cost analyses will be pages and pages in length, covering concrete, structural steel, lumber, wire, flooring, pipes and plumbing fixtures, mechanical equipment, insulation, glazing, paint, drywall, etc. In addition, there is the labor to put these materials together to create a building, management of the process, hiring of subcontractor specialists, and so on. However, very early on in the feasibility evaluation, a developer generally does not break down project costs at this level of detail. In fact, based on experience with other similar projects, the developer will typically estimate costs on a generalized square-foot basis.4 If a developer finds a project financially feasible after a preliminary study, he will add greater details and more refinements to the assumptions in the analysis. Debt Financing

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Development projects require a significant amount of cash for the land, design, permits, and construction. Occasionally, developers will have the cash available and ready for a project. More often they will assemble some or all of the needed cash from partners or investors. But in almost all cases, the developer will borrow a significant portion of the cash required for the project.

chapter 14: real estate development Feasibility and the city as developer: Perspectives and roles

Who provides money for real estate development? There is a wide range of potential sources for development projects. Individuals frequently provide money for projects. They may include the developer, partners, friends or family members; others may simply be people who have excess cash looking for opportunities for a good investment. Often, a developer will put together a joint venture, which can take the form of a legal partnership. One common form is a limited liability company (LLC) with the investors acting as “general partners,” whose role is basically to provide the cash. The developer is named the “managing partner” and is responsible for the administration of the project, and its ultimate success or failure of the venture. Besides individuals, a number of institutions provide financing, including commercial banks, pension funds and insurance companies.5 Most of these kinds of institutions include real estate development projects within their overall investment portfolios. Pooled funds allow individuals and other smaller investors to participate in real estate investment. Real Estate Investment Trusts (REITs) work a lot like mutual funds. One can invest relatively small amounts of money in a REIT; the many small amounts are pooled into large sums that are used to purchase real estate and, in some circumstances, to finance projects. There are two major categories of loans that a developer will seek: construction loans and the long-term “take out” or “permanent” financing.6 In the most basic view, construction loans are relatively short-term, limited to the time it takes to actually build the project. Usually, the principal on the construction loan is due at or shortly after the completion of the project. Typically, the construction loan is paid off through long-term financing that amortizes the debt over many years. Construction loans carry significant elements of risk, the most fundamental being that money is being advanced for a project that is not yet built and could be significantly delayed for a myriad of reasons. Such risk is factored into the decision of whether or not

Concept of Leveraging

using only a small amount of your own cash for a project has significant advantages. First, you simply don’t need as much money in order to do larger-scale projects. Second, because you’ve used less of your resources, and because loans can be paid back in smaller amounts over time, debt financing can spread the risk, or lower the short-term exposure, that you might face if a project doesn’t work out as planned. third, by using less of your monetary resources on any one project, it allows you to use your money for other things, even additional development projects. this is called “leveraging.” the following is an overly simple, but illustrative, example of how leveraging works: Using your own cash to build the project

imagine you have $1.0 million (m) to invest in development. You use it to build $1.0 m project with own cash. You sell your project a year later for $1.1 m. You made $100,000 or 10% on your cash investment.

Leveraging your cash by borrowing money

You build $1.0 m project with $100,000 of your cash and borrow $900,000 at 5% per year. You sell your project one year later for $1.1 m. You pay off loan ($900,000 plus $45,000 in interest). You made $55,000 or 55% on your $100,000 cash investment.

You could use the remaining cash for other purposes.

Say you could do multiple projects with your $1.0 m rather than just one. You could (in our simplified example) do up to 10 such projects (putting $100,000 of your cash into each) and earn $55,000 per project. thus, make $550,000 on your $1.0 m . . . a lot more than if you put your whole $1.0 m into a single project. But leveraging can also be risky!

imagine that you put your $1.0 m in project but can only get $900,000 when you sell it. You lose $100,000 cash. if you had, however, through leveraging in the example invested only $100,000 of your cash and sold for only $900,000, you lose your $100,000 plus interest or $45,000 more (in our example). do that 10 times and you’re out your whole million plus another $450,000 . . .

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to lend and, if so, what terms and conditions should be included in the loan. The take out loan at least is collateralized by the completed project, although there may remain considerable uncertainty as to the project’s long-term success. The differences in the two types of loans also affect which investors and lenders are more likely to participate. Institutions with long-term portfolio needs, for example, may be attracted to funding the take out loans, while local banks may be more interested in providing construction loans to foster growth in their communities.7 Lending practices can be affected by many other factors, including the current regulatory climate, “securitization” and related instruments for accessing secondary markets, and other macro economic conditions. The financial crisis in the late 2000s, for example, dramatically and adversely affected the lending environment.8 Financial Feasibility If a project is deemed potentially feasible from the physical, environmental, legal and political perspectives, then additional financial and market analyses are in order. The analysis of financial return on investment varies with the nature of the development and whether or not the developer intends to retain ownership of the project after completion or to sell it. If the developer intends to sell the project at or shortly after completion, the analysis largely bears on the amount of cash the developer/investors must put into the project versus the revenue generated from the sale after all costs including interest and principal on all loans, are subtracted out. In the case where the developer/investors intend to hold the project after completion, the expected cash flow generated by the development over time is analyzed.9 In cases where the developer intends to sell a project at completion, it will be the potential buyers of the development who will analyze the future cash flow comparing ongoing costs and revenues over time to value the project.

Discounted Cash Flow Models. A common approach to evaluating a project’s future income versus costs is to use a discounted cash flow (DCF) model. The illustration below shows the basic structure of such a model for a project that the developer will continue to own after completion, generating an annual income (from rents/leases, and perhaps the eventual sale of the project some time in the future) and annual costs (debt service/management, etc.). For each year (other increments of time can also be used), all the expenditures are added up and subtracted from all the revenues. This is the net revenue for that timeframe. The net revenue over time is called the project’s cash flow. One overly simple approach to assessing whether or not a project “makes money” would be to add up all the annual net revenues and find out if the sum is positive or negative. If it’s positive, then revenues exceed costs and 194

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Risk and Reward, Opportunity Costs and Liquidity

development is a complex, potentially risky, undertaking. therefore, developers and real estate development investors usually expect relatively significant returns on the money they put into a project. they also try to reduce their exposure to downside situations by minimizing the amount of their own cash they use. Successful developers are also careful: they will try to reduce risk by thorough analysis and will get out of projects when it appears the potential losses are too high given the probability of success. Better to stop, minimize losses, and save one’s resources for a better venture than to “throw good money after bad” in a losing proposition. Because real estate development carries significant risk with it, not to mention a lot of work, developers will evaluate what else they could do with their cash besides develop a project. if it looks like other options are reasonably attractive with less risk and effort, then perhaps that particular development project is not the way to go. the opportunity to do something else with your money (including investing in a different development project) is given

up when you decide to put it toward a particular project. economists call this the opportunity cost of an investment—and thoughtful developers and investors will always consider that cost (that is, what else could they do with their money) in their assessment of a project proposal. another consideration in how to use one’s money is liquidity. money that is readily available for one’s use is considered to be “liquid.” now consider money invested in a real estate venture. typically, one might not be able to get money out of the project until it is built and sold, and so it is relatively illiquid. Liquidity affects how you look at the future value of money: liquid money is readily available while less liquid assets will be harder to convert to cash and use. this is another reason why money in one’s hand is considered more valuable than an equal amount in the future. in sum, real estate development is an investment of money. Before one puts money into a real estate deal, he will consider risk, return, opportunity costs, and his own financial circumstances, including his liquidity needs.

the project “made a profit.” If it’s negative, then costs exceed revenues and it is definitely a “loser.” Such an approach is, indeed, too simple because most people consider money received sooner to have a higher value than an equal amount received later in time.11 This is called the time-value of money. Therefore, the net income (whether positive or negative) in future years is discounted to 195

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the perceived equal value today. This is called the present value of the stream of annual net revenues into the future (and some years those revenues may be negative). Consider the following example:

If the annual net revenues are simply summed the combined net is $15,000: [(-$200,000) + (-$10,000) +$75,000 +$75,000 + $75,000 = $15,000]. Clearly the project made money over this timeframe; but consider that the income doesn’t come in for a few years, while the expenses are all incurred early on in the process. Recall that future amounts generally are considered less valuable than cash in hand; that is, they have lower present values. Thus, an analyst will compute the present value of each future annual amount applying a discount rate. A discount rate is analogous to a negative interest rate; rather than growing a present amount into the future, it takes a future amount and lowers it to its equivalent value today.12 The most appropriate discount rate can be highly idiosyncratic with the developer and development project, but is usually related to perceived risks, opportunity costs, and overall capital markets (see sidebar). The discount rate used to evaluate a cash flow is sometimes called a “hurdle rate,” that is, the minimum rate of return the developer and investors will accept on the cash flow generated from the project. If the project’s DCF analysis indicates that the project will meet or exceed its hurdle rate, then the project is attractive and warrants a higher level of analysis. In the example above, using a discount rate of ten percent, the present values of the annual amounts would look like the table below:

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The sum of all the individual present values equals a negative $36,939: [(-$181,818) + (-$8,264) + $56,349 + $51,226 + $46,569 = -$36,939]. That is, with a discount rate of ten percent, the net present value of this cash flow is negative $36,939. Thus, while the project did, in fact, “make money,” the rate of return that the cash flow realizes is less than ten percent. This type of model is the most common way of evaluating long-term investments, including many real estate projects. A different way to assess the return on a cash flow is to determine its internal rate of return or IRR; the IRR might be considered the rate that is “imbedded” in the cash flow.14 In the example, the IRR of the cash flow is only about two percent. Thus, if one uses a discount rate of ten percent (that is, the developers expect/want a return of at least ten percent), then this particular project appears to be infeasible because it returns only two percent. Most DCF models use pre-tax conditions; that is, tax considerations are not explicitly built into the spreadsheet, but are taken into account later as the developers consider their own tax situation. Because the tax liabilities of any one person or entity can be significantly affected by many other variables including composition of an investment portfolio, other income, and other capital gains or losses, starting with a pre-tax analysis makes sense, especially if it is being used to present a project to investors or lenders (who will have their own tax circumstances to consider).

Assumptions and sensitivity analysis. As a project appears more feasible and the possibility of moving forward seems more attractive, then much more detailed cost breakdowns, sale or lease-up timing estimates, pricing estimates, and financing assumptions will be used. A good assessment will also include “sensitivity analysis,” a series of model runs to test changes in the assumptions. This helps the developer assess risk. If small changes in the assumptions make significant changes in the financial feasibility, then the developer and investors should be especially cautious about proceeding and make sure that there is sound research behind the assumptions.

Despite differences among types of real estate developments, the basic structure of the feasibility analysis is generally applicable: a comparison of income versus costs over time, with the cash flow discounted to its net present value. Market Studies

Market studies form the basis for many of the assumptions used in discounted cash flow models of development projects. They investigate the demand for the particular development type and the supply that will constitute the competition for a project within some geographic location, including similar projects not yet built but in the “pipeline.” The supply and demand for a real estate 197

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product is the market for that product, and the geographic area in which the product will compete with similar products constitutes the competitive market area. Market studies are not only critical for the developer, but also important to lenders and investors who want to see the evidence on which the assumptions in the feasibility analysis are based. Local governments are usually most interested in market analyses of two types of developments: housing and retail sales. Because the projection of future infrastructure and service needs is linked to population growth, understanding the demand for different housing types in different locations is essential for land use, infrastructure and public services planning. Retail sales analyses are important for understanding how existing and future commercial outlets will provide vital sales tax revenue.

Market studies for housing development. Demand for housing is related to population growth and the number of households seeking different types of units. A gross projection of future housing demand can be derived, therefore, by dividing the projected population by the average household size in the area. There are many factors that can refine this rough projection, for example, the percentage of people in the market area who live in housing types that are not individual units (such as retirement homes) and changes in the trends of household size and formation. The U.S. Census is a typical starting point for information on these variables. The California Department of Housing and Community Development, the California Department of Finance, and regional councils or associations of government (for example, Southern California Association of Governments or the Association of Bay Area Governments) are also important sources of demographic information. More important, population projections, especially in smaller communities, are not always simple extensions of past trends. Analysts must, therefore, investigate variables such as new attractors (for example, new job sources) and limits to growth (for example, resource constraints). The gross demand for housing units is segmented based on variables such as the income of the households and other demographics (especially household size and age of householders) to create a clearer picture of the demand from the segment or segments most likely to buy or rent particular housing products. Marketability refers to the mix of features or amenities in housing types attractive to the target population segment. Marketability studies often involve analyses of preferences through surveys (or, for example, looking at behavior of recent home buyers or contacting renters) or focus groups to better estimate what combinations of features versus price are most attractive. If a developer expects to get a certain rent price for an apartment project, for example, and the existing complexes generating those rents all have swimming pools, then the project may need to include this amenity in its design in order to generate the assumed rental income. 198

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Determining the competitive market area can be difficult, but it is often linked to prices of like products within commute distance to jobs—but it can be much more complex, of course (think, for example, of retirement areas and college towns). On the supply side, market analyses look at the existing housing stock, the competition directly relevant to the market segment in question, and projects “in the pipeline.” A good market study will often involve extensive site visits and evaluations of the prices, sizes, age, amenities, etc. of the competition. Macroeconomic variables, such as current lending practices, interest rates, employment, or consumer confidence, can also affect local housing markets at any given time. The assumptions about these variables, and the basis for those assumptions, should be explicitly presented in a good market analysis.

Simple retail leakage analysis. Developers of retail outlets, as well as lenders, investors, and lessees are the usual audience for retail market studies. However, especially since the passage of Proposition 13, cities and counties in California have become especially focused on sales tax revenues and, accordingly, on the feasibility of commercial development proposals and the potential for such development to increase local retail sales. Most retail market studies start by comparing the sales that might be expected in a local area to those that are actually occurring. The most common way is to compare local per capita sales to those of a larger area, typically the statewide per capita average. In California, data for this type analysis can be readily obtained, at least in terms of general types of business, through the Board of Equalization taxable sales tables. If the per capita sales are much lower than the statewide average, it may mean that the community is “leaking” potential sales to other areas and, thus, potentially indicating there is local unsatisfied demand. A simple leakage assessment like this, of course, hardly constitutes a complete market study. It is, however, one element of most retail market analyses. Other variables considered on the demand side will include projections in population growth, income levels and possible changes, and trends in marketing and buying preferences. Analysts may use surveys and focus groups to more closely examine specific retail sectors. On the supply side, existing and projected stores in the competitive market area will be assessed regarding such variables as access, parking, prices, selection, building age, and appearance. Municipalities seeking higher sales tax revenues must be especially wary of transfer effects or cannibalization (see Chapters 13 and 15). Local Government as Developer Playing the role of “capital project developer/owner” is also among the routine activities of local government. Local government typically develops, owns and 199

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maintains capital assets that are needed to deliver basic public services such as sewer and water lines, water and wastewater treatment plants, roads, parks, fire stations, and corporation yards. Like a private developer, they will first identify the project concept, affirm its feasibility (including financial analyses and sometimes market studies), secure financing, design the project, acquire the necessary approvals, build it and then operate and maintain the project for the long term. Provided that the project is not controversial or of great public interest, each step proceeds in a relatively routine and predictable manner, with the usual challenges of development.

The Differences between Public and Private Development. The experiences and standards of judgment used at each phase by private developers and local agencies in developing a capital project are often quite similar. However, depending upon on the project, the experiences and outcomes can be very different, too, especially when a project is speculative and/or controversial. And while the public agency may be in the driver’s seat, there is often a bus load of passengers along for the ride—with some vying for control of the steering wheel. These differences may emerge in the very early phases. Using a parking structure as an example, a private developer would almost certainly abandon a private parking structure idea as soon as it is known that the market for such a structure is weak and that the project will operate at a loss for many years. On the other hand, in order to implement policy in an underperforming area, a local agency might decide to proceed with the structure as an inducement for private investment in the area (even if the project must function at a fiscal loss for a time or even indefinitely—ongoing subsidies may well be worth it if they achieve clear policy objectives). Thus, the private developer uses a profit-loss standard of judgment based on its return-on-investment goals, whereas a local agency uses public policy goals as the standard in making its decision. Furthermore, in order to reach their respective judgments, the processes and participants in decision-making can be very different. While a private developer may consult a small number of partners or investors, the local agency may engage in months of public discussion and debate over the policy merits of the project. Committees or task forces may be formed, advisory bodies might weigh in, and dozens of hearings could be held. If a feasibility study has been completed, there may be long public debates regarding the technical merits and underlying assumptions used in the study—whether or not the opinions expressed by the critics are based on any level of expertise in such feasibility studies. If a project survives the early scrutiny and proceeds further, more public debate and involvement can be expected—and be highly influential, too—at other major project phases, such as during site acquisition, environmental review, and design. This kind of input often results in expensive changes and/or requirements and slows progress.

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To build a project a public agency must follow state contract bidding laws and, in the case of a legally defined “public works projects,”15 it must award construction contracts to the lowest responsible bidder (even if the bidder is a contractor that has underperformed in the past). While a project is being built, a public agency must also assure that the contractor is complying with other laws affecting public projects, such as the Davis-Bacon Act.16 prevailing wage rules17 or special grant requirements (if the financing includes federal or state grant money). In summary, a private sector developer can judge a project based on shorter-term considerations, more focused goals (profit and return on investment) and in consultation with a much smaller number of people (if he needs to consult at all). On the other hand, a public sector agency will take a much longer-term perspective than most private developers and balance financial feasibility with other community values and considerations. And almost always, a robust public process takes longer and costs more money. Literally, it is a price of democracy. Partnering with the Private Sector: It’s Complicated

Government is often encouraged to be more creative, entrepreneurial and risk taking—to operate “more like a business.” However, public enthusiasm for more private sector-like behavior is usually (and quickly) replaced by skepticism and concern when cities, counties, and special districts consider an entrepreneurial venture. This is especially true when the venture involves a complex real estate development. There are many ways an agency might directly participate in a development project, including through land contributions or writedowns, fee incentives or waivers, infrastructure development, financing, or other cost sharing partnerships. While local governments do, under certain circumstances, directly partner with the private sector to undertake real estate projects deemed beneficial to the public and not easily accomplished without help from the municipality, this role is not familiar to many citizens, and, thus, can raise high levels of scrutiny and concern. The public’s reaction is understandable. To engage in such a transaction, an agency must alter its customary regulatory role in relation to private sector development, move beyond its comfort zone in terms of risk, and maybe move beyond its “zone of competence,” too. In typical public-private sector transactions, the local agency role usually falls into one of the following categories: • •

•

Purchaser (such as buying equipment and supplies) Contract manager (managing vendor contracts for services such as janitorial services, landscape maintenance, or fiscal advice) Facility owner (such as contracting for infrastructure construction and maintenance, supervising the work)

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Rule maker and regulator (reviewing building proposal against city policy and rules; enforcing building and other codes; developing and enforcing new rules)

In each of these roles, the municipality is in the superior position, representing the public interest with the backing of specific laws and policies aimed at assuring that resources are protected, risk is minimized and rules are enforced. But when an agency engages in a partnership with the private sector for development purposes, the rules change, roles are more ambiguous and elements of risk enter the picture. Ambiguity and risk-taking (and forming what might be perceived as a “special relationship”) are not natural positions for public agencies. Public exhortations for a greater “entrepreneurial spirit” aside, it is not a local governmental role that the public is accustomed to either. Partnering with a private developer to bring about a project can create real conflicts among a local agency’s responsibilities if its proprietary (ownership) role in the project is not separated from its regulatory role in judging the project for compliance with laws, plans and policies. Creating the right balance of risk and rewards is also exceptionally challenging. In general, public agencies want to maintain control over a project while minimizing risk. However, the more risk a public agency tries to shift to a private partner, the greater the reward the private partner will demand. This often requires the public partner to also relinquish some elements of control. This fundamental tension is often not apparent until the detailed aspects of deal negotiations are revealed. And if a risk does not work out, the loss of public resources is not easily forgiven and the price of failure is high for government officials. For elected officials, the price may be the loss of office. For agency managers, failure of a high-profile risk-taking venture often means termination. Such partnerships, therefore, should only be entered into strategically and selectively, and with the support of proper third-party expertise. Managing the Complications and Risks There are at least five main ways to manage the complex issues inherent in public-private real estate development partnerships: •

• •

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Policy Justification. Identifying, documenting and communicating the public policy benefits. Process. Developing a methodical and transparent process. Government Roles and Responsibilities. Assuring appropriate agency role separation between its proprietary versus regulatory responsibilities.

•

•

chapter 14: real estate development Feasibility and the city as developer: Perspectives and roles

Managing Risk. Negotiating an agreement that minimizes risk (eliminating it entirely is unlikely). Assembling the Team. Putting together a strong, interdisciplinary team that includes needed expertise (that for most agencies will mean third-party professional assistance).

Policy Justification. No public-private partnership should be considered unless the agency can identify (and recite in subsequent agreements) strong and compelling links between clearly articulated policy objectives and the use of a partnership as the best vehicle for achieving those objectives. For cities and counties, relevant policies and goals should exist in the general plan. There may also be other plans that are relevant, such as in specific plans and strategic plans (for example, those addressing downtown vitality, parking or tourism). Existing fiscal policies that call for strengthening municipal revenues are typically important, too. Again, public-private development partnership should be pursued only as the best (or sole) way to achieve the policies. For example, a developer may wish to develop a project that meets numerous agency goals, but can only assemble the needed site if an adjacent agency-owned parking lot can be integrated with land the developer owns or controls. Whatever the justification, the agency will need to assure that the rationale for the project and partnership is consistent with its policies, understood by the community, and strong enough to weather public and media scrutiny and inevitable controversy.

Process. Existing policy should also guide the process, such as whether or not the partnership should be established competitively through a request for proposals or if circumstances justify an exclusive agreement with one developer. If an agency-owned property is involved, policy should guide whether or not the property is sold or leased to the developer. Another vital consideration is the integrity of the public process, including transparency and the method and extent of public engagement, from the conceptual beginning to the final approval of a project and related agreements. To reinforce a point made earlier, a wise developer does not leave public outreach and participation to the government agency, but instead brings a proactive communication and outreach strategy to the table. Typically, if citizens do not like a project, they will also attack the process. A thorough and transparent process, therefore, is very important.

Government Roles and Responsibilities. In a partnership, as noted earlier, the local agency plays two roles. •

•

Its traditional regulatory and decision-making role, such as reviewing the project for code and general plan consistency and serving as “lead agency” for the environmental process. Its proprietary role as investor in the project.

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For example, a major downtown project in San Luis Obispo required a publicprivate partnership due to an exchange of public and private property and other financial considerations. In order to separate its regulatory and proprietary roles, the city created a two-step agreement. Step 1 was to enter into a non-binding Memorandum of Understanding (MOU) with the private property owner/developer setting forth the city and developer’s major expectations. These expectations covered many areas, including the terms of an eventual land exchange, a conceptual project description and future financial considerations. The MOU was also clear that Step 2, a binding agreement, would only be entered into after the project had received its discretionary approvals through the usual development review process—and there were no assurances in the MOU—explicit or implicit—that the project would receive these approvals. As such, the city retained its discretion under the MOU to ultimately not approve the project (or approve it with conditions that were not acceptable to the applicant) without breaching any of the terms of the MOU. Thus, the twostep process intentionally bifurcated and separated the city’s discretionary approvals from the business terms of the MOU. The advantage of this process for the developer is that the business terms of the transaction are clearly set forth at the beginning of the process, so that the financial feasibility of the project can be assessed early on. This type of review process, of course, requires a number of complex steps conducted in public, including a detailed project application, environmental study, advisory body review and final city council approval (acting in its regulatory role). The outcome of this process, given the extensive analysis and public hearing process (under which new information and constraints are likely to emerge), is uncertain in any community that values transparency in decisionmaking, meaningful community engagement and high development standards. Managing Risk. Strategically mapping out roles in an effort to better separate an agency’s proprietary versus regulatory roles is one way to manage the risk in a public-private partnership. There are many other potential problems that must be managed, too, such as the risk of: • • •

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Losing “up-front” expenditures. Losing control of strategically important public property. Suffering the consequences of non-performance and/or project failure.

Addressing these risks proactively is important in the negotiation of any MOU or binding agreement (see sidebar). In presenting “the deal” to elected officials and the community, public managers should clearly identify the risks and how the MOU mitigates them. These possible downsides should be articulated and weighed against the policy

chapter 14: real estate development Feasibility and the city as developer: Perspectives and roles

and/or fiscal upsides of the partnership. In the final analysis, while staff can present the “balancing” case in favor of the partnership, performing the policy calculus on behalf of the community in determining whether the policy benefits outweigh the possible downsides is the exclusive responsibility of elected officials.

Assembling the Team. The best options to protect and promote the public interest may not surface if public agencies do not bring the right expertise to the team. While cities and counties constantly plan for, review and regulate private development, they are not primarily in the role of business partners in private development projects. The core business of local governments is municipal service delivery, and agency staff expertise mostly resides in this area. Therefore, just as developers assemble large, multidisciplinary teams to pursue their interests, local agencies must assemble a team of experts, too. In addition to appropriate agency staff representing a variety of departmental stakeholders (such as planners, engineers, finance and legal staff) third-party contract team members should usually include: •

•

•

Appraisers. Typically, agencies must appraise property to assure proper value prior to sale or lease. However, in the case of a public-private project, the appraiser may need to possess a specialized level of expertise. Discounted land prices are often necessary to attract private participation in revitalization or reuse projects—and local agencies must be able to document and justify any discounted sales. “Reuse appraisals,” for example, are a certified appraisal method that takes into account the unique and expensive factors involved in complex projects involving redevelopment of older existing buildings or sites. The result is usually a value that is discounted to recognize these unique factors.

Fiscal Analysts. Just as a private developer will employ experts to complete pro forma financial analyses and market studies, prior to consummating a partnership, local agencies should analyze the municipality’s costs and revenues of the proposed project. This information is crucial for determining if an agency should get involved in a project at all, and if so, at what level.

Negotiators. Depending upon the complexity of a project and the proposed relationship between the public entity and the private sector partner, an agency may need to engage a professional to assist staff in negotiations. Such experts may be economists, attorneys, or former developers. Consultants who can see things “from both sides of the table” can be especially helpful to public agencies, since these professionals can knowledgably challenge arguments made by developers and can communicate in the terms and contexts most familiar to the private partner. In addition, skilled consultants will have

This Land Is Our Land

even if the price is right, losing control over a publicly owned property can be disastrous, if it is needed to achieving certain strategic goals. this is because the new owner might decide to do something different with the property (or to do nothing at all, and simply “bank” the land). the city of San Luis obispo has had to manage this risk when engaging in public-private partnerships that involve developing strategically located downtown surface parking lots. the city has managed the risk by negotiating agreements that assure that the properties are not transferred prematurely. Before a property transfers, the developers are required to make option payments to the city while they pursue all necessary discretionary project approvals. that’s the first hurdle. the second is that they must also be able to prove that they are fully ready to build the approved project. therefore, land transfers only after the issuance of building permits, proof of financing and execution of construction contracts. and if a project fails during construction, a “reversion clause” returns the land to public ownership. thus, the city only transfers its cherished public property when the development the city wants (and has fully approved) is at the doorstep of construction.

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• •

insights into the considerations that motivate both the private and public entities and can be effective in bridging differences.

Environmental Consultants. For major projects, agencies will usually contract for environmental studies such as traffic, biological and hydrology assessments.

Attorneys. In addition to the agency’s own legal staff, it may be necessary to contract for specialized legal assistance, depending upon the nature of the transaction and the issues involved.

Many local governments have been successful in requiring the private developer to pay for some or all of these “upfront” costs, depending upon the circumstances surrounding the transaction. Summing Up

Developers may have several motivations for undertaking a project, but profit is usually foremost in the private sector. Feasibility studies will assess physical and environmental constraints, the legal and political context, as well as costs and revenues. Market studies provide developers and investors with information about the demand for certain types of projects, as well as the competition in the marketplace. Market studies generate many of the assumptions used in feasibility models. Local agencies frequently are developers, building infrastructure and other public facilities. While many of the steps are similar to those taken by private developers, the process used by local governments has some important differences. For example, profit is generally not a motive, but other policy goals do drive a public project. This also alters the feasibility assessment. In addition, public projects are subject to different laws regarding labor costs. And, of course, public projects should take place in an open environment, subject to the inputs and criticisms of a municipality’s citizenry. There are public policies and public benefits that cause local agencies to partner with the private sector in a development project. Such partnerships are inherently fraught with complex issues such as the potential for conflicts of interest, an agency’s lack of relevant development experience, and the public’s intolerance of failure when public money or other resources are involved. There are ways to manage risks associated with public-private partnerships, but the public benefits must be clear and substantial before local agencies take on this type of role.

All real estate development projects require expenditures by local governments to provide ongoing services, while they also generate new revenues in the form of taxes and fees. The next chapter discusses these “fiscal impacts.” 206

chapter 14: real estate development Feasibility and the city as developer: Perspectives and roles NOTES Financial considerations are always in the mix, and can cause some developers to pursue outcomes and a standard of development that may not always result in attractive projects preferred by the community. On the other hand, some developers may be motivated by a desire to leave a positive mark—a legacy—that might result in a much better project (and possibly a lower level of return, too). 2 See Miles, Mike E., Gayle Berens and Marc A. Weiss, Real Estate Development: Principles and Process, 3rd Edition. Urban Land Institute, Washington, D.C., 2000, p. 186 and Peiser, Richard B. and Dean Schwanko, Professonal Real Estate Development: The ULI Guide to the Business, Urban Land Institute, Washington, D.C., (1992), pp. 7-8. 3 See Miles, et al., especially Chapters 1 and 3, and Peiser and Schwanke, especially Chapter 2, for a more complete list and fuller description of what the developer does and of several of the many specialists who may be involved in a project. 4 For example, the developer might assume that based on his last housing project, he can effectively construct the next housing development for $100 per square foot (“$100 per foot”). Thus, if he believes that the new project will involve ten units of 2,500 square feet each, the rough construction cost would be ten units x 2,500 sq. ft. x $100/sq. ft. = $2,500,000. 5 After the financial crisis of 2008, real estate development loans were more difficult to obtain for most parties, due in part to greater scrutiny regarding lending practices by state and federal governments, the over supply of real estate products in many areas, fear of overexposure in a risky sector, and general uncertainty about the economy. More recently, the tight real estate development lending environment has eased. 6 Some large development firms may establish lines-of-credit with lenders, usually large commercial banks, for financing large-scale projects. The line may be available for land, infrastructure, construction, or even carrying costs of completed projects until sold or refinanced. 7 In many cases, after long-term loans are originated, they are bundled with other income generating instruments (for example, other loans) and “securitized;” that is, the bundle is converted into bonds that can be bought and sold. In this situation, the traditional relationship where the lender and borrower know each other and the real estate project provides the collateral directly to the lender is confused, if not lost altogether. 8 As has been now well documented, a housing “bubble” significantly contributed to the financial meltdown of 2008 and beyond. Loose lending practices for construction financing and, more particularly, for house mortgages (appalling in many cases), combined with imprudent leveraging, exposed financial institutions from the smallest community banks to the most well-known international firms to calamitous risk. In the wake of this crisis, real estate lending has contracted in many markets, including in California. For a compelling description of the housing bubble and other contributing factors to the crisis see, for example, All the Devils Are Here, by Bethany McLean and Joe Nocera, Portfolio/Penguin, 2010. 9 Note that this is frequently the case when a public agency is the developer of capital 1

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improvements such as parking structures, wastewater treatment plants, or even lowincome housing where future revenues are expected to cover ongoing debt service and operating costs. 10 In the case where the developer intends to sell the project at or shortly after completion, the developer’s pro forma’s timeframe would not extend beyond the projected sale of the property. However, in such cases, the purchaser of the project would likely do his own operating pro forma, comparing annual costs and revenues in order to evaluate the return that could be expected from the projected cash flow of the purchased project. 11 This relationship between time and money prevails in most times; however, in circumstances called “deflation” money is not viewed as having greater purchasing power in the future due to falling prices on goods and services. In a deflationary scenario, money is horded and spending slows. Deflation is generally associated with long-term economic distress and has been, thankfully, rare. 12 The formula for discounting a future value to a present value given any discount rate is PV = FV/(1+r)n where PV is Present Value, FV is Future Value, r is the rate and n is the number of years into the future one expects to receive the FV amount. (More technically, “n” is the number of discounting periods as other time increments other than years could be used.) 13 These calculations assume that all payments and receipts occur at the end of the year, a common simplification. 14 More technically, the IRR is defined as the rate at which the net present value of the cash flow just equals zero. If an IRR is greater than the discount rate used to calculate a cash flow’s NPV, then the NPV given that discount rate will be positive (greater than zero); if the IRR is less than the discount rate, then the NPV given that discount rate will be negative (less than zero). If the IRR equals the discount rate, the NPV using that rate will be zero. There is no straightforward formula for calculating the IRR. Computer spreadsheet programs reach the IRR by iteration: the computer assumes a starting point then tries various rates until it finds the one that generates the NPV of zero. 15 California Labor Code § 1720(a) defines “public works” in order to establish the laws for the bidding, award and contracting associated with maintenance and construction projects done under contract and paid for in whole, or in part, with public funds. Charter cities and counties may set their own public works contracting procedures; but in that case, the state laws must be followed, too. 16 The federal Davis-Bacon Act, and various related state acts, require contractors completing publicly funded projects to pay all workers the local “prevailing wage” and fringe benefit for the work they perform in order to ensure that the ability to get a public works contract is not based on paying lower wage rates than a competitor. 17 California’s prevailing wages are set by the California Department of Industrial Relations. The department determines the general prevailing wage rate by craft, classification or type of worker and enumerates the rates by geographic areas. All bidders are required to use the same “prevailing wage” rates when bidding on a public works project, including projects funded by the federal government.

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Fiscal Impact Analyses: Costs and Revenues of New Development Chapter 15

T

here is little doubt that land development has significant impacts on a community, both positive and negative. That’s why so much political energy is typically directed to encouraging or discouraging growth. The types of development impacts that most often interest the public focus on physical and aesthetic changes and environmental effects, such as traffic congestion, air pollution, or loss of open space. What many people don’t focus on is the potentially significant impacts new development has on a municipality’s financial picture. And while state law requires that development projects be consistent with adopted general plans and that they be subject to environmental impact reviews, there is no statutory requirement that the financial effects be assessed or considered. The Effects of New Development on Municipal Finance New development increases the demand for local government services and facilities; of course, development also generates revenues to the local government through fees and taxes. The comparison of the costs versus the revenues anticipated from new plans or projects is often referred to as “fiscal impact analysis.” Since at least the 1970s, as cities and counties faced constrained revenues and ever-increasing demand for services, they have been correspondingly anxious about fiscal impacts from growth. Communities recognize that to avoid diminished levels of municipal services, fiscal “losers” (development where costs will likely exceed revenues) must be offset by other fiscal “winners.” The most typical analyses focus on impacts to discretionary monies in the general fund because, as discussed earlier, local governments have, at best, only limited control of these revenues that are used to pay a wide variety of critical municipal services.

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Guide to LocaL Government Finance in caLiFornia Fiscal Impacts and Capital Projects

most local jurisdictions have much greater latitude in funding new capital projects than ongoing General Fund operating costs. For public agencies concerned about new development impacting infrastructure, development can be required to incur the cost of the needed facilities through impact fees and/or environmental mitigations. Furthermore, as discussed in chapter 12, local governments can use several types of debt financing for capital projects such as assessment districts, revenue bonds, or special tax bonds. these instruments can direct the burden of paying for new infrastructure onto new development. the major long-term fiscal problem for many agencies, however, is generating enough ongoing operational money, especially in the General Fund, to maintain and operate facilities such as parks, fire stations, libraries, and other capital facilities that rely largely on tax revenues for sustenance.

In most communities, fiscal impact analyses will usually show that residential development, especially less expensive housing accommodating larger households, tends to cost more to service than are returned by new offsetting revenues. Sometimes, however, expensive homes with small households will show net fiscal benefits, but they will tend to remain net revenue generators over time only if real estate prices are rapidly appreciating and if residences are being resold frequently due to Proposition 13 limits on property taxes. The strongest fiscal winners are usually retail businesses, due to the sales tax typically attributed to the developments (although as discussed below, some analysts argue that sales taxes should be attributed to the population that generates such sales). Automobile sales and large-volume “big box” stores tend to be among the greatest net revenue generators. Other fiscal winners typically include motels and hotels, not only because they increase tourism-related spending with corresponding sales-tax revenues, but they also bring in considerable income from the local TOT. Developments such as offices and industrial projects tend toward fiscal neutrality, although obviously they may be very valuable to a community for reasons other than the direct fiscal impacts attributed to them. For example, additional jobs increase local income that results in significant secondary fiscal benefits. In addition, business-to-business sales resulting from these types of developments can generate substantial sales tax income. Figure 15-1 shows an illustrative,1 although by no means universal, outcome from a project-level fiscal analysis of apartments, high-end singlefamily houses, and retail commercial. One problem with this modeling result is that it assumes that the sales tax is largely attributable to the new stores and not to new population. The rationale is that if the community currently lacks adequate local retail opportunities, purchases and the corresponding sales tax may occur outside the jurisdiction, resulting in “leakage” of both sales and tax, because sales taxes are largely distributed based on the “point of sale;” that is, where the transaction occurs.2 Furthermore, certain types of retail stores will have a regional draw, bringing in money from outside the local jurisdiction. Yet, even without new stores, sales tax revenues will increase with a growing population as the existing stores will have a larger customer base. Thus, housing developers will typically emphasize the sales tax generated by the new population and argue that, without more people, more retail would not be possible. This and related problems associated with accounting for new sales tax revenues, and possible solutions, are discussed later in the chapter. Fiscal Impacts Over Time Many analyses suggest that the service costs associated with new development tend to rise faster than the corresponding revenues.3 One explanation is that

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Figure 15-1. Illustrative Fiscal Impact Modeling Results

Estimated and annual general fund and revenues per acre of development

$20,000.00

Retail

$15,000.00 $10,000.00 $5,000.00

$-

$(5,000.00)

$(10,000.00) $(15,000.00)

Large Lot Single Family

Multi Family

Note: Illustrative only: actual results will vary significantly by the type of model, its assumptions and the circumstances of any particular development and location.

Source: Adapted from “Theoretical Comparison of Annual Costs and Revenues from Different Develpment Proposals” at californiacityfinance.com

municipal costs tend to increase at rates above that of general inflation (see Chapters 2 and 8). Key revenues, on the other hand, often more closely reflect general inflation changes, and thus, cannot keep pace with accelerating operational costs. For example, sales tax correlates well with the general inflation rate; thus, if one assumes a “steady state,” that is, no increase in sales, the revenue must lag behind costs if the latter are rising faster than inflation. This fact forces many communities to chase new sales to keep up. The alternative is to reduce the scope or level of services, which many local jurisdictions are forced to do when retail sales stagnate as they do during recessions. In the case of property taxes, Proposition 13 linked revenues to the rate of real estate appreciation and a regular turn-over of properties. In circumstances of rapidly escalating real estate prices and high rates of property sales (e.g. real estate “bubbles”), property tax revenue can outpace inflation. On the other hand, especially during recessionary times, property values will stagnate or decline and real estate sales become sluggish. In those situations, property tax revenues continually fall behind service costs if the community tries to maintain its levels of service. These effects are further compounded whenever the state raids local government revenues to offset Sacramento’s budget shortfalls. Again, the only responses are to increase efficiencies, reduce the scope of services, reduce the level of service . . . or find new revenue sources. For these 211

Guide to LocaL Government Finance in caLiFornia Analyze Plans or Projects?

municipalities may apply fiscal-impact analyses not only to individual development projects but also to specific plans and general plans. this level of analysis actually makes the most sense. there is little doubt that in most california jurisdictions certain developments are likely to generate more service costs than offsetting revenues. nonetheless, some of those uses—affordable housing and public open space, for examples—are important to a wellrounded and healthy community. this makes estimating whether or not a community’s overall mix of fiscal “losers” and “winners” is sustainable so important. the key in fiscal impact analysis is understanding how the community’s desired mix of land uses will “perform” in generating the revenue needed to maintain desired service standards. analyzing fiscal impacts at the larger specific plan or general plan level also makes the problem of assigning sales tax revenues to residential versus commercial growth easier to resolve because in most cases both types of land uses are analyzed at the same time, and double counting can be more readily avoided.

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reasons, municipal governments have found themselves continually hunting for money to maintain services. Uses of Fiscal Impact Analyses There are several reasons why local government may undertake a fiscal impact study.

Assessing the fiscal sustainability of community plans. As noted in the side bar, the most valuable use of fiscal modeling is to help determine whether or not a community’s general plan is financially sustainable. The analysis can show if the mix of land uses and the services levels envisioned in the plan are practical. This approach may also make sense for larger specific plans, and may even be required in jurisdictions where policies dictate that such plans and their subsequent development must be fiscally neutral.

Highlighting fiscal costs or benefits from development projects. Especially in controversial cases, the local government may want to provide estimates of fiscal impacts from individual development proposals. In some instances, for example, estimates of significant financial benefits may bolster public support or contribute to the reasons for approving a discretionary permit. On the other hand, the identification of proposals that may result in significant potential fiscal drains might warrant project-level changes, conditions of approval or other offsetting mitigations (if not outright denial). That said, good community planning should never be solely dictated by fiscal impacts. The “fiscalization” of planning is further discussed later in the chapter.

Annexations and incorporations. Fiscal analyses are essential elements of annexation studies where Local Agency Formation Commissions (LAFCOs) try to ascertain whether or not the local government has the financial capacity to adequately serve the expanding jurisdiction. At the same time, LAFCOs similarly assess the fiscal impact that annexations may have on the counties or special districts losing territory. Fiscal assessments are even more critical in cases of incorporations where the LAFCO must evaluate the financial capacity of the proposed new city. In addition, state law requires that proposed annexations include property tax sharing agreements between affected agencies; fiscal impact analyses can help inform such agreements.

Interjurisdictional service agreements or revenue-sharing agreements. Various local governments commonly create service agreements to realize efficiencies in service delivery. Libraries, transit, fire protection, and utilities are common examples. In these cases, the participating agencies will use fiscal studies to negotiate cost allocations and revenue sharing.

chapter 15: Fiscal impact analyses: costs and revenues of new development Consultants and Third Party Analysts In situations calling for a fiscal analysis, local governments often turn to consultants. One reason is that a competent fiscal study requires a type of expertise not always found among an agency’s staff (and even if they have that expertise, they often don’t have the time to perform the necessary data collection and modeling). Practically speaking, many consultants have broader experience working among different jurisdictions and different situations than most staff. But another important reason is that outside consultants are often perceived as providing greater objectivity and a dispassionate analysis. This is especially valuable in controversial cases, or when more than one local agency is using the analysis. Typical Techniques Fiscal impact analyses typically are developed on spreadsheets that extrapolate from existing conditions to an anticipated future state after the new plan or project is implemented. The fundamental assumption in virtually all models is that the demand for municipal services is largely determined by the people who consume such services: for example, residents, workers, students, and tourists. If these populations increase, then the demand for services will increase as well.

The Service Population. Thus, the first step usually entails defining a “service population;” that is, the group(s) of people that use municipal services. The simplest approach is to assume that current service costs are attributable to existing residents. If new plans or projects will increase the residential population—and assuming the same levels of services—then costs will increase more or less proportionately with the projected population growth. This approach implies that non-residents and businesses, who may also demand municipal services, are highly correlated to the residential population such that changes in residential population effectively capture the effects of these other sectors. In locations where non-residents may have significant impacts on city services, modelers will usually try to take those people in account in their service population. Examples would be tourists in popular visitor destinations or nonresident college students commuting to a large university. Thus, more sophisticated (or perhaps simply more detailed) models will explicitly recognize that people besides residents use city services, albeit in different ways from residents. For example, people working in local businesses also use some city services even if they do not live in the city. Because employees are in the city for less than a twenty-four-hour day, the analysts typically discount the impact from employment numbers relative to the residential population. For example, to take into account that employees are in the city perhaps only eight to twelve

Counties Are Very Different from Cities

Fiscal analysts in california recognize that modeling counties is quite different from modeling cities primarily because some county services extend to all county residents, while others are provided only or largely to those living in the unincorporated territory. For example, most social services are available to all eligible county residents; however, the majority of sheriff costs are focused on unincorporated communities. Similarly, counties are responsible for land use planning and building inspection in the unincorporated areas, only. apportioning service costs between incorporated and unincorporated areas requires considerable care, and the exercise is often “data hungry,” that is, needs a lot of information to be meaningful. in addition, the share of property tax revenues received by counties can vary widely between incorporated versus unincorporated areas, as well as within its different incorporated cities, for a variety of reasons.

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hours per day, a model might assume a service population that is comprised of all residents plus one-third or one-half of employees.

Per Capita Multipliers. Once a service population is assumed, the existing cost of services is divided by that population to give a “per capita multiplier”; that is, the cost of a municipal service per each person assumed in the service population. Once derived, the model applies the per capita multiplier to the estimated increase in service population, to gauge how much costs will increase. Thus, the simplest approach, and in many instances overly simple, is to use current expenditures per capita of the service population as a predictor of future costs. By estimating how the service population will increase due to a new project or plan, one can, in turn, estimate the service costs associated with that future growth. This, of course, assumes that costs will increase proportionally to service population growth; that existing levels of municipal services are acceptable today and will remain acceptable in the future; that municipal service costs will not rise faster than the general inflation rate; and that the necessary increase in service can be provided incrementally rather than in “choppy” steps. Another approach is to review historical data of different types of services and count what share went to different service population subgroups. For example, the analyst might use public safety response calls as a surrogate for police or fire services and tabulate how many such calls were directed to residential developments versus non-residential ones. These data can then be used to develop separate multipliers based on residential population versus employee populations of the community. On the revenue side, many revenues are indeed linked very closely to population growth. For example, many transfers from state and federal governments to cities and counties are tied specifically to residential population. Other revenue sources such as fees and certain taxes are also highly correlated, especially over the longer term, with population growth. However, two of the most important revenue sources—property and sales taxes—may not be so closely tied to residential population growth, especially at the project level and in the short to mid-term (see Chapter 4 for a fuller discussion of these taxes). In the case of property taxes, the formula prescribed by Proposition 13 suggests that revenues will be highly affected not only by population growth (and more building activity) but by appreciation in the real estate market as well as real estate re-sale rates. In times of rapid housing appreciation and house “flipping” and “trading up,” property tax revenues may improve substantially. On the other hand, sluggish or recessionary housing markets can retard or shrink property tax revenues. These conditions are probably hardest to predict in the mid-term. Short-term (a year or two) trends are often, but hardly always, discernable. Likewise, long-term trends can be usefully predictive over perhaps a decade or more as shorter-term fluctuations tend to be smoothed out. 214

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In the case of sales tax, there is good evidence that at least in a regional context, and over several years, revenues are strongly correlated with population growth. The smaller the area analyzed, however, the more unreliable is the per capita technique. It then becomes imperative to consider such factors as competition outside the jurisdiction, income and employment changes within the resident population, and the ability of the expected businesses to attract shoppers from outside the local community (for example in tourist areas or municipalities with large, regional retail centers, resident population growth may be less important than other variables such as regional expansion or tourism trends).

Alternatives to Service Population Multipliers. For certain types of municipal services, there may be readily available alternatives to per capita multipliers that more closely correlate with operational costs. For example, many municipalities have good estimates of the ongoing costs of maintaining streets and parks. Thus, if a new development includes new public streets or parks, then using “lane miles” of streets or park acreage could likely produce more direct, and accurate, cost estimates than ones derived simply from population growth. In other situations, the analyst may have sufficient data to develop a case study as the basis for estimating service costs. For example, if a new residential subdivision is proposed, the analyst may better estimate public safety costs by reviewing the numbers and types of service calls generated by a similar, existing residential area. Another technique sometimes used instead of, or in addition to, population-based multipliers is to look at comparable jurisdictions. If a city, for example, agrees that another city sufficiently reflects their own community—based on such variables as size, location, and service levels—then the first city can use the actual budget-based costs of the comparable city for estimating fiscal impacts.

Level of Service. A critical assumption when using existing budgets and populations to extrapolate future costs and revenues is that the current budget reflects acceptable or desirable levels of municipal services. In many situations, communities may actually strive for higher levels of service: more police officers, more fire stations, more parks, etc. than they currently have or can afford. In those cases, modelers need to adjust the current budget amounts to reflect desired levels of service. For example, consider the following infor mation: • Current population is 10,000 people and police budget is $900,000. • The city currently has 9 uniformed police officers, or $100,000 per officer. • The current level of service is .9 officers/1000 residents.

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Assume that during public workshops, the community expresses a desire to increase level of service to 1.5 officers/1000 residents, more in line with the regional average. The budget needed to reach that level of service would be substantially higher than the current one: • 1.5 officers/1000 residents x 10,000 residents = 15 uniformed officers. • Current budget for 9 officers is $900,000. • Thus, for 15 officers, the budget would need to be about $1,500,000 to reach the desired level of service.

The fiscal impact modeler needs to make clear whether the assumed level of service is simply the current budget, or if adjustments are being made to reflect higher levels that the community might aspire to in the future.

Sales Tax, Cannibalization, and Double Counting. When considering a large-scale plan, such as a community general plan, there may be a strong rationale for linking sales tax growth to population increases, and using a per capita multiplier as the estimating tool. However, especially at the project-level, the sales tax presents some special problems for the modeler. At the level of a new retail project, modelers tend to look at the size and nature of the commercial development being proposed and may use the average annual retails sales per square foot of retail space for the anticipated store types to project the overall annual retail sales tax revenues to the local agency. Two potential problems warrant careful attention, however. First, few new retail developments will generate entirely new sales within the jurisdiction in which they are located. New outlets are likely to reduce, at least in part, sales volumes in existing similar stores. As noted earlier, this transfer effect is sometimes called “cannibalization” where the new stores consume some of the sales from existing stores. Thus, the net sales tax generated to the local government by a new commercial project might be less than suggested by the simple volume of sales per square foot formula because of the reduction in sales tax from already existing stores. The converse of this effect may occur if a new retail development is able to capture sales that previously “leaked” to another community and/or attract sales from non-residents. In this case, the volume per square foot method may more closely reflect the net increase in sales tax revenue. A second problem occurs when modelers analyzing new residential developments assume (reasonably) that new residents will help generate new sales tax but then also credit new commercial developments for the new sales tax, too. Over time, as further discussed in the sidebar on plans versus projects, this will lead to significant double counting.

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chapter 15: Fiscal impact analyses: costs and revenues of new development Criticisms Average Costs Versus Marginal Costs. Many analysts have pointed out that small increases in city growth don’t really noticeably increase demand for city services.4 For example, while a new ten-unit apartment house in an already built up neighborhood will increase the population, it is not likely to trigger increases in the need for police patrols or for new fire stations, equipment, and firefighters. The “marginal cost” of the project is negligible given the true capacity of services within the city. When one uses per capita multipliers, an “average cost” rather than the marginal cost is computed. While there is certainly validity to this observation, a marginal cost analysis, especially at the project level of review, will eventually lead to problems. Over time, the incremental costs of small projects will accumulate to the point where they are significant. The average cost method does tend to overstate costs in the short term, but it more carefully accounts for the long-term growth in costs. Step Functions. A similar criticism of typical fiscal models is that many municipal services are not provided in smooth increments, but rather are “lumpy” in that they often occur in “chunks.” This may be obvious for capital improvements like fire stations or parks, but can also affect services like police patrols or “beats” which require a crew of officers to function effectively. Modelers must be clear about how they are treating these types of situations. Again, the larger the plan area and the longer the timeframe, the less important is accounting for step functions versus average costs.

A Lot of Assumptions; Stability of Multipliers. All fiscal models require a lot of assumptions. Among the most important is that the past will predict the future and that multipliers derived from past or current budgets will be stable into the future. While past trends are probably the best available information for looking into the future, there are hardly any guarantees that such trends will be accurate forecasters of what is to come. Both macro and local effects can upset what seemed like reliable trend lines. The housing bubble and related economic crisis in the late 2000s are clear evidence of how large-scale events can dramatically and suddenly alter the local government’s financial picture. At the local level, events like the opening of a large shopping center—or the bankruptcy of an important local business—can make projections based on past trends irrelevant. It is also a big assumption that the regulations affecting municipal revenues will remain constant during the timeframe of the model. In California, the legislature, and voters through initiatives, have regularly altered the ways local governments can raise money and spend it.

Need for Sensitivity Analysis. One way to help address the problems with assumptions in fiscal models (and any modeling exercise for that matter) is to 217

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conduct “sensitivity analysis.” As noted in the previous chapter, such analysis tests different assumptions to see how modifying the input affects the model results. If a small change in an assumption significantly changes the model’s output, then one should focus on increasing the reliability of that assumption. If on the other hand, change to an input assumption does not vary the results a lot, then one can be more confident about using that assumption in the model. Fiscalization of Land-Use Planning

Caught between the twin pressures of restricted and often shrinking revenues, and the relentless demand for more public services, cities and counties in California have placed a great weight on the fiscal impacts of their land-use plans and resulting development projects. After Proposition 13 especially, many cities and counties began regularly requiring fiscal impact analyses of their general and specific plans, and of large-scale development proposals. The pressure to promote only “fiscal winners” has become known as the “fiscalization” of land use; in other words, net-revenue trumps other project considerations. While the consideration of fiscal impacts is a valid element of planning, the criteria for judging projects were more in balance when local governments had greater control over revenue sources.5 But as money became more important, many planners feared that fiscal considerations would overwhelm other important factors such as protection of open space and natural resources, social equity, and the logical expansion of community boundaries . . . and surely in many cases they did. By the early 1990s competition for revenue-producing land uses among cities, and between cities and counties, became increasingly commonplace. In some situations, adjacent cities vied for big box outlets or auto dealerships by reducing their impact fees, omitting usual conditions of approval, or conducting less-than-rigorous environmental reviews. Developers, on the other hand, played each jurisdiction off the other. In several instances, competition between cities and counties pitted otherwise amiable agencies against one another over annexations, especially of commercially zoned land.6 Similarly, counties in the early 1990s routinely challenged the formation of redevelopment areas unless they received a favorable increment-sharing agreement with the redevelopment agency.7 The emphasis on the fiscal effects of land-use decisions will undoubtedly continue until the municipal finance system in California is overhauled. Fiscal impact analysis, in itself, is not a problem—and in fact should be relevant especially at the general plan level. But, when financial implications override all other factors, good land use planning is, indeed, threatened.

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chapter 15: Fiscal impact analyses: costs and revenues of new development Summing Up Fiscal impact analysis estimates the costs and revenues to a local government from new plans or development proposals. They are also explicitly used to assess annexations, incorporations, and certain joint powers agreements. Fiscal models in California will typically find retail commercial and tourism-related land uses to be “winners” while housing, especially lower-cost housing, is a financial “loser.” This effect frequently is exacerbated over time. Thus, community plans should strive to develop a balance of land use that includes sufficient net revenue generators to offset financial drains and/or to avoid diminishing service levels. All models include a lot of assumptions about the future. Models that use more assumptions may not be more predictive than simpler approaches. It is important to conduct sensitivity analysis to test which assumptions make the most difference in a model’s output. When a small change to an assumption results in a large change in the result, special scrutiny should be applied to the basis for that assumption. Since Proposition 13 cities and counties have increasingly considered the fiscal impacts of their land use decisions—sometimes to a fault. The “fiscalization” of planning will undoubtedly continue until local government financial conditions are uncoupled from their land uses through various reforms. In the meantime, local governments must weigh fiscal impacts—but with the recognition that financial factors constitute just one consideration among many in creating thoughtful, balanced plans and quality communities.

This discussion of fiscal impacts and the fiscalization of land use planning highlight just one set of problems local governments face related to finance. The next part of the book takes a look at the history of finance in California (Chapter 16) and suggests some new directions for possible reforms in California’s public finance system (Chapter 17).

NOTES Generalized results adapted from “Theoretical Comparison of Annual Costs and Revenues for Different Development Proposals” (2007), by Michael Coleman, www.california cityfinance.com. 2 Note, too, that this illustration assumes new retail development actually generates new sales and is not simply replacing sales in existing retail outlets in the same jurisdiction. 3 For example, see “Fiscal Impacts of UCSB Long Range Development Plan,” County of Santa Barbara (2008); or “Long-Range Financial Model,” City of Atascadero (1992). 1

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See, for example, Eric Heikkila, The Economics of Planning, especially “Chapter 7: Rethinking Fiscal Impacts,” The Center for Urban Policy Research, Rutgers University, New Brunswick, 2000. 5 Another reason for the rise in fiscal modeling was technological. With the advent of desktop computers and sophisticated and readily available spreadsheet software, models that were dauntingly complex and expensive became much more accessible. Decision-makers were also able to ask “what if ” questions to the modelers, which actually allowed for more sophisticated planning. 6 See Michael Multari, “Planning on the Edge: Why New Developments in Counties Don’t Pay,” Western City, 1994. 7 The practice of negotiating tax-sharing agreements among affected agencies was halted in the mid-1990s by a major overhaul of redevelopment law; the new statute prescribed by formula the shares of the increment the various affected local agencies would receive. 4

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Looking Back, Going Forward: The Road to Reform Part V

Looking Back: A Brief History of California Local Government Finance Chapter 16

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his book has thus far mostly focused on the what and how of municipal finance in California. However, any aspect of California municipal finance—say, how streets are paid for—begs the question: Why it is it done that way? That, in turn, begs a history lesson. Absent this history, many of the ways local government services are funded in California seem arbitrary or downright nonsensical.1 And the reforms suggested in the last chapter will perhaps lack the context needed to make sense of them.

The Early Constitution and Local Home Rule The rules for California’s system of local government finance are provided in the state’s constitution, state laws and regulations, local ordinances or laws, and the legal determinations of the court system concerning these laws. California’s second constitution, adopted thirty years after becoming a state in 1849, created the first substantial and meaningful home rule for California’s local governments. Home rule refers to the authority of local governments to conduct certain of their affairs without interference or preemption from the state. The 1879 constitution vested in cities extensive powers of self-government and specified that the state could authorize local governments to impose taxes for local purposes. A 1910 ballot measure known as the “Separation of Sources Act” established the principle that the state and local levels of government should have separate revenue sources and designated the property tax as a local government source. The property tax was considered the best way to fund critical local services such as law enforcement, fire protection, parks, libraries, schools, and hospitals.2 This concept—that the property tax should be the largest and most important source of local government funding—would stand 223

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for sixty-eight years, until Proposition 13 drastically altered California local government finance.

The Changing Complexion of Local Revenues. Although the property tax is the oldest source of municipal funding, as explained in prior chapters, local governments have come to rely on a much broader mix of taxes, fees and aid from the state and federal governments. In 1930, property taxes provided over seventy-five percent of all revenues of California cities; by 1960, the property tax accounted for less than forty percent, and by 1990, just ten percent. Counties experienced a similar downward trend. In part, this reflected changes in the purpose and expectations of cities and, especially, counties, over time. A dramatic shift occurred during the 1930s when counties implemented many aspects of New Deal programs oriented toward public health and aid to the needy. As counties increasingly became the service delivery arm for state and federal programs, they relied on grants and other forms of revenue from those higher levels of government to help fund those services. Meanwhile, the state shouldered greater responsibility for funding (and policy) related to public education. The growing service demands of their residents spurred cities and counties to seek other revenue sources to supplement the property tax. In 1955 California cities and counties were authorized to impose local sales taxes, and since then, this revenue source has been increasingly important. In addition, cities and counties turned to fees for various public services, to better reserve general-purpose taxes for critical functions such as police or sheriff departments that are not typically fee-supported. Figure 16-1. Historic Revenues, California Cities

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chapter 16: Looking Back: a Brief History of california Local Government Finance Figure16-2. Historic Revenues, California Counties

Matters of Statewide Concern Versus Home Rule. The distinctions between what is a “local” responsibility (and revenue source) versus what is a “state” responsibility (and revenue source) has never been fully clear, and in any case, is in continual flux. In 1914, the California constitution was amended to provide charter cities with strong home-rule authority over most municipal affairs. Never theless, the constitution also clarified that all local authority remained subject to state preemption in matters of “statewide concern.” Thus, for any par ticular program or issue, the legislature may assert that statewide concerns override local priorities or preferences, with disputed cases adjudicated by the courts. The state has preempted local home rule regarding financial matters on a number of occasions In 1935, for example, the state disallowed the imposition of the local property tax on motor vehicles and instead established a statewide uniform tax, known as the “motor vehicle in lieu tax” or Vehicle License Fee (VLF), which it then allocated to cities and counties based on population. (The VLF later became the subject of intense political and budgetary gyrations, a “cautionary tale” told in Chapter 17.) In 1955, the legislature passed the Bradley-Burns Uniform Sales and Use Tax Act, which replaced existing locally variable sales taxes with a uniform, statewide sales tax system, and authorized all cities and counties to adopt local sales tax rates of up to one percent within that framework. 225

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These two examples illustrate attempts to balance local control of municipal government funding against the advantages attendant to uniform practices and rates across the state. But they, and others like them, clearly centralized fiscal authority at the state level, constraining local fiscal autonomy, with significant repercussions later in the twentieth century. During the last thirty years, this state-local tension has been aggravated by a retrenchment of the state’s financial support for local government and yet a shift of responsibilities and related costs to local government for programs of statewide scope. And what state aid has been provided almost always comes with “strings attached”—that is, they are only available for purposes determined by the higher level of government, essentially preempting local priorities. Further exacerbating the tension during this time has been Californians’ desire to limit taxes and to direct budget decisions through voter-approved initiatives. However, tax restrictions and spending limits have not been accompanied by a correspondingly diminished appetite for public services.3 The efforts to require the state to reimburse municipalities for the costs of mandates imposed by the legislature illustrate another area of the state-local financial conflict. The legislature continued through the 1960s to impose more responsibilities on local governments but without the accompanying financial resources. So acute was the growing problem, that in 1972 the legislature passed SB 90, which requires the state to reimburse costs to local agencies when the state mandates them to undertake certain programs. In 1979, this reimbursement requirement was added to the state constitution as a part of Proposition 4 (see below). Nonetheless, the state continued to push more obligations onto local governments, but with fewer resources, especially during recurring budget crises in Sacramento. This pressure resulted in yet another proposition in 2004 to strengthen the requirement to reimburse municipalities in such situations.

Proposition 13 and the Era of Limits The property tax is determined by applying a percentage tax rate against the assessed value of the taxed properties. For over a century in California, County Assessors determined the value of the property for tax purposes (within certain parameters) and city councils, boards of supervisors, and special district and school boards decided local tax rates . . . until 1978 and the passage of Proposition 13. This proposition has been mentioned repeatedly in this book for good reason. This was a truly landmark constitutional amendment that took away most of the discretion out of property assessments and all of the authority for local rate setting. It completely changed the way local government is financed in California for all local agencies—cities, counties, and special districts. 226

chapter 16: Looking Back: a Brief History of california Local Government Finance Figure 16.3. Fiscal Limits Breed Fiscal Limits

When fiscal constraints are imposed on local governments, they often find creative ways to respond. taxpayer advocates often respond with attempts to impose more fiscal constraints.

Roots of a Taxpayers’ Revolt. Many factors combined to generate what is often referred to as a taxpayers’ revolt. By the 1970s, property tax rates often varied widely from property to property due to rate setting by different local agencies. At the same time, as California real estate values enjoyed a period of rapid appreciation, property assessments outpaced the general inflation rate, and especially to those on limited income, appeared to be spiraling beyond the means of many homeowners. Concurrently, the state was building up multibillion dollar surpluses. Furthermore, several scandals emerged during the previous decade involving corrupt assessors giving tax breaks to friends. In 1967, a new state law (AB 80) attempted to reform the property tax system, requiring regular periodic and standardized methods for assessments of all properties. But the new procedures also had the unintended effect of shifting a larger percentage of the total tax burden from commercial to residential property. Stoked by fears that fixed income homeowners might be taxed out of their houses, as well as general anger over rapidly increasing taxes and a perception of state government bloat, the electorate was ripe for a drastic change. Led by Howard Jarvis—a prominent activist rallying support for slashing taxes—the momentum for major reforms through the initiative process was clearly building. The landmark initiative, Proposition 13, qualified for the June 1978 ballot. Strong Institutional Opposition, but Overwhelming Voter Approval. The state legislature, feeling the pressure and deeply concerned about repercussions of the pending Proposition 13 on the state, schools and other

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local governments, enacted some mitigating measures, but was generally slow to produce a workable reform package.4 In February 1978, the legislature narrowly approved a measure to appear alongside Proposition 13 on the June ballot. Proposition 8—the legislature’s reform package presented as a less drastic alternative to Proposition 13—was backed by surprisingly wide array of interest groups: the state Chamber of Commerce, banks, teachers, unions, the League of Women Voters, party leaders on both sides of the aisle and even the California Taxpayers Association. All opposed Proposition 13. Regardless, sixty-five percent of California voters approved Proposition 13 in June 1978. The voters sought property tax relief, predictability regarding increases, and uniformity in application. And the initiative delivered on its promises. It applied the same rules regarding property taxes throughout the state, significantly reduced property taxes paid by property owners, and perhaps most importantly, capped increases in taxes so long as the property ownership was not transferred, providing both significant tax relief and a high degree of predictability.5 Curiously, while the primary audience of Proposition 13 was homeowners (the campaign for Proposition 13 prominently featured stories of elderly ladies forced to move from their lifelong homes by increases in taxes they could no longer afford on their limited pensions), less than one-fourth of the measure’s benefit has actually accrued to residential property owners. The much greater beneficiaries, forty percent of the savings, have been owners of commercial 228

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property. Another unexpected consequence was an increase in state (and federal) income tax collections because there were reduced property tax deductions on personal income tax returns. State policy makers took advantage of this effect when they implemented the post-Proposition 13 shift of state revenues to cushion the adverse impacts on cities, counties, special districts, and schools.

Proposition 13 Re-makes the Property Tax Situation. The one percent limitation on the property tax rate and the rollback to 1975-1976 assessed values resulted in an immediate fifty-seven percent reduction in property tax revenues statewide.6 In 1979–1980, the legislature tried to cushion the fiscal impact of Proposition 13 on local governments. In what is often called the “bail out,” the state was able to shift about $2.7 billion of annual on-going revenues to local governments in part because of the state’s $5.0 billion surplus8 and an annual $1.0 billion-plus revenue boost it received from higher income taxes due to lower property tax deductions. With the “bail out,” city property tax losses from Proposition 13, for example, were about twenty-eight percent less than they might have been. Over time, local agencies came to view the “bail out” as an accepted and permanent transfer of state revenues to local governments, while many at the state level considered it only a short-term ameliorative that the state could call back at any time in the future. The state legislature also used its new authority under Proposition 13 to re-allocate property taxes among local governments. In what was intended as a permanent resolution to the issue of how to distribute the significantly reduced property tax revenues among local agencies, the legislature reduced the share of property tax revenues previously going to schools, and gave larger shares to cities, counties, and special districts. In return, the state assumed a larger financial responsibility for K-12 schools and community colleges, in part due to the Serrano v. Priest decisions of the California Supreme Court in the 1970s, mandating equalization in funding among rich and poor schools districts. The state also increased its share of costs for

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Proposition 13’s Key Effects on Local Finance

One percent rate cap. Proposition 13 caps, with very limited exceptions, property tax rates at one percent. Prior to Proposition 13, local jurisdictions independently established their tax rates, and the total property tax rate was the composite of the individual rates. Assessment rollback. Proposition 13 rolled-back property assessments for tax purposes to their 1975-1976 level. Reassessment upon change in ownership. Proposition 13 replaced the practice of annually reassessing property. rather, property is assessed at market value for tax purposes only when

it changes ownership (or there is new construction in which case the new construction is assessed separately). thereafter, increases in annual assessments are capped at two percent until the property is transferred, at which time the assessed value is again the market value (that is, the sales price, in most cases). Disallowed local General Obligation bonds. through most of california’s history, General obligation (G.o.) bonds were the most common instruments for debt financing local capital improvements (see chapter 10). Proposition 13 actually prohibited new local G.o. bonds. Within a few years, even many anti-tax advocates recognized that this blanket prohibition was too harsh and truly unworkable. in 1986, Proposition 46 lifted the local G.o. bond ban and allowed this type of debt subject to a local two-thirds voter approval. more recently, the super-majority hurdle was reduced to fifty-five percent for local school bonds. Responsibility for allocating property tax transferred to the state. Proposition 13 gives state lawmakers responsibility for allocating property tax revenues among local jurisdictions. Prior to Proposition 13, local agencies independently established their own tax rates and proceeds were distributed accordingly. Voter approval for special taxes. Proposition 13 requires twothirds voter approval for local taxes (other than ad valorum based taxes) raised for a designated (“special”) purpose. Taxes imposed by the state require a two-thirds vote of each chamber of the state legislature. this restriction on state-level revenue generation has direct repercussions for local governments.

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Guide to LocaL Government Finance in caLiFornia Who Really Benefited from Proposition 13?

Proposition 13 delivered on its promises to homeowners. it significantly reduced property taxes paid by property owners and, perhaps more importantly, capped increases in taxes so long as the property ownership is not transferred, affording both significant tax relief and a high degree of predictability. But while the primary audience of Proposition 13 was homeowners (the majority of voters), less than onefourth of the benefit of the measure has gone to residential property owners. the much greater beneficiaries, forty percent of the savings, have been owners of commercial property.7

a number of social service and health programs operated by counties to promote greater statewide equity in benefit levels. Taking on these new financial obligations would cause significant problems later on, when state revenues stagnated due to changed economic and political conditions.

A Blow to Local Autonomy. In spite of these efforts to reduce its impact, Proposition 13 dealt a major blow to local fiscal autonomy. In a 1994 ruling upholding the state’s shift of property tax revenues from local governments (the “ERAF” shift, see below), the California Supreme Court noted that the taxing powers of local governments are “derived from the Constitution upon authorization by the Legislature.” Local governments had lost the authority to alter the property tax rate. Thus, since Proposition 13, even if local voters want to raise their property taxes to improve services, they are constitutionally prohibited from doing so (the one exception is for repaying certain bonds for capital projects approved by voter super-majorities; see Chapter 10). The state was handed the authority to determine each local agency’s share within the one-percent umbrella covering all taxing agencies. Where once a community could devote more or less property tax revenue to fire services versus libraries versus schools, now all communities are constrained by taxing decisions enacted a generation ago—when California was a different place socially, economically and politically. The Gann Limit

Taxpayer advocates soon followed up Proposition 13 with a companion measure in 1979 aimed at limiting government spending. In other words, reducing taxes was not deemed sufficient: tax-related expenditures were to be capped as well. Proposition 4, commonly known as the Gann Initiative after anti-tax activist Paul Gann, set tax expenditure limits on the state and local governments based on the proceeds they received from taxes in 1978-1979.9 The limit increases annually according to a formula that accounts for changes in population and inflation. In any year, an agency may not appropriate tax proceeds in excess of this limit. If an agency has the good fortune to take in tax revenues above the limit, the excess funds must be returned to taxpayers through reduced taxes or fees, unless an override to increase the limit—lasting a maximum of four years—is approved by a majority of voters.10 Proposition 4 had little impact in the early 1980s as high inflation raised the spending limits faster than the growth of tax revenues. However, later in the decade several cities did reach their limits and had to hold votes to get permission to use that money. In 1987, the state unexpectedly reached its spending limit and refunded $1.2 billion to taxpayers as a result.11 In 1990, the voters approved Proposition 111, which relaxed, but did not eliminate, the spending limit, making the formula more responsive to local growth. 230

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The Gann limit also has, from time to time, pushed cities to seek nontax revenue sources (including higher fees but also the sale and lease of city properties) that are not subject to the spending restriction. The Gann limit is another example of California’s complex and confusing mix of laws affecting how local governments can raise and use money. The 1980s: State Fiscal Retrenchment and Local Responses

In the years following Proposition 13, local governments faced substantially constrained revenues not only from reduced property taxes but also from substantial reductions in state aid to local agencies. Shortly after the postProposition 13 “bail out” to local governments, the state found itself in its own fiscal trouble and repealed various state aid programs. During these years, the state also repealed an assortment of revenue pass-throughs (“subventions”), whereby certain monies collected by the state had previously been directed to local agencies. Many of the subventions had been instituted to offset losses to local governments from earlier legislative actions, but the fiscal tide had clearly turned and brought with it more intense competition for money between the state and local governments, and among local governments themselves. In what was a particularly ominous bellwether for later “take-aways,” the state shifted over $700 million of Vehicle License Fee (VLF) revenues from cities to the state general fund between 1981 and 1984. The state’s confiscation of VLF revenues was unprecedented, as described further in the next chapter. With property tax revenues down, sales taxes became increasingly important for cities and counties12 forcing them to focus on expanding commercial development in their jurisdictions. The competition for sales tax dollars led to the “fiscalization” of land use decisions (see Chapter 15). In some places, the competition among jurisdictions for these sales tax generators led to some agencies offering subsidies, infrastructure, fee waivers, or reduced environmental mitigation requirements if the sought-after businesses would locate in a particular municipality (reasoning that short-term costs were worth it if they resulted in long-term income streams). Disputes between cities, and between cities and counties along their borders, sometimes led to bitter relationships and even lawsuits. In many parts of the state, previously cordial city-county relationships became heated and strained. As explained earlier, local governments also responded to the decline in traditional revenue sources by increasing fees. The increases were intended to expand the scope of services subject to fees and to better capture the full costs of providing services. Many also adopted new taxes, such as those imposed on utility users, parking, and admissions to sporting and entertainment events, when such taxes were permitted. They also sought to raise those existing taxes still under direct local control such as business license taxes and TOT. Innovative state laws permitted local authorization for new forms of special tax and assessment districts

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Proposition 13

Lowered tax burden for property owners. treated similarly situated properties disparately. cut local agency property tax revenues by nearly sixty percent. made tax revenues out of sync with public service demands. created a greater reliance on state general fund for county and school spending. accelerated the turn by cities and counties to fees and other local taxes.

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to fund such things as streets, parks, lighting, and landscaping. Furthermore, local agencies transferred more of the costs of infrastructure needed for new development onto developers through impact fees and exactions. Cities and some counties turned increasingly to redevelopment as a tool to enhance local revenues. California’s Community Redevelopment Act allowed a city or county to establish project areas in which most of the growth in property tax revenues within the area was captured by the redevelopment agency and used to address blight. Many municipalities recognized that if large portions of their jurisdictions could be considered blighted and, thus, encompassed in a redevelopment project area, larger shares of the property tax revenues would be available for municipal infrastructure projects and some services. This situation led to some cities finding large portions of their territories “blighted,” sometimes including large tracts of undeveloped land. In the mid-1990s major reform legislation largely ended what were seen as abuses of redevelopment as a general municipal revenue tool. (See Chapter 13 for additional discussion of redevelopment.) ERAF: Educational Revenue Augmentation Funds

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The most dramatic example of the shift of power from local governments to the state is the legislature’s use of property taxes to address budget troubles in the early 1990s. The state’s apportionment formulas for distributing postProposition 13 property taxes among local jurisdictions had remained largely unchanged for over a decade. But in 1992, facing a serious general fund deficit, the state legislature again exercised the power granted by Proposition 13 to allocate local property tax revenue and redirected revenues from cities, counties, and special districts in order to remedy its own financial difficulties. The state instructed county auditors to shift significant portions of property tax revenues previously allocated to local governments into “educational revenue augmentation funds” (ERAFs). The ERAF monies were then used to support schools, at the direct and substantial loss to cities, counties, redevelopment agencies, and other special districts. With this added property tax revenue flowing to schools, the state was able to reduce its general fund obligations to schools by billions of dollars.13 ERAF just moved money around; it didn’t increase tax revenues for public services. And municipalities, especially counties, were on the short-end of the move. In 2010-2011, the annual impact of the ERAF shift on cities, counties, and special districts was over $7.5 billion. Counties have borne some seventyfour percent of this redirection of funds; cities sixteen percent. Over the years, the legislature has provided some funding to local governments that it considers mitigation of ERAF. However, the vast majority of these funds are earmarked for particular purposes. For example, in 1992, California voters approved Proposition 172, which provided additional sales tax funding for police, fire

chapter 16: Looking Back: a Brief History of california Local Government Finance

and other public safety programs. In 2010-2011, Proposition 172 funds provided $2.2 billion to local government (mostly to counties) well below the property tax losses due to ERAF. Of course, the multibillion-dollar impact of ERAF is just another of the effects on public revenues that can be traced in large measure to Proposition 13. Proposition 218 (1996): “The Right to Vote on Taxes Act”

In 1982 voters approved Proposition 62 in an attempt to clarify certain implications of Proposition 13 including the circumstances under which voter approvals would be required for different taxes and fees. For over a decade afterward, despite Proposition 62, the courts struggled to answer those and related questions. The Howard Jarvis Taxpayers Association, frustrated that earlier measures had failed to require voter approval of all local taxes, then led a new far-reaching tax limitation effort. In 1996, California voters approved Proposition 218, the “Right to Vote on Taxes Act,” expanding restrictions on local government revenueraising.14 The measure allows voters to repeal or reduce taxes, assessments, fees, and charges through the initiative process; reiterates the requirement for voter approval for different types of taxes; and imposes procedural and substantive limitations on benefit assessments imposed on real property and on certain types of fees. Proposition 26 (2010): Refining the Definition of “Tax” In November 2010, California voters passed Proposition 26, which added a definition of “tax” to the California Constitution. The new provisions state that a government-imposed charge, levy, or exaction of any kind is a tax unless it falls into one of seven express exceptions. The effect of the measure was particularly to tighten the definition of regulatory fees and certain assessments. According to Proposition 26, a government-imposed charge, levy or exaction of any kind is a tax unless it falls into one of seven express exceptions.

Provisions of Proposition 218

• imposed a majority voter approval

requirement for general taxes (which had already existed for general law cities under Proposition 62), and a supermajority requirement for special taxes (which had already existed under Proposition 1315) and established a clear constitutional standard distinguishing locally imposed general taxes from special taxes.16 • Provided citizens with the power to repeal taxes, assessments, fees, and charges that are subject to Proposition 218. • established a formal balloting procedure for the adoption of benefit assessments imposed on property. • required a distinction between special benefits and general benefits with regard to assessments and prohibits the funding of general benefits from property assessments. • required the assessment of public property within an assessment district. • Placed the burden of proof for demonstrating special benefit on the local agency imposing the property assessment. • established a new category of fees called “property-related fees” with new approval procedures and substantive provisions for those fees.

• A charge imposed for a specific benefit conferred or privilege granted directly to the payor that is not provided to those not charged, and which does not exceed the reasonable costs to the local government of conferring the benefit or granting the privilege. Examples may include fees for planning permits, restricted neighborhood parking permits, and entertainment and street closure permits.

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Guide to LocaL Government Finance in caLiFornia The State/Local Realignment of 2011

the 2011 state budget agreement shifted the primary responsibility for a number of public safety and related services to counties. the costs of these programs—about $5.6 billion in 2011-2012 and estimated to increase to $6.8 billion in 2014-2015—are primarily funded from the transfer of revenues to counties of a share of the state’s sales tax. counties assume responsibility for certain low-level felons, adult parolees, and juvenile offenders, enabling the state to comply with a federal court order to reduce the state’s prison population. the state estimates that the realignment plan will reduce state corrections system costs by about $1.0 billion per year. other programs shifted to counties include child welfare services, mental health services, substance abuse treatment, and adult protective servies. By designing a portion of the state sales tax to go to local governments to pay for realigned programs, the state effectively reduced its overall general fund, which, in turn, reduced its funding obligations to K-12 schools and community colleges stipulated by Proposition 98 by about $2.1 billion.

• A charge imposed for a specific government service or product provided directly to the payor that is not provided to those not charged, and which does not exceed the reasonable costs to the local government of providing the service or product. Examples may include user fees for parks and recreation classes, utilities (other than those covered under number seven), public records copying fees, DUI emergency response fees, emergency medical and ambulance transport service fees.

• A charge imposed for the reasonable regulatory costs to a local government for issuing licenses and permits; performing investigations, inspections, and audits; enforcing agricultural marketing orders; and administrative enforcement. Examples may include health and safety permits, building licenses, police background checks, pet licenses, bicycle licenses, and permits for regulated commercial activities (such as massage establishments, card rooms, taxicabs, and tow-truck operators).

For exceptions one through three, the fee imposed must not exceed the agency’s reasonable costs. • A charge imposed for entrance to or use of local government property or the purchase rental or lease of local government property. Examples may include facility room rentals; equipment rentals; park, museum, and zoo entrance fees; golf greens fees; onand off–street parking; and tolls.

• A fine, penalty, or other monetary charge imposed by the judicial branch of government or a local government as a result of a violation of law, including late payment fees, fees imposed under administrative citation ordinances, parking violations, etc. Examples may include parking fines, code enforcement fees and penalties, late payment fees, interest charges, and other charges for violation of the law.

• A charge imposed as a condition of property development. Examples may include planning fees, building permit fees, construction and grading permits, development impact fees, fees imposed by California Environmental Quality Act mitigation requirements, and Quimby Act and park mitigation fees.

• Assessments and property-related fees imposed in accordance with the provisions of Article XIII D (Proposition 218). Examples may include assessments on real property for special benefit conferred, fees

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imposed upon a parcel or a person as an incident of property ownership, and fees for a property-related service such as many retail water. Proposition 1A (2004) and Proposition 22 (2010)

Reacting to continued state shifts of local property tax revenues, the deterioration of local control of fiscal matters, and the substantial limitations imposed by Proposition 218, cities, counties, and special districts crafted a local revenue protection initiative that garnered enough signatures to qualify for the November 2004 ballot. Governor Arnold Schwarzenegger, who had recently taken office after the recall of Gray Davis, immediately signaled his opposition to the measure but a willingness to support a different one if it were part of a larger state-local fiscal restructuring package. The result was Proposition 1A, which garnered an unprecedented eighty-four percent of the vote. Proposition 1A accomplished the following: •

• •

•

Strengthened prohibitions against unfunded state mandates by requiring the state to suspend such mandates in any year the legislature does not fully fund those laws.17 Expanded the definition of state mandate to include transfer of responsibility of a program for which the state previously had full or partial responsibility. Prohibited the state from: a) Reducing the local portion of the sales and use tax rate or altering its method of allocation, except to comply with federal law or an interstate compact. b) Decreasing the 0.65 percent Vehicle License Fee rate without providing replacement funding to cities and counties. c) Reducing the share of property tax revenues going to the cities, counties, and special districts and shifting those shares to the schools or any other non-local government function.18

Allowed the legislature to suspend the property tax revenue protection provisions of Proposition 1A and “borrow” not more than eight percent of total property tax revenues if: a) the governor issues a proclamation of “severe fiscal hardship”; b) the legislature enacts an urgency statute suspending Proposition 1A property tax protection with two-thirds vote of each house; and c) the legislature enacts a law providing for full repayment of the “borrowed funds” plus interest within three years. 235

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Proposition 1A did not provide local governments with any new revenue nor reduce or alter the earlier ERAF revenue shifts. In 2010, voters passed another measure to strengthen local governments’ position relative to the state. Proposition 22 prohibits the state from borrowing, delaying or taking motor vehicle fuel tax allocations, gasoline sales tax allocations, public transportation account funds, or redevelopment agency property tax revenue. Despite Proposition 22, the legislature dissolved RDAs (see Chapter 13). Summing Up It is impossible to understand municipal finance in California without some appreciation of the long and contorted history of state-local fiscal relations. Likewise, meaningful reform to address the state’s frequent budget woes also requires an understanding of the web of these relations; tickle the web in one place and there will be responses throughout the system, over time, and often unintended. Early in its history, California granted substantial home-rule authority to local governments. While this authority slowly eroded over time, truly cataclysmic changes occurred with Proposition 13 in 1978 and its various offspring. The long standing source of local revenue, the property tax, was restricted; control over taxes was further concentrated at the state level; taxes previously in the purview of local elected officials now required direct voter approval; and new sources, such as fees, were sought and found, only to be subject to still further voter-approved restrictions. Competition for public monies forced the state legislature to shift funds that had traditionally gone to municipalities to its own general fund and to schools. There has been endless “tinkering” with the system over the years and “solutions” that have been more political than real. In the meantime, the financial integrity of the state and local government has spiraled down. Now what?

The history of public finance in California is no less diverse and intricate than its people, its economy, its culture and its public policy issues. Municipal finance is inextricably bound up with California’s changing society. It is rooted in the policy and finances of the state government, and it has been profoundly shaped (some might say distorted) by the will of statewide voters expressed through California’s unique initiative system, as well as by other statutes and case law. It is a complex web, indeed, and any reform measures must be sensitive to this reality. Within this broader context, suggestions for reform are offered in the following chapter.

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chapter 16: Looking Back: a Brief History of california Local Government Finance NOTES Actually, even after learning the historical underpinnings, many of this state’s financial practices still seem puzzling. 2 The suitability of the property tax for local taxation was especially compelling at that time. In the nineteenth and early twentieth centuries, wealth was strongly linked to property holdings. Furthermore, most local services, such as water and fire protection were viewed as closely linked to property as well. Thus the long history of viewing the property tax as a local funding source can be traced to the nexus between property and local services demands, as well as the readily existing and continually updated information about property ownership and the strong links between property ownership and wealth. 3 See for example, LA Times/Greenberg poll citied in “Poll: Californians Want It Both Ways on Budget,” Los Angeles Times, November 18, 2010. 4 In part because a two-thirds supermajority was required in each house of the legislature to place a constitutional amendment before the voters and also for any budgetary appropriations necessary to fund property tax relief. 5 An obvious effect of Proposition 13 is that similar properties may be taxed differently depending simply on when the property was last purchased. A home purchaser found that she was paying as much as five times more property tax than neighbors in similar houses—the difference simply being that the neighbors had purchased homes earlier. She sued, arguing that the tax system under Proposition 13 violated the equal protection clause of the U.S. Constitution. In Norlinger v Hahn, the U.S. Supreme Court found that while “California’s grand experiment appears to vest benefits in a broad, powerful and entrenched segment of society, and . . . ordinary democratic processes may be unlikely to prompt its reconsideration or repeal,” Proposition 13 was, nonetheless, constitutional. (Nordlinger v Hahn (901912), 505 U.S. 1 (1992)). 6 Prior to Proposition 13, effective total property tax rates varied from place to place, but averaged about 2.5 percent of market value. 7 California State Board of Equalization Annual Report 1978-1979. 8 At that time, this was equal to about forty percent of the state’s annual expenditures. 9 California Constitution Article XIIIB. 10 Excess revenues in any given year may be carried over for one year without a vote, provided that the spending limit is not exceeded in the second year; subsequent carry-overs, however, must be refunded or approved by the voters. 11 Governor George Deukmejian insisted on the tax refund—amounting to an average of seventy-one dollars for each taxpayer—rather than bypassing the limit which could have been simply achieved by shifting some state funds to schools or other local governments. 12 In fact, by 2004 sales tax revenues replaced property taxes as the largest single portion of city discretionary revenues, statewide. 1

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Proposition 98 requires that at least forty percent of the state’s general fund be dedicated to school funding, with some exceptions during fiscal “emergencies.” Proposition 98 is one of the more egregious examples of budgeting by ballot initiative that has certainly contributed to California’s ongoing fiscal crises. 14 By adding Article XIIIC and XIIID to the state constitution. 15 Proposition 1A does not apply to mandates affecting local schools or mandates related to employee relations and collective bargaining. 16 In 1982, the State Supreme Court decided City and County of San Francisco v. Farrell, which defined the term “special tax” as any tax earmarked for a specific purpose. Under Proposition 13, a new or increased special tax requires the approval of twothirds of voters (City and County of San Francisco v. Farrell (1982) 32 Cal. 3d 47, 5). 17 Special taxes are those earmarked for specific purposes; general taxes are discretionary revenues, deposited in the municipality’s general fund. 18 However, the legislature may alter the allocation of property taxes among cities, counties, and special districts within a county with two-thirds approval in each house. 13

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Going Forward: Outlook and Reform Chapter 17

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ocal government finance in California—who would design such a system? As one peels back the layers of public finance structure and lays bare its many elements, it seems hopelessly complicated, internally inconsistent, and even nonsensical. The historic underpinnings of each element help explain why specific measures were done certain ways. But the fact is that this is not a system that was designed in an integrated, comprehensive manner. Rather, it reflects the political and social complexity of the populace it serves, with all their conflicting goals and interests. It is a product of an evolving society with changing needs, changing technologies, shifting challenges and varied and onstantly evolving opinions. It is a compendium over time of tweaks, changes and “reforms.” The net result has certainly not helped local government; in fact, it has been severely undermining. Nevertheless—and controversies and scandals of the moment notwithstanding—local government has performed rather heroically. Police continue to fight crime, fires are extinguished, paramedics save lives, trash is collected, clean water is provided, sewage is treated, children play in parks, and drivers go about their business on local roads. But in many ways, local governments today are hanging on by a thread. And there are more threats to public services on the horizon, if reforms to the overall state-local system are not made. Towards Reform In order to govern effectively, local officials need confidence that fiscal reform is not just another way to take away revenues, leaving them to face their constituents with service cuts or attempts to increase taxes. Consequently, the necessary foundation of fiscal reform must be the restoration of local revenue stability: the protection of local revenues from capricious actions of the state. Despite numerous studies and recommendations of reform groups since the

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Reform Efforts That Include Local Government Finance Components

Legislative analyst’s office “making Government make Sense” (1993) california Business – Higher education Forum (1994) california council for environment and economic Balance (1995) League of california cities “making california Governments Work” (1995) california Business roundtable (1995) constitutional revision commission (1996) california Planning roundtable (1997) SandaG “achieving Fiscal reform” (1999) redefining Progress “Greening the Golden State” (1999) california Governance consensus Project (1999) controller connell’s Smart / Smarter (1999) Public Policy institute of california (Silva,Barbour):the State-Local Fiscal relationship(1999) Speaker’s commission on State & Local Finance (2000) commission on Governance for the 21st century (2000) Legislative analyst’s office: “reconsidering aB8” (2000) california State association of counties (cSac) (2000) League of california cities Fiscal reform task Force (2000) california commission on tax Policy in the new economy (2003) Little Hoover commission (2004) commission on the 21st century economy (2009) california Forward (2010-)

late 1990s, the continuing actions of the state legislature and governor to shift local revenues, to defer mandated funding, and to cut local taxes without reimbursement have contradicted the goals of fiscal reform. These actions have reduced local revenue, lowered service levels, and created distrust. However, the reform of California public finance must focus not just on the reallocation of local revenue by the state, but also on removing the barriers to local choice. That is, reform should reduce the fragmentation of local governance and finance, increase discretionary funding and provide greater flexibility for local elected policymakers to reallocate resources to reflect the changing needs and priorities of their constituents. Too many proposals have sought only to engineer a master solution from Sacramento instead of enhancing choice and flexibility at the local level. Identifying the specific reform solutions that are needed is the challenge facing the leaders and citizens of California—and it is a challenge that goes well beyond the parameters of this book. However, the last half of this chapter proposes four principles to guide the development of solutions.

Reform Efforts There have been a number of concerted efforts to examine some widely acknowledged problems with state and local governance and finance in California and to propose appropriate reforms. These have come from a variety of institutions, each with its particular leanings, objectives, and approaches. Some have come from policy think tanks such as the non-partisan Legislative Analyst’s Office, the Little Hoover Commission or the Public Policy Institute of California. Some have come from stakeholder groups such as the League of California Cities or the California State Association of Counties. Some have been the product of blue ribbon commissions established by the legislature such as the Constitutional Revision Commission (1996) or the Speaker’s Commission on State and Local Government Finance (1999). Some have come from non-profit groups established for the purpose of studying and enacting reform such as California Forward. Reform efforts have been aimed at a wide variety of issues related to local government finance including: 240

• • • •

• •

• •

• •

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Shifts of local revenue by the state Unfunded mandates on local government Inequities among communities Antiquated revenue structures out of sync with social, technical and economic changes The decline of discretionary local revenue Need for consolidation—too many local agencies, especially special districts Fragmentation and inequity in local property tax shares Declining public infrastructure: roads, water systems, sewer systems, drainage, flood control, parks, etc. Unsustainable costs of excessive public pensions Supermajority vote requirements

Of course, any proposal to change some aspect of the system will be considered “reform” by its supporters. And, therefore, reform has meant different things to each group involved in a reform proposal. Given their diverse origins, different emphases, and the unavoidable biases of participants, reform efforts may not have entailed a broader, more thoughtful review of the local government landscape and its flaws. Consequently, the proposals of these groups often do not address many of the local issues, and may even complicate them. There is no better story to illustrate the complexity and unintended consequences associated with reform than that of the Vehicle License Fee (VLF). The cautionary VLF story is detailed on the next page and illustrates how changes in the fiscal system to address one policy objective may conflict with others. There have been numerous other efforts to reform various aspects of the California’s state and local governance and finance structure. Each of these has begun as an attempt to address a particular problem but, inevitably, diverse participants view the problem from different, often conflicting, perspectives. Challenges to Reform Almost everyone’s quick answer as to why so many reform proposals have done so little is “political obstacles.” Indeed, the task of local government fiscal reform involves hundreds of varied interests, each impacted uniquely. Even within major interest groups, any discussion of change frequently generates divided opinions. Cities, counties, and special districts vary, not only in size, populations, and underlying economies, but in the character, needs, and desires of their residents and in their service responsibilities—all of which are reflected in different financial situations and dependencies. Most reform measures, therefore, would result in both “winners” and “losers” among local agencies.

Scandal and Erosion of Trust in Local Government

People tend to trust their local governments to do the right thing more than they do the state or federal governments, as borne out by numerous surveys.1 thus, efforts to reform municipal finance in ways to direct more revenues and more controls to local governments tend to be relatively popular. But these efforts can be seriously undermined when local governments are the focus of high-profile scandals of an especially egregious nature. in 2010 the Los Angeles Times uncovered (in a series of articles) misappropriation of funds, improper election procedures, questionable reporting practices, and outlandish compensation packages for high officials in the city of Bell.2 Some of the principals in the scandal were arrested, facing criminal charges, as the district attorney, state attorney general, federal government, state controller, and others launched investigations and probes. media of all types covered the story (from local newspapers to national television networks). the outrage over this case carried over into the general psyche, as demonstrated by political advertisements leading up to the subsequent statewide election. opponents of a proposition protecting certain local revenues from state take-aways aired radio pieces in which the “villains” were greedy city managers who used public monies to enrich themselves, citing the Bell case as proof. the proposition passed despite the ads, but the strategy demonstrates how local government malfeasance, no matter how rare, can erode trust and inhibit changes that would empower local governments relative to the state.

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Guide to LocaL Government Finance in caLiFornia The Vehicle License Fee—A Cautionary Tale

california’s vehicle License Fee (vLF) is an illuminating example of the challenges of local fiscal reform. as discussed in chapter 5, the vLF was established as a statewide tax on motor vehicles in 1935, exempting automobiles from the local property tax. the legislature determined that a standardized statewide tax would be simpler to administer, and fairer and more consistent to taxpayers. the vLF was allocated to cities and counties on a population basis. in the early 1980s, state budget troubles and the complicated post-Proposition 13 state-local fiscal relationship caused the state to repeal a number of local subventions. From 1981 to 1984, the state shifted to its general fund a total of over $700 million in vLF revenues that otherwise would have gone to cities and counties. in an apparent fit of remorse over its actions, the legislature placed Proposition 47 on the november 1986 ballot. voters approved the measure, ensuring that vLF revenues must go to cities and counties. But the state retained the authority to determine the tax rate, the tax base (i.e. the method of valuation of taxed vehicles), and the formulas for allocation of the revenues among cities and counties. in 1992, the state legislature adopted a “realignment” of public services, shifting the responsibility for various health and welfare programs to counties. the legislature adopted new revenues to assist counties in providing these programs, including an adjustment to the vLF. rather than raise the two-percent vLF tax rate, the legislature adopted a new, longer depreciation schedule for the taxable value of motor vehicles. the resulting thirty-three-percent increase in vLF revenues was allocated to counties for these realigned programs. others turned to the vLF for special allocations. certain non-full service cities, arguing that their property tax shares were unfairly low, garnered the legislature’s approval for a special supplemental allocation of vLF revenues. in 1982, counties began receiving special allocations to replace repealed state subventions that had reimbursed them for various property tax relief programs (related to motion pictures, business inventory, livestock, and cotton). the vLF rate had been two percent since 1948 but in the late 1990s a political movement emerged to cut the “car tax.” the 1997 virginia gubernatorial campaign of Jim Gilmore (r) had been fueled by his opposition to that state’s taxation of automobiles. anti-tax advocates in california seized on this idea and in 1998, Governor Pete Wilson signed a bill “offsetting” the tax by twenty-five percent to a rate of 1.5 percent effective January 1, 1999, with deeper cuts possible in future years depending on the adequacy of state general fund revenues. in 1999, the law was amended, accelerating the tax cut to thirty-five percent in year 2000. in 2000, the

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“offset” was further accelerated to 67.5 percent, bringing the rate to 0.65 percent commencing January 1, 2001.

the lowering of the vLF rate was structured as a local tax reduction, made possible by a state general fund subsidy to local governments. under the law, local governments were “backfilled” by the state general fund for any loss of revenue due to vLF reductions. not trusting the state to keep its promise to continue to provide the backfill, cities and counties argued vehemently against the vLF cuts. in the 1980s, local governments had experienced a series of cuts in state subventions, many of which had initially provided compensation to local agencies to help offset earlier reductions in local revenues. But the “dot-com boom” of the late 1990s had provided the state with substantial growth in revenues with which to fund tax cuts as well as growth in education, prison, and health and welfare spending. Pension benefits afforded public employees were significantly increased. advisors cautioned that the higher revenues might not last and warned against permanent tax cuts or spending commitments. ironically, the vLF tax cut showed up in the state general fund budget as a spending increase because the reduction in revenues affected local revenues but the multi-billion dollar backfill to cities and counties was a new state expenditure. the law stipulated that if state general fund revenues were insufficient to fund the backfill, then the taxpayer rate would return to its two percent 1998 level. on June 19, 2003, the california State controller’s office and director of finance made findings of insufficient revenues and the effective vLF rate was increased from 0.65 percent to two percent. Both the spending increase for the backfill and the tax increase to remove it were then used by opponents of Governor Gray davis in the successful special recall election in october 2003. Following his inauguration in november 2003, as his first official act, Governor arnold Schwarzenegger issued an executive order restoring the reduction of the vLF from two percent to 0.65 percent and instructing that refunds be given to anyone who had paid the higher rate. But the “vLF trigger” remained the law, providing that the vLF tax be increased if the state could not afford the backfill. to avoid increasing the tax, the governor had to refuse to make findings that the state budget could not afford the backfill, a political conundrum. in may 2004, Governor Schwarzenegger proposed a swap of vLF backfill for local property tax as a part of a state-local budget agreement. the legislature included its version of the swap in the 2004 budget package. under this arrangement the vLF rate was “permanently” reduced from two percent to 0.65 percent. the vLF backfill to cities and counties (approximately $4.4 billion) was

chapter 17: Going Forward: outlook and reform eliminated and replaced with a like amount of property taxes, dollar-for-dollar. Subsequent to the fiscal year 2004-2005 base year, each city’s (and county’s) property tax in lieu of vLF or “vLF adjustment amount” increases annually in proportion to the growth in gross assessed valuation in that jurisdiction. the additional property tax shares are constitutionally guaranteed to cities and counties by Proposition 1a, passed by the voters in 2004. What kind of reform was this—besides being mind-numbingly arcane? it did reduce taxes—but failed to anticipate state and local budget stresses just around the corner. the effort did succeed in achieving some important goals. By essentially replacing lower vLF monies to cities and counties with more property taxes, and by preventing future take-aways by the state, it enhanced local control and fiscal stability. in addition, it relieved the governor from having to make the politically uncomfortable finding each year as to whether or not the general fund was out of balance and, thus, whether or not a vLF tax rate

increase should be imposed. this change pleased anti-tax groups and took one hard decision away from the governor. However, on the other hand, there were other results that could not be considered successes. revenue allocated to cities and counties on a per capita basis was replaced by revenues linked to the assessed value of property. this exacerbated the disconnect between population growth and accompanying service demands with revenues to meet those demands. it would seem to be sensible that per capita revenues flow to communities that accept residential development. instead, this change linked the revenues to cities and counties to assessed valuation. But lower value housing—affordable housing—as discussed in chapter 15 often does not generate municipal revenues to cover the costs of public services needed for the growing population. this reform, thereby, most probably makes affordable housing less attractive to communities from a fiscal standpoint. as in most cases, the reform package is a mixed bag.

Mindful of this inherent reality, many proposals have suggested that the state provide funding to mitigate the financial losses of any losers at the local level. The result is that such proposals may ensure that no individual local agency is negatively impacted by a change, but it would also mean an ongoing commitment of additional money to local government by the state. Also, by eliminating the “losers” under any reform, the proposal is likely to contradict the intents, and actual effects, of reform itself—at least in part. Most major local finance reform proposals have included constitutional protection of local revenues and a call for additional on-going state funding to local governments to mitigate the negative impacts of change. But such proposals could not succeed in the legislature even in years of state budget surplus.

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Guide to LocaL Government Finance in caLiFornia Most Changes to Local Finance Have Been Born of State Budget Concerns

major changes to local finance have usually been the product of ulterior motives, particularly those of the state legislature and governor to remedy the state’s fiscal woes. the disappearance of many state subventions during the 1980s, the eraF property tax shifts that began in the early 1990s, the realignment of state health and welfare programs to counties, the sales tax triple flip (2004), the property tax-vLF swap (2004), the gas tax swap (2009), the corrections realignmentt (2011) . . . were all born out of efforts to solve state budget shortfalls. But as the vLF story illustrates, when the prime objective is solving a state budget problem rather than improving local finance, the “reform” may have negative consequences for local public services. the legislature’s cuts of local revenues have run directly contrary to the common core goals of local government fiscal reform. in particular, shifts of local city, county, and special district revenues have: • reduced general purpose revenues, increased earmarked revenues. • increased pressure for local tax increases with disparate results. • increased the dependence of local government budgets on more volatile, less sustainable revenue sources. • Worsened the disincentive to develop moderate and low cost housing. • Increased the incentive to compete with other jurisdictions for sales-tax generating development. • eroded intergovernmental trust and cooperation.

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Complicating matters, the fiscal impacts are frequently poorly understood or in dispute. When uncertain, interest groups tend to oppose reform proposals, particularly in a climate of local distrust of the state legislature and the specter of continuing raids on local revenues. But sometimes ideas fail for legitimate public policy reasons. After all, most of the ills in the current system that we now seek to cure are the result of usually unforeseen effects of some previous reform. Nearly every proposal from a blue-ribbon commission, academic study, or interest group is presented in concept. But an adequate, thorough analysis of the implementation and impacts of the concept, particularly as it would extend over time, is rare. It should come as no surprise, then, that the legislative process uncovers difficult, even fatal problems in these types of reform proposals. Common Flaws in Reform Efforts Many of the reform efforts have had little success. The reasons for this are telling for future reformists: •

•

Poor problem definition. Reform groups, such as blueribbon committees, typically feature a series of hearings by interested parties. But they often fail to define, carefully and accurately, the problem which they are addressing. In the worst case, they plunge into solutions without understanding and clearly defining the problem. Some have had trouble reconciling very different views and agendas among members. The better efforts have had expert staff and have taken the time to build a consensus around a common and accurate understanding of the problem before launching into talks of “reform.” Results are too often assumed rather than carefully analyzed. Even if the problem is well defined, the solutions are not always as obvious as some people think they are. Some reformists leap to a favored solution—perhaps one that seems to address their favorite part of the problem—and then seek justification to support that solution. But these conceptual solutions are usually not analyzed to determine if they would really work; success is often just assumed.

The local revenue system is complicated, and the implementation and effects of, for example, a revenue swap or reallocation proposal are always

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California’s Fragmented Property Tax Allocation

For years after the legislature established the post–Proposition 13 property tax shares to local agencies, the Loomis Fire Protection district (FPd) struggled with its low share, less than seven percent of the property taxes collected in the district. it was a volunteer fire protection district in a relatively rural area and had never imposed a very high property tax rate prior to Proposition 13, so it was stuck with a low share afterward even as the city that was essentially coterminous grew, putting pressure on the fire agency for more full-time professionals, new technology, new standards, and higher compensation to retain staff. the fire district would appear each year before the city council budget hearings asking for additional funding. in some years the city council might oblige but would at the same time point out that the city was not a full-service agency; that fire service was not among the city’s responsibilities. eventually, the district convinced voters to approve parcel taxes with the required two-thirds approval. the added fire taxes in this community are over $300 per year for a single-family home. ten miles away, the Sacramento metropolitan Fire district receives more than double the average property tax share that Loomis FPd does. in fact, this district’s seventeen percent share rivals the base share allocation to most full-service cities—cities that are responsible for fire funding in addition to police, parks, streets, etc. Sac metro Fire’s employees are among the most well paid in the country, and its equipment and facilities and service levels meet or exceed top standards. there are no supplemental fire parcel taxes or benefit assessments. But cities in the service area of this district struggled through the impacts of the Great recession, reducing library hours and street maintenance because no one at the local level had the authority to make a different allocation of property tax revenues that might better reflect the priorities and needs of that community. a side effect of Proposition 13 is that it took away local control of the rate and the local allocation of revenues so communities can no longer affect their property tax revenues in response to differences in property values, service demands, and willingness to pay. the allocation of tax revenues is less efficient, less transparent, less responsive, and less accountable to citizens than it could be. Because of this balkanized property tax allocation, based on relative shares that are nearly forty years old, citizens cannot reallocate resources among the different public agencies that serve them (the city, the library district, the fire district, the water district, etc., depending on the community) as their community evolves, as new challenges arise, and as needs and priorities change. moreover, they face added pressures for tax increases where the need for funding might be solved or reduced by a more efficient allocation of revenues among the local agencies serving the area. Local authority to alter property tax allocations could be provided to communities by giving a local agency the ability to reallocate property tax shares going to all municipal functions including police, fire, libraries, parks, water, sewer, transit, etc. Given the authority to alter revenue allocations, that agency would also have to assume the responsibility for the services. Logically, this means that agency would be the city, or, in unincorporated areas, the county. in some instances, a special district may be the best most efficient and effective service provider and could be engaged to provide these services on contract with the city. another legacy of the way the legislature chose to implement Proposition 13 is the shares of the local property tax that go to utility enterprise services such as water. By funding these commodityoriented services with general property tax, user fees may be set lower than full cost. they are effectively subsidized, thereby encouraging overuse of a limited resource or service. moreover, since general property tax revenues are limited, the community is not funding and providing services from other local programs at the levels they may want to, given the choice. the utility rates would probably need to be increased to cover a shift in property tax revenues, but the consumers of this service would bear this, a more full reflection of the actual cost of their use.

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much more complex than the concept suggests. Analytical evaluation of these proposals has often been quite limited. Consequently, both proponents and opponents of these reform proposals usually do not really understand the fiscal effects of their ideas and, most important, if the intended policy goals would really be met at all. Defining the Problem Real improvement requires a sufficient and accurate understanding of the problems. There are four primary areas of California’s local governance and finance system that need reform. These four problem areas emerge among the most well-considered reform efforts.

The authority to fund core tax supported services, especially police, fire, libraries, parks, planning, streets, and roads must be strengthened in local agencies. As discussed in the prior chapter, California’s unique initiative process has enabled activists to go to the voters and seek strict limitations on local government’s ability to raise revenues. The collection of voter approved statewide measures, most amending the state constitution, have: •

•

•

Removed the ability of locally elected officials to increase taxes without voter approval. Removed the ability of local agencies to increase the ad valorem property tax rate for local services, even with voter approval. Established new limits and procedures on the imposition of property related assessments, property related fees, and regulatory fees.

At the same time, assistance from the state and federal governments has declined and general purpose revenue subventions from the state and federal governments have largely disappeared. The loss of local control over the property tax has resulted in allocations that are fragmented, inconsistent and outdated. Current property tax shares are based mostly on the decisions about the needs of cities, counties, and special districts made thirty-five years ago; it is unlikely that they reflect the modern needs and priorities of communities. The authority to adjust local property tax shares, however, rests solely with the state legislature—a body that is ill suited to determine the relative priorities for limited tax resources in local communities. Moreover, in some areas of the state, portions of the property tax subsidize commodity-based special district enterprises (water, solid waste collection, etc.) that could, in most cases, be fully funded by user fees as they are in most other jurisdictions, freeing discretionary revenues for other community priorities. 246

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The costs of some local government pensions and other post employment benefit levels are unsustainable. As outlined in Chapter 8, public pension and retiree health benefit costs, especially for corrections, police, and fire employees, have become financially problematic. Unsustainable levels of benefits were approved at a time when the CalPERS portfolio was generously funded because a healthy economy and thriving markets boosted the value of its investments. But when the economy soured (only a couple of years later), the value of the pension funds declined sharply. Because the funds are legally obligated to pay retirees their promised benefits, state and local public agencies and their taxpayers are on the hook for any shortfall. Meanwhile, changes in governmental accounting standards required state and local agencies to identify the costs of “other post employment benefits” (OPEB) such as retiree health care. The reporting revealed dramatic increases in future OPEB costs and inadequate funding policies. The problem of public pensions and other post employment benefits may be the largest fiscal problem facing state and local governments. But in many ways, there are fewer barriers to public pension and OPEB reform than the other fiscal problems in California. There are few constitutional barriers, no voter approval requirements in most jurisdictions,3 and few conflicts with other objectives. Moreover, there is wide and growing public awareness of the problem and sentiment in favor of reform.

The fiscal structure does not adequately respond to social and technical changes. Tax structures designed many decades ago for very different social, technological and economic situations are out of sync with today’s world, and efforts to modernize the law run into onerous approval processes and other limits. For example, the sales tax provides cities and counties (and the state) with vital general purpose revenues, yet, unlike most states, California taxes only the sale of tangible goods, not services. Since the growth in the California economy over the last half century has been primarily in the service sector, taxable sales in California have not kept up with the combined growth in inflation and population. Other aspects of the state and local tax system lag behind social and technical changes. For example, most utility user taxes on telecommunications were crafted at a time of land lines and billings based on time and distance. With wireless technology, flat rate bundled services, and prepaid phone cards, many utility user taxes are antiquated—and have needed new wording to keep the taxes applicable to the new technologies and practices. But because of the Proposition 218 tax rules, these updates typically require voter approval even if rates are not increased. State and federal Motor Vehicle Fuel Taxes (also known as Highway User Taxes) are based on an amount per gallon with no adjustment for inflation. 247

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California’s Troubled Sales and Use Tax

as described in chapter 4, the local sales and use tax is second only to the property tax in its magnitude and importance as a general-purpose revenue source to cities and counties. But california’s sales and use tax collections have not kept pace with inflation and population growth over the last fifty years. this is largely because growth in the economy and consumer spending over this period has been stronger in areas that are generally not taxed in california. as the population has aged, the demand for services, which are generally not taxed, has grown more than the demand for taxable goods. the cost of services has increased at a faster pace than the cost of goods. in addition, a growing portion of previously taxable goods are now being provided digitally and in that form are generally not taxed. examples include music, videos, and computer software. a second major issue area for reform in sales and use tax concerns the growing concentration of local sales and use tax allocations and the leakage of tax revenues through corporate rebate agreements. in recent years, as the proportion of retail purchase made online retail has grown, there has been and alarming increase in arrangements to encourage certain land use development with rebates and incentives which exploit california’s origin sales tax sourcing rules. this has resulted in the concentration of sales tax revenues in a few jurisdictions at the expense of many others. it has resulted in the diversion of sales tax revenues away from the provision of important public services in amounts far in excess of any conceivable economic benefit. in the typical arrangement, a city provides tax rebates to a company that agrees to move or expand their operations in the jurisdiction of the city. the expansion may be little more than an order desk. under such an arrangement, the company generally agrees to make a specified amount of capital investment and create a specific number of jobs over a period of years in exchange for specified tax breaks, such as property tax abatement or some sort of tax credit. in some cases, this has simply taken the form of a sales office, while customers and warehouses and the related economic activity are disbursed elsewhere in the state. in some cases, the development takes the form of warehouses, in which the sales inventory, owned by the company, is housed. Sales tax incentive agreements in california rebate amounts ranging from five to eighty-five percent of sales tax revenues back to the corporations. in 2016, experts familiar with the industry estimated that between fifteen to twenty percent of local Bradley-Burns sales taxes paid by california consumers was being diverted from local general funds back to corporations: over $1 billion per year. in 2015, a law was enacted that tightens existing law to prohibit sales tax agreements that result in shifting sales tax revenue from one local agency to another when the retailer continues to maintain a physical presence within the territorial jurisdiction of local agency from which funds are being shifted. the measure also requires more public transparency on existing and future agreements which result in the loss of sales taxes by other local agencies, by establishing new notification requirements for any new agreement (and reentering or expansion of an existing agreement) that, in the absence of the agreement, would result in a reduction of Bradley-Burns local tax proceeds to another local agency.

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Consequently, even as the use of streets and roads increases, revenues from these taxes do not keep pace with even a modest inflation index as the society pushes for better fuel efficiency and alternative fuel technologies (and thus fewer gallons consumed for the same use roads and lane capacity). The Internet has affected the taxability of some sales transactions. It has also re-shaped entire economic sectors, such that certain tax and fee rules are largely outmoded. For example, when on-line travel companies collect the full TOT rate for a hotel or motel booking, they only pass on the portion related to the wholesale rate to the local hotel (who then pays the city or county) and retain the difference as a processing charge. This adds up over time to significant reductions in local TOT.

The disconnect between service costs and ongoing revenues with certain types of land uses deters balanced planning. As discussed extensively in earlier chapters, many cities and counties have tried to increase local revenues by pursuing the kinds of land development that generates a net gain in municipal revenues.4 A problem may arise, however, if project approvals emphasize fiscal impacts without also properly weighing other public costs (for example, environmental impacts) and benefits (for example, affordable housing). Furthermore, in the current system, housing for a growing population is not so strongly tied to significant revenues as certain non-residential land uses, especially retail.

Figure 17-2. Revenue from Local 1% Sales Tax as a Percent of California Statewide Personal Income

chapter 17: Going Forward: outlook and reform

Principles of Local Government Fiscal Reform It’s one thing to identify something that isn’t working. The next step is to orient thinking toward what would be better. As promised at the beginning of this chapter, the authors offer four principles to help ground and guide proposed solutions: • • •

•

Seek greater fiscal stability and local choice. Better match local government revenues with local public service costs. Improve transparency and simplicity to residents, taxpayers and customers. Avoid harmful effects on individual agencies and groups.

Enhancing Fiscal Stability and Local Choice. The efficient and effective delivery of public services requires reasonable durability and stability of fiscal resources. It also requires flexibility for local policy makers to make choices, including the reallocation of resources to meet changing needs. Improvements to the local fiscal system should: •

•

Polarized Constituencies

a barrier to meaningful reform is the polarization of constituencies and the hyperventilating rant that seems to pass as political discourse in the early twenty-first century. in particular, partisans holding entrenched ideologies and a political system that empowers them (through, for example, gerrymandered voting districts and rules requiring supermajority approvals to govern) make any attempt at compromise difficult, perhaps impossible. But the problems facing local government finance are, as discussed throughout this book, complex and interwoven. Simple solutions, reduced to catchy slogans, will not work, and changes focused on one part of the system will inevitably have impacts on other parts, often with unintended, but dismal, consequences. Some people, furthermore, have adopted a win-at-any-cost mentality, confusing the right to participate and be heard with a “right” to win. compromise is viewed as abandoning principle, but compromise and give-and-take have always been the mainsprings of a workable democracy. the future of reform while not bleak is certainly harder to discern in such a political context.

Increase “local control,” the ability of local governments to respond effectively and efficiently to local public service priorities and needs of their residents, property owners, businesses and civic institutions. Stabilize and protect local government revenues and prevent mandated responsibilities from capricious actions by the state.

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Guide to LocaL Government Finance in caLiFornia •

• • •

•

Improve the efficiency, effectiveness, and responsiveness of local government by consolidating finances, roles, and responsibilities and increasing the ability of cities and counties to decide the allocation of public revenues, and how and what municipal services they will provide. Provide sufficient fiscal resources to underfunded local governments. Enable and encourage intergovernmental cooperation, consolidation and improvement. Establish a sustainable local fiscal system, and one that can respond to evolving economic and social conditions and local public service needs. Return public employee compensation and benefits, including pensions and post-retirement healthcare, to sustainable levels.

Matching Local Government Revenues with Local Public Service Costs. When the demand for local public services expands due to development and population growth, local fiscal resources need to grow in tandem. Improvements to the fiscal system should: •

• • •

Provide a responsive menu of revenues that grows concomitantly with service demand so as to minimize the need for restructuring or tax increases except to enhance service levels. Provide sensible incentives for accommodating desired land uses that may not generate high revenues, such as affordable housing or open spaces. Avoid incentives that encourage cities and counties to overemphasize certain land uses, such as retail development, at the cost of wellbalanced communities. Consider income tax deductibility for a wider variety of local taxes and fees, so that the structure of state and local taxes causes the federal government to shoulder a greater share of public service costs and provide tax relief and/or service improvements.5

Improving Transparency and Simplicity to Residents, Taxpayers, and Customers. The local fiscal system is extremely complicated. Unnecessary complexity wastes resources and creates distrust. Improvements to the fiscal system should: •

•

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Enhance the transparency of where taxes, fees, and other funds are allocated and spent, making the system more understandable, accessible and less complicated. Minimize administrative bureaucracy and costs while providing sufficient systems to assure accountability and to measure the efficiency and effectiveness of public service delivery.

chapter 17: Going Forward: outlook and reform

Avoiding Harmful Effects on Individual Agencies and Groups. In almost any fundamental change to the local fiscal system there will be some agencies and individuals that will be better and some worse off. This is the “winners and losers” challenge of reform. Improvements to the fiscal system should endeavor to minimize or mitigate the negative impact of changes on institutions and individuals.

The Growing Skills Gap: Nalbandian’s Assessment

efficiency is important in building trust, but it is not the only thing that counts. Leaders build trust and a sense of obligation to the public good by also respecting values related to legitimate representation, social equity, and individual rights. John nalbandian argues that staff modernization “creates an administrative culture driven by efficiency and the pervasive influence of technique. this trend increasingly is divorced from the passion that can characterize citizen engagement, participation, and local politics.”6 as noted earlier, elected officials are expected to set goals, provide policy direction and “lead.” However, in most agencies, the elected decision-making body must carry out these largely undefined duties without many of the formal accoutrements of organization enjoyed by the staff: they have neither formal hierarchy nor specialization (e.g. job descriptions); in california, they have very limited ability to meet “privately” to discuss municipal problems; and they seldom have ongoing training or organized performance feedback opportunities (aside from the elections themselves!). at the same time, the public policy issues that local elected officials must address are getting more complex, as resources— both natural and financial—become more strained and scarce. adding to this complexity are the growing pressures and expectations of modern society and community life. these include fastpaced and multi-faceted forms of communication, more political fragmentation and conflict, greater ethnic diversity, more problems requiring regional solutions, and a citizenry that demands higher levels of service and involvement in public decision-making. as a result, in order to achieve positive and sustainable local government outcomes, a wide variety of skills related to community-building are more important than ever among a municipal organization’s leaders. and yet the skills elected leaders bring to office are typically a matter of serendipity: the qualifications for most offices in california are simply that the candidate be eighteen years old, a citizen and a resident of the jurisdiction. on the other hand, the skills of staff members have continued to grow over the years as public administration, and its related disciplines (for example, planning, finance and public policy) have become institutionalized programs in colleges and universities

throughout the nation. typically, a college degree is among the minimum qualifications required for most local government professional and management level jobs, and advanced degrees are becoming more commonplace. an increasing number of staff at various levels are professionally certified in their fields. Furthermore, the range and depth of professional staff skills have evolved with the adoption of modern technologies and the advantages of ongoing career education and training. For example, local government staff members today are commonly trained to handle geographic information systems (GiS), performance based budgets, performance measurement and bench marking systems, and advanced communication technologies (now including “social networking” techniques). the trend toward greater organizational and staff modernization is likely to continue into the foreseeable future. the pressure on local elected officials for public policy solutions that are sensitive to non-technical variables such as the values of representation, social equity, and individual rights can also be expected to further grow. Staff members must, therefore, view community engagement and sensitivity to non-technical values as among their needed core competencies and integrate these considerations into their work. examples of methods to connect professional staff to these considerations in the area of municipal finance include:

• community based budget and goal setting processes • Budget committees and/or task forces • community strategic plans • citizen academies or other training programs to teach the

basics of local government (including the complexities of how local government is financed and how it allocates resources)

as nalbandian states, “[t]he effectiveness of local government professionals depends upon their acceptance of responsibilities and roles associated with this bridge building.”7 and, by extension, municipalities will be more likely to effectively manage their financial health for the long haul if they do so with an awareness of, and skill in, navigating in—and connecting with—the larger, non-technical landscape of local government and community.

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California communities and the public agencies that serve them are diverse in service needs, in philosophy, and in the structure of their finances. Changes to the system should allow for local flexibility and choice and avoid “one size fits all” solutions. Summing Up

From the vantage of the second decade of the twenty-first century, the future of local government finance in California is anything but bright or clear. The past few decades have witnessed a continual erosion of local governments’ autonomy in raising revenues, punctuated by voter-approved state constitutional amendments restricting taxes and fees, as well as by massive take-aways by the state legislature to fill huge fissures between the Capitol’s spending and income. Furthermore, the “Great Recession” exacerbated state and local shortfalls, and its economic and fiscal consequences will likely reach well into the future. These tectonic stresses have occurred in a context of great partisanship and diminished sense of civility, and a growing distrust and dissatisfaction with all levels of government. All that said, local governments have survived difficult conditions in the past and with a sincere commitment by not only state and local leaders, but also the citizens of the state, the structural problems undermining governance in California today can be corrected. It won’t be easy and it won’t be painless; there will be some short-term winners and losers. It will take high levels of commitment, professionalism, and creativity—qualities that have served local government staff and officials well in managing the many challenges of the past. It will also take sacrifice on the part of everyone—government leaders, public servants, and citizens.

Hard as it will be, there is some good news. As detailed in this book, the underlying financial systems, methods, and tools are in place at the local levels of government to make thoughtful reform work. Cities, counties, and special districts do not need to be “reinvented.” The framework is already built. What is needed, however, is a less wobbly, stronger and more reliable foundation to stand upon in delivery of service to the citizens of this most complex state. With proper resolve, it can be done.

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chapter 17: Going Forward: outlook and reform NOTES See, for example, trend lines over several years in “Trust in State Government Sinks to New Low. Trust in Local Government Relatively Stable” by Jeffrey Jones, accessible at www.gallup.com/poll (September, 2009). 2 See “How Bell Hit Bottom,” Los Angeles Times, December 28, 2010, for a recap of the events. 3 See Chapter 9. 4 The term “fiscalization of land use” was first used to describe the skewing of land use decisions by fiscal impact considerations by Dean J. Misczynski (1986) in the article “The fiscalization of land use.” In J.J. Kirlin & D.R. Winkler (Eds.), California Policy Choices (Vol. 3, pp. 73-105). 5 Taxpayers who itemize on the federal income tax returns can deduct state income taxes, property taxes, and vehicle license taxes, but may not deduct fees, sales taxes, utility user taxes or hotel taxes. By allowing these types of local taxes and fees to be deductible from income taxes, additional money could be directed to the state, offset at least in part, by federal income tax savings. For example, a proposal in 2010 called for reduction in the state sales tax, to be offset by a state income tax increase, thereby substituting a deductible state tax for one that could not be deducted from federal income tax. Any such change in tax structure requires two-thirds vote of each house of the state legislature or majority approval by the voters. 6 Nalbandian, John, “Professionals and the Conflicting Forces of Administrative Modernization and Civic Engagement,” The American Review of Public Administration, 2005. 7 Ibid. 1

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An Overview of Public Finance Theory Appendix A

W •

•

•

• • •

•

hole books are written to explore philosophies on how best to pay for public goods and services. Theorists and practitioners have grappled with several fundamental questions, including the following:

Under what circumstances is the government the more appropriate provider of services than the private sector? What level of government is the best for providing different kinds of public goods and services? For any government organization, how should priorities be set among numerous competing, worthy programs and projects? How should public services be paid for? How can costs be fairly allocated among the public? In the case of building public facilities, when is borrowing more appropriate than paying with cash? What processes provide the transparency and oversight required by the public?

Certainly, comprehensively investigating answers to such questions is beyond the scope of this book. Nonetheless, persons interested in the practice of municipal finance do well to revisit such underlying theoretical touchstones occasionally. This appendix poses some of the most common philosophical questions and foundational theories of public finance. The Role of Government in a Free Society—and How It’s Paid For In a “free” society—that is, one that strives to promote individual liberty, make public policy decisions democratically and preserve human and civil rights— government traditionally serves two distinct roles: law maker (setting the rules

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for acceptable behavior and enforcing them) and provider of various public goods and services.

Government as Law Maker. Oliver Wendell Holmes famously observed that freedom of speech does not include the right to falsely shout “Fire!” in a crowded theater. Even a free society needs some agreed upon rules for acceptable behavior to protect the public health, safety and welfare. And, for these to be meaningful, there also needs to be the ability to enforce them. In the United States, under its federal system, different levels of governments are assigned different roles in setting the rules and for enforcing them. At the federal level, the Congress sets laws regarding national issues crossing state lines that broadly affect many citizens and businesses regardless of where they are, such as regulations on interstate commerce, air travel, and certain large-scale questions of environmental quality and public health. Regulatory agencies are established to enforce these national ground rules, and when necessary, the national government prosecutes suspected offenders, who will be tried in federal courts and sentenced to federal prisons, if convicted. Many other laws, however, are established at the state level. In California, enforcement of state laws largely occurs at the local level through city police departments and county district attorneys. All units of local government in the United States (“political subdivisions”) such as cities and counties are known as “creatures of the state”: whatever they can or cannot do is determined solely by the state in which they are located.

Government as Provider of “Public” Services and Goods. The United States constitution says nothing about local governments. Thus, every state has defined for itself the services that its local governments will provide—and also establishes the revenue sources available to them in funding those services. And California, in a theme that recurs throughout this book, is extraordinary in its state-municipal government relationships, especially when it comes to financing local services. Public goods are facilities or services needed or desired by the people that the private sector is unlikely to deliver—because of the scale and scope of the service (for example, national defense) or because there is no practical way of making a profit in providing them (for example, neighborhood parks) or because the society or a community determines it should be directly controlled by the public (for example, police protection). As such, citizens come together as a group— through their government—to provide and fund these kinds of services.

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appendix a: overview of Public Finance theory An Example of a Classic “Public Good”—The Lighthouse An illustrative example of a “public good” is a lighthouse that would signal to ships they are near dangerous shoals as they approach the entry of a seaside town’s harbor. All of the ships would benefit from the protection that such a lighthouse would offer. However, no individual ship owner is likely to undertake purchasing land and then building and operating a lighthouse himself because of the high cost and because there is no obvious way of creating a private market to recover such a cost (let alone make a profit). But clearly, the lighthouse is important not only for the immediate safety of ships, but also valuable for local economic development by encouraging commerce that provides people and business with goods, and produces jobs and other related benefits. A lighthouse surely would advance the public health, safety, and welfare and, thus, comes within the legitimate purview of government. This simple example surfaces a host of complex public finance issues.

What level of government is responsible? If the harbor is a major international port or used by ships from several states and other countries, then a case could be made that the federal government should pay for the lighthouse. Or, if the lighthouse does not significantly benefit the nation, but is, nevertheless, regionally important, benefiting several communities, then the state may be the appropriate level of government for funding the facility. Assume in this case, however, that neither the federal or state government is willing or able to fund the lighthouse. Perhaps the town is relatively isolated and the harbor is used primarily by local fishing and tourism industries that together form the basis of the local economy. The responsibility of providing this public good, if it is to be provided at all, falls on the local community. Lacking federal or state funding support but still seeing the high value to the community, the citizens of the harbor town decide to fund the construction and operation of the lighthouse publicly through their municipal government. Their local officials are elected by the citizens and are entrusted to be stewards of this public trust and will be held accountable, accordingly.

How does this priority compare with others? The community must first decide whether or not this facility is worth undertaking given all the other needs and desires they have. Lighthouse service is just one that the town would provide to its residents, businesses and visitors. It also needs or wants to provide, for example, police and fire protection, sewer and water service, street maintenance, traffic signals, libraries, planning, senior services and flood protection. Given its limited resources, how does the community determine the priority of committing funds to the construction and operation of the lighthouse versus all of the other competing demands for service? This is the important process of soliciting public ideas about how to use limited financial 257

Guide to LocaL Government Finance in caLiFornia National Debate on Infrastructure Funding Goes Back to Our Founding

Policy questions about the role of the federal government in funding infrastructure date back to our founding, with the construction planning for the erie canal in 1816 an early poster child. the need to improve transportation via roads and canals into the new nation’s interior and over the massive natural hurdle posed by the appalachian mountains surfaced early in our history. among these plans was linking Lake erie and the other Great Lakes with the atlantic coast through a canal. once the route for the erie canal was established, congress readily approved federal funding for its construction. However, President monroe vetoed the funding because he believed it was unconstitutional. much like our fictional lighthouse, the State of new York then went ahead and funded construction of the canal with its own resources, financed via tolls (a form of service charges). debate over federal funding for infrastructure continues to dominate the national domestic agenda. While today it is often viewed as a “liberal versus conservative” issue, in our early years it was largely regional in nature, with representatives from the western states— like Henry clay from Kentucky and abraham Lincoln from illinois— strongly supporting federal funding; and those from the eastern states (like vetoer James monroe) generally opposed.

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resources, setting priorities, and agreeing to pursue some and put off others. This is what the budget process is about: making decisions about the highest priority undertakings to accomplish for the community, assessing the financial capacity of the community for such undertakings, and then raising and allocating the resources needed to do them. If the community decides the lighthouse is a high priority, it must then consider how to pay for it. How is the cost shared? When the local community decides that the benefits of the lighthouse are so great that it will fund the construction and operation, it then faces the question of how it will share construction and operating costs among community members. There are two basic methods: •

•

The facility could be financed through service charges, which attempt to allocate cost obligations based on the benefit that the facility provides to different, identifiable parties. A simple method in this case might be that each ship is compelled to pay a fee for mooring at the harbor. A flat fee could be charged, or the fee structure might be more complex, such as one based on the size of each ship, weight of its cargo, or the size of the crew. Or the lighthouse could be financed by taxes. A tax, different from a fee, requires a broad base of people or businesses to pay some money to the government for widely shared public facilities or goods. In public finance theory, the underlying principle in assessing taxes is that the potential beneficiaries should make roughly equal sacrifices.1

There are two kinds of taxes that could be levied in the lighthouse case: a tax that is applicable to just the ship owners, or a broad-based tax shared by the community as a whole. On one hand, the ship owners are direct beneficiaries of the lighthouse (it is their safety and property at risk, after all), and, thus, a tax targeting the ship owners might seem appropriate. On the other hand, the community may believe that the lighthouse offers broader benefits than just to the ship owners. Since the harbor and related ship activity is a key component of the local economy, the entire community benefits from the employment and incomes associated with that activity. Accordingly, the community as whole may choose to tax themselves to build and operate the lighthouse, spreading the cost over a wide base so that no single taxpayer is unreasonably burdened. A variety of taxing techniques may be used depending on the state in which the city is located. In California, the question of whether a revenue strategy constitutes a tax or a fee is continually debated with significant implications about how the strategy can be adopted and how the revenue can be used.

appendix a: overview of Public Finance theory

How will construction be financed? The lighthouse will last for many years. Should the cost be funded over just one year? Or, like a mortgage on a house, should it be funded over a much longer period, spreading the cost over time and making it more affordable for the community now? A long-term loan also results in what is sometimes called “intergenerational equity” where those who will also benefit from its use in the future help pay for the improvement.

Is the project financially feasible? Early in the process, the city officials need to prepare a financial feasibility study. What are the costs, both for construction and for operations, that the city is burdening itself by this project? What are the fees or taxes that the city is reasonably able to raise for offsetting these liabilities? Projecting future costs and revenues is an important analytical tool used for determining if an undertaking is likely to be financially sound.

How is the builder selected? Once the decision is made that the city will buy property and build a lighthouse, the city council must choose a contractor to do the work. The mayor’s daughter is a builder with a well-deserved reputation for delivering high-quality projects, on time, and at a competitive price. In the private sector, negotiating a contract directly with the boss’s daughter might be an acceptable business practice, and, in fact, given the description above, contracting with her might be the best possible course of action in prudently managing a private company’s funds on behalf of its investors.2 However, city regulations and other laws require that there be a competitive bid process and that people who might financially benefit from the selection of the contractor not participate in the decision in any way. With a public agency, how government makes decisions while avoiding real or perceived conflicts of interest, and ensuring fairness and equal opportunity, is even more important than the actual decision reached.

How are operations managed? Once built, the lighthouse could be operated by city employees or contracted out to a private sector vendor. On one hand, city employees may feel a greater sense of responsibility than a for-profit contractor—and it is important that the lighthouse be operated to high standards. On the other hand, rising public employee salary and benefit costs may make contracting out an attractive cost-containment strategy. Local agencies struggle with these kinds of decisions every day in managing their finances: assessing the trade-off between potential cost savings versus greater direct control and accountability.

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Guide to LocaL Government Finance in caLiFornia NOTES This concept is the foundation for progressive income tax rates. While it may on the surface seem proportional and fair for an income tax rate of ten percent to be applied to all wage earners, the relative sacrifice by someone earning $10,000 is far greater at ten percent, where only $9,000 remains after taxes, than for the same ten percent rate for someone earning one million dollars where he or she will still have $900,000 remaining after taxes. On the other hand, regardless of the “sacrifice” principle, there may be offsetting concerns that progressive income tax rates— especially at high rates—are also unfair and will result in lower investment, productivity, economic growth, and revenue generation, and, thus, have adverse consequences for everyone. 2 Under various circumstances, however, sound practices even in the private sector might dictate against this kind of potential conflict of interest. 1

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Detailed City Budget Process Appendix B

T

his appendix provides an overview of how to prepare, review, and adopt a city budget, using the following step-by-step process

1. Setting the budget calendar 2. Establishing budget instructions 3. Policy review/environmental scan 4. Revenue projections 5. Department-by-department budget preparation 6. Central budget preparation (most notably regular staffing cost projections) 7. Internal budget review 8. Preliminary budget preparation 9. Budget review and adoption 10. Implementation 11. Monitoring and taking corrective actions

1. Budget Calendar The first step in the budget preparation process is developing a budget calendar that details: • • •

Budget tasks that need to be accomplished Departmental responsibility for accomplishing them And key due dates for each budget task

Preparing the “budget calendar” with a comprehensive listing of tasks and realistic due dates for documents, internal staff reviews, and for public study sessions, workshops, and hearings as well as community outreach and any

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advisory body reviews, is the single most important planning step in the budget process. It will ultimately drive the work program for a large portion of the organization for many months preceding issuance of the preliminary budget, and subsequent council review and adoption. While the budget calendar is largely an internal working document for the staff, many agencies find it helpful to provide their governing bodies with an early report on the proposed calendar and overall approach to the budget preparation process. This helps assure that one of the most important stakeholders in the budget process—the folks who will ultimately approve it— are in conceptual agreement with the proposed approach. And, more practically, this ensures that key city council meeting dates are calendared early in the process to avoid conflicts down the road. • • • • • • • • •

Budget Calendar Tips

Work backwards from the targeted council adoption date in setting task due dates (“begin with the end in mind”). do not plan for the “best case” for department submittals and response times, or for internal review and evaluation of them; instead, plan for the most likely case, given the organization’s culture and the fact that budget preparation is not the only thing on department or budget review staff’s plate. Have several sets of eyes review the calendar for reasonableness and unintended consequences (like scheduling staff due dates or council meetings on a weekend or holiday). differentiate and highlight in the calendar staff due dates versus council meeting dates. Whenever possible, schedule discrete tasks for earlier completion. For example, the city of San Luis obispo starts the internal development and review of capital improvement plan (ciP) project requests ahead of the operating budget process; and fleet replacement evaluations even earlier. on the other hand, keep it simple: schedule few key due dates for department deliverables. Be sure to schedule appropriate time for any focused interdepartmental review teams,

such as technology, fleet, ciP or operating budget requests. Provide council members with reasonable lead times to review written materials before meeting dates; and provide staff with reasonable lead times between meetings to respond to council requests for information. remember: there’s only one way to eat an elephant—one bite at a time.

2. Budget Instructions With a clear game plan in place via the budget calendar, the next step is to prepare more detailed budget instructions. Along with due dates in accordance with the budget calendar, these should include: 262

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Overview of the fiscal situation facing the agency and broad strategic themes or budget-building principles. The instructions should provide the policy context in completing the budget tasks ahead. This is especially important if the scope of the budget process is likely to include significant expenditure reductions (which has been the case for most local governments during the Great Recession). Below is a sample of possible principles and strategies:

Sample Budget-Balancing Principles There are six basic components to balancing the Financial Plan: •

•

• • • •

Limiting operating cost increases and reviewing service levels for expenditure reduction opportunities. Developing a capital improvement plan (CIP) that is the lowest cost possible while reasonably maintaining our existing infrastructure and facilities. Considering new revenue opportunities as allowed under Proposition 218. Making strategic use of available fund balance. Identifying organization-wide cost reduction opportunities. Developing operating budget reduction options.

As discussed below, these general strategies fall into two categories: shorter-term, “Phase 1” activities as part of the Financial Plan process; and longer-term “Phase 2” activities we should also consider as part of our long-term fiscal health goals.

Purpose of the budget instructions. These explain to the council and the public the principal ground rules of the budget-building work to follow; an example of what might be included:

The purpose of these instructions is to set forth the budget-building tasks ahead of us in helping the City Manager present the Financial Plan to the Council for their consideration and approval. In accordance with the budget principles set forth below and the goals set by the Council, our job is to build a budget that: • • • •

Is fiscally responsible and balanced. Preserves core services and adequately maintains existing facilities. Responds to Council goal-setting. Links what we want to accomplish for the community over the next two years with the resources necessary to do so.

This is much more than just a “number crunching” exercise. As we go about the detailed tasks ahead of us, it’s important for us to keep in mind that preparing the budget is 263

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not just a number-crunching, bean-counting exercise (although achieving our goal of producing a fiscally responsible budget makes these an important aspect of this process). But rather, it’s the primary tool available to us in translating the many hopes and aspirations of our community—as expressed in a myriad of policy documents and in many other more or less formal ways—into actual services that count on a day-to-day basis. Let’s keep this in sight as we prepare our departmental budgets.

Summary of process changes since the last budget cycle. Since most budget processes build on past practice, this is especially helpful for the more experienced “budgeteers” in the organization by highlighting the “new” things they need to pay attention to. It is also an opportunity to present improvements recommended by “stakeholders” if the agency conducts regular “budget process critiques” (see sidebar). Use of hard copy versus e-documents. Many agencies have moved towards “e-submittals” of budget documents, either through browser-based Intranets or simple saving of documents to shared drives and folders.

Budget roles and responsibilities. The instructions should make clear who is responsible for what tasks in preparing revenue projections, operating and CIP budget requests and budget reduction options, and in reviewing them in making recommendations to the Chief Administrative Officer (CAO). This should include all of the “budget actors,” such as: • •

•

• • • • • • • •

Governing body Advisory bodies (including the Planning Commission for cities and counties for the required review of capital improvement plans) Chief Administrative Officer: City Manager (or Mayor), County Administrator, General Manager Department Heads Division Heads and program managers “Central” budget staff CIP review committee Special staff reviewers, such as engineering for CIP projects; infor mation technology (IT) staff for IT-related operating or CIP requests; fleet maintenance for vehicle replacements or additions; or planning staff for environmental assessments Finance Department/Division Department “fiscal officers Budget Review Team

Budget evaluation criteria. How will budget requests (or expenditure reductions) be evaluated? Department staff members are powerfully interested 264

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in this aspect of the budget process (which in many organizations appears to be the “black box” of the budget process). Below are sample the criteria in evaluating CIP project requests:

Sample CIP Budget Evaluation Criteria • Does it complete an existing project? • Is it mandated by the state or federal government? • Is there significant outside funding for the project? • Is it necessary to address a significant public health or safety concern that cannot be deferred beyond the budget year? • Is it necessary to maintain existing facilities, infrastructure, or equipment adequately? • Was it previously scheduled in the Financial Plan? • Does it implement a high-priority Council goal for the budget year? • Will it result in significant operating savings in the future that makes a compelling case for making this investment solely on a financial basis? If yes, how can we ensure that these savings will in fact occur?

Budget request forms, templates and worksheets. From a departmental perspective, this is often the most significant entrée listing on the instructions menu: what forms, templates, worksheets need to be completed—and guidance on how to successfully do so. This includes: • Program budget narratives • Program objectives linked to major City goals and other key plans and policies • Line-item budget worksheets and supporting documentation • CIP budget request template, forms or content guidelines • Any special format requirements for operating budget requests • Format for operating budget expenditure reduction options (if applicable)

“Budget Process Critique”

Some progressive agencies conduct budget process reviews at the end of the budget cycle asking key stakeholders (like department heads, division heads, department fiscal officers, central budget staff, and perhaps the most important stakeholders of all: the governing body) two key questions:

• •

What worked well, and should be retained? What improvements should be made for the next year budget process?

depending on the circumstances, this process could entail structured surveys, interviews or focus groups; or simply asking the two questions above to stakeholders via email. the results should then be shared and consensus reached on changes for the next budget cycle.

Along with due dates and the criteria for budget request evaluation, this is an area of great concern to operating departments: once set, the “ground rules” and forms should remain largely in place throughout the process. Given this, the budget staff is well advised to give the “forms aspect” of the Budget Instructions close review before finalizing and presenting them to the operating departments.

Complete packet and due dates summary. Operating department staff will appreciate a concise recap of what’s due and when. Again, there are few things more likely to demoralize operating staff during the budget process than continued changes in what is required and when it is due: while some flexibility will always be needed as changed circumstances and challenges emerge, effective budget planning and organization help mitigate these. 265

Guide to LocaL Government Finance in caLiFornia Kick-Off Briefing Tip

management guru Bill daniels says that meetings are only effective when participants can act on the information within thirty minutes after the meeting (otherwise, the information loses its relevance quickly). Plan for this by scheduling the briefing for thirty minutes longer than you think it will take; and then encourage participants to use the “saved time” when they go back to their offices to at least start thinking about what their internal department budget process will need to look like.

Kick-off briefing. Rather than simply issuing the instructions in written form (whether in hard copy or electronic versions), it is common to hold a “kickoff ” briefing for the key staff throughout the organization that will be involved in the budget process. Along with an opportunity for budget staff to cover key areas, the kick-off briefing also provides an opportunity for department staff to ask questions (and hopefully get them answered). 3. Policy Review/Environmental Scan

Early in the budget process, agencies should take a close look at existing policies, the status of current major goals and key projects, and the economic, demographic and related fiscal outlook facing them, along with other challenges and opportunities on the horizon (such as the impact of the State budget situation on their operations and fiscal health). This stage could include preparation of five- or ten-year forecast in “setting the table” for the fiscal difficulties that may lie ahead. 4. Revenue Projections

Projections will typically be made by the budget staff, with assistance from the operating departments for “functionally” related revenues such as grants and service charges. Sources available in developing revenue projections include: Budget Worksheet Preparation

even agencies that use “program budgets” generally maintain line-item budget detail for each program for internal information and accounting purposes—they just don’t publish it in the budget document. in preparing the worksheets, agencies have typically taken one of four approaches: • Manual Preparation: the use of calculators, pencils, and hard copy ledgers is still alive and well in many agencies; and for smaller ones, this may in fact be the most efficient and effective technology. • Software Module as Part of Financial Management System: most financial management systems (FmS) come with a budget preparation module that allows for eventual uploading of budget data to the general ledger. However, many agencies find that the standard module does not fit well with their internal budget process; and perhaps more problematic, that the once-a-year nature of the budget process (or every two years in the case of multi-year budgets) makes training of both finance and operating budget staff a major work effort with a high level of error (and frustration). • Specialized or Custom Budget Preparation Software: in response to the constraints of FmS budget modules, some agencies have moved to either specialized or customized software that allows them to better match the technology tool with their internal process. However, for many of these agencies, the challenges of keeping skills fresh that are used just once a year (or every two years) remains. • The Goldilocks Solution? Standard Spreadsheet Software: as an inexpensive alternative, some agencies have moved to simply using standard spreadsheet software (like excel) for this purpose. account number and relevant financial data (such as prior year actual expenditures, current budget and year-to-date expenditures) can readily be downloaded to spreadsheet software in most FmS packages; and from there “worksheets” can be created for each program using whatever format the agency prefers. once adopted, the budget data can then be uploaded or keyed to the FmS general ledger. this has the advantage of providing budget and operating staff with tools they are familiar using year-round; flexible formatting; detailed data from the FmS; easy implementation; and low cost.

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• •

Long and short-term trends in key City revenues. Forecast data for California as developed by the UCLA forecasting project and regional forecasts prepared that may also be available. Economic trends as reported in the national media. Economic and fiscal information developed by the State Legislative Analyst’s Office and the State Department of Finance. Materials prepared by the League of California Cities and State Controller’s Office. New projects in the development “pipeline;” or conversely, any potential closings or downsizing of current significant revenue generators.

• •

•

•

Ultimately, however, whether based on complex models or more qualitative assessments, revenue projections reflect the staff ’s best judgment about the performance of the local economy, federal and state budget impacts and how these will affect the agency’s key revenues.

• • • • •

Revenue Projection Tips

Focus on the most important revenues. For example, in most california cities, the top five General Fund revenues will account for two-thirds to eighty percent of total sources (the top ten will likely get you to ninety percent). as such, invest quality time in understanding and analyzing these key drivers. Make clear assumptions. Budgeteers don’t control the performance of state and regional economies (let alone State budgets)—and fortunately, most staff and governing body members understand this. But the secret to success in estimating revenues lies in clearly stating the assumptions that underlie them. When significant variances do emerge, the only effective way to explain “why” is if the basis for the initial projection was clearly articulated. The past doesn’t determine the future; but if the future is going to be different than the past: why? this is a corollary to clear assumptions: what do you know about what drove significant ups and downs in the past; and what similar factors (or dissimilar ones) are on the horizon? Identify where estimates are most subject to change. then if (more likely when) this occurs, there will be a context for explaining the variance: you won’t be caught flat-footed. Use common sense. at the end of the day, based on what you know about your local community and the overall economic, demographic and fiscal environment, do the projections make sense?

5. Departmental Budget Preparation While revenue estimates are largely the responsibility of the budget staff, development of the expenditure side of the equation typically begins with budget preparation by the operating departments. Generally, key guidelines, preparation principles, and due dates were included with the Budget Instructions and covered in the kick-off briefing. Departments should prepare their own internal budget calendars to ensure there is adequate time for staff preparation and department head review before the department’s submittal is due to the budget staff. 267

Guide to LocaL Government Finance in caLiFornia 6. Centralized Budget Preparation While the operating departments will typically have the lead responsibility for preparing expenditure plans, there are some expenditure areas that may benefit from centralized preparation:

Regular staffing costs. Staffing costs typically account for eighty percent of General Fund operating expenditures; and regular staffing costs (including benefits) typically account for up to ninety percent of total staffing costs (with temporary staffing and overtime costs accounting for the other ten percent). The overwhelming dominance of regular staffing costs means that it is critical that this part of the operating budget be prepared within clear guidelines on a consistent organization-wide basis—and as accurately as possible. For this reason, many agencies prepare regular staffing costs centrally (while leaving temporary and overtime costs to the departments: needs and cost drivers in these areas are not the same organization-wide, but are specific to department programs). As discussed in Chapter 8, there are many significant components that determine regular staffing costs besides “base salary”: benefits like retirement contributions, health and dental coverage, life insurance, long-term disability, paid-leave benefits, workers compensation, Medicare, and unemployment insurance—along with “special pays” such as educational incentives, shift differentials, paramedic certifications, bilingual skills, vacation and administrative leave cash-outs, and uniform allowances—can add up to over eighty percent to “base” salary costs. Regular staffing budgets are driven by seven key factors: 1. Authorized regular positions within the department, division, or program (including pro-rations for any partial “full-time equivalents.” 2. Classification and salary range for each authorized position. 3. Benefits and special pays for each position (which are likely to vary significantly between employee groups as well as between sworn public safety employees like police officers and firefighters versus non-sworn employees like planners, engineers, maintenance workers, dispatchers, administrative assistants and accountants). 4. Scheduled salary or benefit increases based on Memorandums of Agreement (MOA) that will be in place during the budget period. 5. Incumbent employee placement within the salary range and assumptions for movement through the range during the budget cycle (step increases or merit raises based on pay-for-performance programs). 6. Assumptions for current vacant positions and those that might become vacant during the budget cycle.

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7. Assumptions for across the board salary or benefit increases where MOA’s will lapse during the budget cycle or the employee group is unrepresented.

For “drivers” 1 through 4 above, while the calculations may be complex (and as such, for larger organizations, best made using spreadsheets with downloaded data from the payroll system or specialized software for this purpose), they are Regular Staffing Cost Projection Options Option

Advantages

Disadvantages

do nothing: assume overall composition of placement in the ranges remains unchanged during the budget period.

Simplest, easiest approach: uses data as downloaded from payroll system. if high percentage of regular staff are already at the end of the salary range, the results may be similar to more complex approaches.

if there is a high percentage of regular staff that are not at the top of the range, this can lead to significantly under-estimating staffing costs and subsequent budget overages. the potential for this is even greater with two-year budgets.

Simple approach. if a high percentage of regular staff are already at the end of the salary range, the results may be similar to more complex approaches.

if there is a high percentage of regular staff that are not near the top of the range, this can lead to significantly over-estimating staffing costs. the potential for this is even greater with two-year budgets.

driver 5: Step and merit increases

Budget all positions at mid-range.

Budget all positions at the top of the range.

Simple approach.

Project salary range movement most reliable approach in mitigating during the budget cycle based on over or underestimating; this may be scheduled step increases (or likely especially important for two-year budgets. merit increases based on the pay-forperformance plan) and due dates for all employees.

depending on regular staff placement in the ranges, this may result in significant over or under-estimating staffing costs. the potential for this is even greater with two-year budgets.

this can be mitigated somewhat by using estimated “expenditure savings” on a departmental or fund-wide basis (see discussion below).

may require significant resources to make this assessment, especially for two-year budgets. assumes that any turn-over in staff will result in similar overall placement in ranges.

Note: For all of these options, while the results organization-wide may be on target, there is the possibility that there may still be underages/overages within departments, divisions and programs.

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Guide to LocaL Government Finance in caLiFornia Option

Advantages

Disadvantages

driver 6: vacant Positions

Budget only for currently filled positions. Simplest approach. recognizes that it is unlikely that all authorized Significant potential for underestimating positions will be filled at all times during the year. costs (and related budget overages at year-end). Budget for all authorized positions (with clear assumptions about where they will be placed in the salary range when filled).

reduces potential for budget overages if budget reduction options are required, makes clear the savings if authorized but unfilled positions are deleted. Similarly, where the goal is to achieve savings by keeping unfilled positions vacant, makes costing the savings possible.

Without a mitigating strategy (such as “estimated expenditure savings” as discussed below), this is likely to result in over-estimating costs, with the potential for significant budget underages at year end. in tough fiscal times, this means that budget cuts and lay-offs may have been made that were not necessary.

Simplest analytical approach: avoids sending any potentially “awkward” or unintended messages about “meet and confer” parameters.

if adjustments are likely, significant potential for under-estimating costs and resulting budget overages.

driver 7: across-the-Board Salary and Benefit increases not covered by moas

do nothing.

make assumptions about likely increases in light of past trends, other moas that will be in place with other groups during the budget cycle, targeted goals or other factors that make sense under current circumstances.

incorporates reasonable cost projections into the budget transparency.

Potential for cost projections to be misinterpreted as “meet and confer” goals or parameters rather than cost assumptions.

relatively straight forward. However, “drivers” 5 through 7 require assumptions. There is no “correct” answer for the “right” assumptions to use: however, just as with revenue estimates as discussed above, it will be important to document and articulate the assumptions used clearly. The chart above identifies options that agencies might consider, and the advantages/disadvantages of each. Again, there are no “right” assumptions: any of these approaches can make sense depending on the circumstances. However, the advantages and disadvantages should be discussed with key budget stakeholders before being finalized, and then clearly documented and communicated to key budget staff. To avoid overstating program budgets, it may be useful in the budget document to show “estimated MOA costs” with “other sources and uses” in presenting changes in fund balance. (This approach is described below under “Expenditure Savings.”) 270

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Insurance, information technology, fleet operations and other support services. Where these types of support operations are centralized in the organization, it may make sense for these organizational units to centrally prepare budgets for these types of costs. And where these types of operations are not centralized, it makes sense for the Budget Instructions to provide clear guidance for common assumptions that should be made by all departments for common costs.

Utilities. In most cases, budgeting for utility costs (like electric, gas, and water) will be the responsibility of the operating department, since usage is unique to the operation, such as electric costs for street lighting versus the water treatment plant, and natural gas usage at City Hall versus the swim center. However, this is another case where clear guidance should be provided for common assumptions for common costs.

Reimbursement transfers. Most organizations account for their “indirect costs” like finance, city clerk, legal services, and human resources in the General Fund. However, these operations also benefit other funds, like water and sewer. To ensure appropriate accounting for these costs, many agencies prepare “cost allocation plans” that allocate these costs in logical, consistent ways to all direct cost programs. Reimbursement transfers indirect costs are typically prepared centrally by finance or budget staff.

General “cost of living” adjustments. There should be central guidance where any general cost of living adjustments are to be used by departments. This could include direction that no such factor should be assumed by departments.

Expenditure savings. “Use or lose it” may be the norm in some organizations. However, in many local agencies, it is unlikely that all appropriations will be spent by fiscal year-end, especially if all authorized regular positions are budgeted as filled. To avoid the potential for significant budget underages at year-end, some organizations use the “contra budget account” of expenditure savings (or salary savings) to account for this. No direct postings are made to this account: the “budget variance” overall is netted from actual expenditures versus the reduced budget total. The estimate is typically based on past experience, but applied conservatively to avoid an unpleasant year-end surprise (for example, two percent of budgeted expenditures). As the year progresses, this estimate may be further refined by asking departments for their estimates of year-end expenditures. With this approach, the estimated expenditure savings is not a target per se, but rather, an attempt to reflect more accurately year-end results. For this reason, it is not typically assigned to specific programs or departments (although this is an option) but at the fund level. This recognizes two factors: 271

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•

While the estimate may be based on past experience (which may be relatively consistent over time in total at the fund level), the reasons for expenditure savings can vary significantly from year to year, between line items and between department and programs. (This is especially likely if salary savings due to vacancies are a large component of overall savings: while turnover in the organization overall may be relatively consistent over time, it is unlikely to occur in the same way every year within the same department, division, or program). And since it is primarily a way of more accurately projecting expenditures—rather than an expenditure control per se—it would be inappropriate to reduce department or program budgets by this amount. On the other hand, if the goal is budgetary control, then it would be better to reduce specific accounts within the department or program to ensure that the savings occur, and to make the service impact of the reduction clear.

There are several ways of presenting estimated expenditure savings in the budget. The sidebar table on the next page provides an example showing expenditure savings of two percent of operating expenditures as “other sources and uses” (like interfund transfers or proceeds from long-term debt) in accounting for and presenting changes in fund balance. As shown in this example, accounting for expenditure savings at a modest two percent level results in a change in ending fund balance of almost one million dollars ($997,000), and shows a modest increase in fund balance of $76,000 rather than a shortfall (at least in the year shown) of over $900,000.

• •

Key “Expenditure Savings” Concepts the purpose of using an estimated expenditure savings “contra-account” is not for budgetary control purposes per se, but to more accurately project year-end expenditures rather than simply assuming that all appropriations will be spent.

if the goal is budgetary control, rather than better year-end expenditure estimates, it would be better to reduce specific accounts within the department or program to ensure that the savings occur, and to make the service impact of the reduction clear.

In summary, while there are several options for showing this, in those cases where there is a consistent history of actual expenditures coming in under budget, the use of an estimated expenditure savings contra-account will result in more accurate expenditure projections (and thus better estimates of ending fund balance) than simply assuming that all appropriations will be spent. 272

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This is especially important in tough fiscal times, where failing to do so in trying to balance the budget is likely to result in unnecessary budget cuts and layoffs—and an undermining of confidence and credibility in the agency’s financial management if year-end results are significantly better than projected due to this. 7. Internal Budget Reviews

After departments submit their budget request, they will be subject to some type of budget review. In very small organizations, this may simply be done by the chief administrative officer. In most larger organizations, there will be an internal budget review organization. This may be based on internal review teams, assigned central budget analysts, finance staff, or other internal review organization that will be responsible for making budget recommendations to the CAO, based on: •

• •

Available resources (as determined by the revenue projections and minimum fund balance policy). Demonstrated need for service improvements or cost increases. Or the need to make significant cost reductions.

This is often a two-step process: •

Detailed line-item reviews by budget analysts to ensure that the “base” budget numbers are justifiable and reasonable in light of past and current expenditure trends, workloads, program goals, and formal contracts for goods and services that are in place.

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And assuming the “details” are in place, higher level policy reviews of any significant service improvements or cost increases, or in times of economic downturn like the Great Depression, cost reductions and related service impacts. This process can be very hierarchical and top-down, or it can be broadbased and highly participative, depending on the organizational culture. Regardless of the internal review process, most agencies provide department heads with an opportunity to “appeal” internal review recommendations to the CAO. 8. Preliminary Budget Preparation Once the CAO has finalized her or his recommendations, the budget staff will finalize the budget document for distribution to the governing body. As discussed below, while there are no “rules” for budget contents, an effective budget document will include: •

• •

•

•

•

•

• •

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Budget message from the CAO that clearly and concisely discusses the key fiscal issues facing the agency and how the budget responds to them. Summary charts and graphs that highlight key fiscal relationships such as top revenues, expenditures by type and function, authorized staffing and changes in financial condition (fund balance or working capital). Overview of the budget process, organization chart and directory of key officials and advisory bodies. Key fiscal policies that guide preparation and management of the budget. Summary of major city goals for the upcoming budget and the status of current major city goals. Operating budget that describes the agency’s basic organizational units, including policies and goals that determine the nature and level of services to be provided, activities performed in delivering program services, objectives for improving the delivery of service, and the amount appropriated. Capital improvement plan (CIP) expenditures for the agency’s large construction projects and equipment purchases that are not included in the operating budget. (Many agencies prepare a separate companion CIP document spanning several fiscal years with detailed information for each project.) Annual debt service obligations. Statements of revenues, expenditures and changes in fund balance/ working capital for each of the agency’s funds. Prior year actuals should be reconciled to the agency’s audited financial statements.

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Financial and statistical information such as detailed revenue estimates (and assumptions for top revenues), interfund transactions, authorized staffing levels, appropriations limit history, and general demographic information about the city.

How this information is organized and presented—and how much detail is provided—is best determined by each agency based on its own circumstances. In general, however, at whatever detail level, financial data should be provided for at least three years: last completed fiscal year (actual), estimate for the current year in progress, and the upcoming budget year. The information above should be provided in a way that ensures transparency and a clear understanding by the governing body, staff, and community of the resource constraints facing the agency and the proposed allocation of those limited resources in delivering services to the community. 9. Budget Review and Adoption After the CAO issues the preliminary budget, a series of public workshops and hearings are scheduled for the governing body for staff presentations, public comment, and member discussion. This may mean one public hearing; it may mean a long series of study sessions and hearings. This will be largely deter mined by the fiscal issues facing the agency, its “civic infrastructure, and its organizational culture. As discussed below, if key process goals include meaningful community participation and elected official guidance of priorities, significant opportunities for this will have already occurred before the preliminary budget is issued. In this case, the budget document will largely reflect the results of community participation and Council goal-setting, rather than presenting these issues for the first time. The Mechanics of Adoption The review process may result in robust and diverse • Budgets can be adopted by minute action or resolution (in rare circumstances, an opinions, or it may result in strong consensus: usually it has agency might choose to so by ordinance). elements of both. Budget making is both a rational process as • most agencies adopt the budget via resoluwell as a subjective one, where community values are the main tion. currency being exchanged. • the resolution can be very detailed, identiFrom time to time, local governing bodies may find that fying appropriations by department, fund, they are not able to adopt a budget by the beginning of the program, or line item. • or it can simply reference the preliminary fiscal year (July 1 in virtually all cases, but this is deter mined by budget as amended by the governing body. each agency, and a few have chosen other bases for their fiscal • The Conventional Wisdom: the simpler year) due to time constraints, revenue uncertainties, or other the better. the resolution isn’t the policy factors. document and expenditure plan: the budget In this case, agencies can adopt a “continuing approdocument is. priations resolution,” which provides ongoing authority for 275

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some basic level of operation (typically based on the prior year’s budget), with whatever conditions or limits make sense for the agency under the circumstances. While the preliminary budget is the staring point for formal governing body discussion, it is rarely adopted as presented: the governing body has the discretion to make whatever changes are supported by a majority of its members. On the other hand, significant changes—either in number or substance—most likely reflect a breakdown early in the process in the governing body providing clear policy direction to the CAO—or the CAO not paying attention to it. 10. Implementation Once adopted by the governing body, the responsibility for implementation lies with the CAO and agency staff. This falls into two categories:

Preliminary Budget Distribution

along with hard copy distribution to the “usual suspects,” it is becoming common practice to post the Preliminary Budget (along with all other budget-related documents) on the agency’s web site. While this may not result in printing fewer hard copies, it makes the information much more accessible.

Where hard copies are still desired by others outside of the organization, it is a “best practice” to have a clear policy on reproduction costs in place before distribution.

Ministerial. This consists of entering the new budget data into the financial management system, creating new account numbers as required, ensuring that the totals reconcile to the approved budget and disseminating this information to the operating departments. It also includes printing the final budget document and posting it on the agency’s web site. Additionally, it may also include preparing a “Budget-in-Brief ” and providing it at public counters, posting it on the agency’s web site and distributing it to the community via direct inserts in utility bills, direct mailings, or newspaper inserts. Implementation also covers budget amendments: under what circumstances and under whose authority. Typically, the governing body can approve budget changes at any time with majority approval. Staff authority is usually covered in the agency’s fiscal policies. While there is no “correct” policy, the key principle is to be sure that the policy is clear. For example, in the City of San Luis Obispo, the City Manager has the authority to make administrative adjustments to the budget as long as those changes will not have a significant policy impact nor affect budgeted year-end fund balances. In turn, the City Manager has delegated authority to department heads to make budget changes within their department between programs and line items as long as department totals by fund remain unchanged and there are no significant policy impacts (with some limits on staffing and training accounts). In summary, whether there is narrow or broad administrative authority, it should be clear. Policy and Program. This is the larger task: ensuring that any new initiatives are faithfully launched and managed within the approved resources. For larger programs, this may mean preparing detailed work plans. It also may include hiring new staff, purchasing supplies and equipment and entering into service agreements. It also includes implementing any rate increases or new fees.

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In tough fiscal times, it may also mean implementing cost and related service reductions, including lay-offs. Part of the implementation process may also involve setting benchmarks for achieving goals and reporting on their status, along with monitoring fiscal results. 11. Monitoring and Taking Corrective Action Monitoring results and taking corrective action fall into two broad categories: •

•

Fiscal Results: How do revenues, expenditures, and beginning fund balance compare with budget projections? Program Results: Appropriations exist to accomplish results. How is the organization doing in achieving key budget goals?

Monitoring fiscal results is covered in Chapter 12 (Financial Reporting) and effective presentation ideas follow in Appendix C. However, monitoring nonfiscal or “program” results are just as important. Some pundit once observed “that which gets measured is what gets done.” While there are some conceptual limits to this as discussed in Chapter 7 under performance budgeting (for example: But are we measuring what we really want to achieve?), the fact is that structured reporting on progress in achieving goals is one of the most effective tools available to local government managers: it keeps important goals in front of staff, governing body, and the community and enhances accountability. However, for this to be effective, the reporting needs to be focused on the most important things and presented in a concise manner.

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Presenting Financial Information Appendix C

“The unexamined life is not worth living.” ~Socrates—a long time ago

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“Unexamined data is not worth having.” ~The authors—pretty recently

Financial Analysis Tools ith the Internet, blogs, Twitter, social media, and wide range of “24/7” cable news outlets, there is unprecedented access to information. However, for information to be meaningful—to translate raw data into knowledge—requires analysis. Stated simply, data has no meaning unless placed in some context, usually in comparison with something else. There are three basic approaches for creating context: • Comparisons with others (cross section) • Comparisons over time (time series) • Comparisons of results with expectations (variance analysis)

For example, the question “how is the city doing financially?” can best be answered in the context of “compared with what?”

• Compared with other regions or communities? (Others) • Compared with how we did last quarter, last year or the last ten years? (Time) • Compared with the budget? (Expectations)

Each of these analytical approaches is discussed below. However, the first step in all of these is to look for the fewest number of things that explain the most amount of 279

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stuff. This is an extension of the Pareto Principle, which is often referred to as the “80/20” rule—(or the “vital few and the trivial many.”) The basic premise is that roughly eighty percent of the results come from twenty percent of the causes. This “rule of thumb” is a useful framework for getting focused on the most important factors that determine results. For example, local government agencies—whether large or small—have thousands of balance sheet, revenue and expenditure accounts in their general ledgers. Effectively reporting on financial results to elected officials and senior managers means focusing on the most important of these. This recognizes that it is important to see the “forest for the trees” (while at the same time recognizing that the forest is made-up of individual trees: effective managers pay attention to both).

Comparisons with Others. This is approach compares different things in the same time frame. In a local government context, this might mean: • How your agency compares with other communities • How your agency’s revenues compare with each other this fiscal year • How your agency’s expenditures compare by function, department, or type this fiscal year

These types of comparisons are typically best shown in tables showing “percent of total” (such as Tables 1 to 3) or doughnut charts (such as Charts 1 to 5).

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Table 1 focuses on the most important revenue sources, where the top five revenues account for almost eighty percent of total revenues (and all revenues are accounted for in just seven main categories—with “other” accounting for just five percent of the total). In this case, it also shows that sales tax revenues are the most important revenue source—and at thirty percent, it is twice as

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important the next most important revenue source (property taxes at fifteen percent). In evaluating this city’s revenue outlook, the focus needs to be on these top revenues.

Table 2 shows operating costs by function, with public safety accounting for about half of all operating costs. This emphasizes that if cost reductions are needed, it will be difficult to do so without making reductions in public safety. In fact, if public safety is excluded from reductions, this means that the required reductions in all other functions will be double what they would otherwise be if the cuts were made evenly “across-the-board,” i.e., an overall cost reduction goal of ten percent becomes twenty percent if public safety is exempted. (This goes a long way towards explaining why cost reductions can be so difficult in many cities with police and fire responsibilities.)

Table 3 takes this same operating expenditure information and shows it by type —staffing, contract services, and other expenditures. In this case, staffing costs account for about three-quarters of all operating costs, and almost half of these 281

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operating costs are for public safety: police officers arrest bad guys and fire fighters put out fires. Contracting with the private sector for services, telecommunications, utilities and insurance accounts for almost another twenty percent. This leaves only ten percent for materials and supplies like chemicals for pools and asphalt for street maintenance, let alone funding for training. This also shows why cost reductions can be so difficult: there may be some low-hanging fruit in that ten percent—but there’s so little of it. Budget balancing efforts would be helped if there were a line-item account labeled “waste and fat,” but the fact is that the overwhelming portion of costs are tied to staffing and other hard-to-control (but essential) costs like phones, utilities, and insurance.

Pie or doughnut charts can take similar information as those in Tables 1, 2, and 3 and express it in graphic ways that help show relationships more clearly. For example, in understanding an agency’s overall funding sources, Chart 1 shows that the General Fund accounts for only about half of the agency’s funding sources. Enterprise funds like water and sewer (which are selfsupporting) and special revenue funds that are restricted for specific uses (like the Community Development Block Grant) account for the other half. If the intent is to begin focusing on the challenges in the General Fund, this helps place the scale of the General Fund in context.

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Chart 2 shows that within the General Fund, day-to-day operations account for about eighty percent of total costs. This can also be helpful in understanding an agency’s ability to reduce costs: reducing the budget in a sustainable manner requires ongoing operating cost reductions, and as shown in Charts 4 and 5, public safety costs by function, and staffing by type, are the areas that require the most attention.

Charts 3, 4, and 5 present the same information as Tables 1, 2, and 3, but in a graphical way that may better illustrate the data relationships.

appendix c: Presenting Financial information

When asked why he robbed banks, the famous bank robber Willie Sutton was quoted as saying: “Because that’s where the money is.” Similarly, these types of charts and graphs help organizations focus on “where the money is” by identifying the fewest things that explain the most amount of stuff (or the “vital few” that best describe an agency’s financial situation). In many cases, focusing on the “Top Five, Ten, or Dozen” will go along way in providing context and in explaining the most important factors that determine an agency’s fiscal circumstances.

Time Series/Trend Analysis. This approach compares what’s happened over time to the same things: what are the trends? • How have costs increased (or decreased) over the last year, five years, or ten years? • How have revenues increased (or decreased) this quarter compared with the same quarter last year? Over the last year? Five years? Ten years?

These types of comparisons are typically best shown in charts showing results over time (such as Table 4) or line/bar graphs (such Graphs 1 to 9), either by the amount, amount of change or percentage change, depending on the story you want to tell.

Table 4 shows the annual amount of sales tax and percentage change for ten years (1991 to 2001), which reflects a series of “ups and downs.” In analyzing these changes, the key question emerges: why? For 1992, the seven-percent decrease likely reflects the 1991-1992 recession; and the modest increases in the mid-1990s likely reflect the recovery and continued strength of the economy. On the other hand, what accounts for the fifteen-percent increase in 2000? It may be an anomaly, a strong year statewide or regionally for retail sales, or it may reflect the opening of a significant new retail center—or a combination of 283

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all three. This “why” question is critical in assessing the agency’s long-term fiscal heath: which of these factors is likely to play an important role in the future? After identifying the most important things through cross-series analysis, looking at trends over time is the next step in surfacing the most important “why” questions. Trend data like that provided in Table 4 may be easier to understand in line/bar graph form, like those provided in Graphs 1 to 9. Graph 1 shows taxable retail sales for fifteen calendar years (1993 to 2007). This graph shows a steady upward trend, with “plateaus” in recession years. Three “practice tips” from this graph:

• The “vertical axis” (in thousands of dollars) does not start at “zero.” Where the numbers are large, this helps better shows key trends, which are not likely to be as apparent if the axis begins at zero. This approach of starting the vertical axis at a meaningful point above zero is used in most of the graphs except Graph 8, since the comparison numbers are very small. • The “base” is taxable retail sales—not sales tax revenues. There are two reasons for this: the “base” for sales tax revenues includes more than “situs” retail sales: it also includes allocations from county and state pools, which may be a significant factor for some agencies, and can also be quite volatile from quarter to quarter. More importantly, sales tax rates can change through local-option sales tax rates. As such, if the intent is 284

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to show how the underlying base for sales tax revenues has performed over time, this provides a better assessment than sales tax revenues. • The graph presents data for calendar years for consistency in using data from the State Board of Equalization, which presents “cleaned-up” annual data on a calendar rather than fiscal year basis. This underscores the importance the selecting the period for which data will be presented in most effectively telling your fiscal story: Monthly? Quarterly? Calendar Year? Fiscal Year?

Graph 2 shows changes in assessed value for fifteen years—not property tax revenues. Like sales tax revenues versus taxable sales, the selection of assessed value is intended to show how the underlying economic base for property tax revenues has performed over time. This is not likely to be presented as clearly in a fifteen-year graph of property tax revenues, due significant reallocations of the “1% of market value maximum levy” by the state during this period. (On the other hand, if “state takeaways” is the story you want to tell, then showing property tax revenues would make sense.) Similarly, Graph 3 shows taxable hotel sales for fifteen years—not transient occupancy tax (TOT) revenues. Again, this approach better reflects changes in the underlying economic base for this revenue source, as there may have been tax rate changes during this period of time. For example, in the 1990s, many cities and counties raised their TOT rates from five percent or six percent to ten percent (or 285

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higher). All other things being equal, this alone could have caused a doubling in TOT revenues, even if the underlying tax base remained the same. While the kind of trend data shown in Graphs 1 to 3 is helpful in assessing trends, it can be even more powerful if placed in relation to what? For example, in relation to:

• Changes in population (while imperfect, this helps assess changes in service demand and the revenue base). • Changes in the cost of living (such as an external index like the consumer price index). • Changes in costs versus revenues.

In these three cases, by providing context for the trend data (“in relation to what”), better assessments can be made of the relative ability of key revenues to meet increasing service demands due to population and inflation.

For example, Graphs 4 to 6 take the same basic data as presented in Graphs 1 to 3, but present it on a per capita basis, adjusted for inflation. In all three of these cases, the “story” of these trends changes with these adjustments (in all cases, it gets worse). 286

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Graph 7 compares fifteen years of “major revenues” in the City of San Luis Obispo (in this case, these are the “Top 8,” which account for about eighty percent of General Fund revenues) with operating costs (which historically account for about eighty percent of total costs). While a comparison of total General Fund revenues and costs might also yield a useful analysis of trends, comparing “major revenues” with operating costs has the advantage (albeit not a perfect one) of adjusting for “lumpy” one-time revenues (such as grants or property sales) and one-time capital costs. The City’s fiscal—and budget accountability story—is effectively told in this graph:

• From 1994 to 1997, “major revenues” are in very close alignment with operating costs. • From 1998 to 2001, major revenues exceeded operating costs, which allowed the city to invest in infrastructure and facility improvements. (For example: during this period, the city updated its Pavement Management Plan and launched a significant increase in funding for street resurfacing, built a major athletic fields complex, and increased its funding for open space acquisitions). • In the aftermath of 9/11 and “dot.com” meltdown, operating costs became higher than major revenues from 2003 to 2005. • However, through long-term financial planning and the budget process, major revenues and operating costs are again in alignment in 2006, 2007 and 2008. 287

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Graph 8 shows how debt service costs (payments of principal and interest on outstanding debt issued to finance large, “one-time” capital improvements) in the City of San Luis Obispo compare with General Fund revenues over fifteen years. This graph shows two things: 288

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• Debt service costs as a portion of total revenues have stayed relatively constant—and at a modest level of about four percent (in fact, the highest ratio was six percent in 2001). • And this compares favorably with the city’s policy of keeping General Fund-supported debt service below ten percent.

Lastly, Graph 9 shows how unreserved, undesignated (available for new appropriation) General Fund balance has changed compared with the City of San Luis Obispo’s policy minimum of twenty percent of operating expenditures for twenty years (1990 to 2009). As reflected in this graph, even in the toughest years, San Luis Obispo has consistently met this policy goal.

As these “times series” examples show, comparing how financial information has changed over time can be very helpful in assessing fiscal condition, and comparisons over time can be even more powerful if placed in the context of other trends during the same period.

Variance Analysis. This approach compares results with expectations: what did you think would happen? The “expectation” may be set in the budget, long-term fiscal forecast or bid estimate. But the key questions asked with this approach are:

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• How does the actual result compare with what you expected? • Why is it different? • And what does it mean?

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From a policy perspective, variance analysis in the form of “budget versus actual” is perhaps the most meaningful form of analysis for three key reasons:

• In government, fiscal success cannot be measured by profit versus loss as it can be in the private sector. The closest (albeit imperfect measure) is how well local agencies meet budget projections on the both the revenue and expenditure side. • Spending plans and programs for the coming year are not based on revenues received in the past, but on projected revenues for the coming year (and these in turn are largely based on what are still revenue estimates for the current year); and while the past plays a role in projecting costs for the coming year, these are based on cost projections as well. When the year begins, it becomes far more important in managing the agency’s finances to evaluate how revenues are performing compared with the budget than how they are performing compared with the past or with other revenues. • Lastly, it plays an important fiduciary and accountability role in showing compliance with adopted spending plans and programs.

The problem in showing “how are we doing” without context is reflected in Table 5. 291

Guide to LocaL Government Finance in caLiFornia Changes in General Fund Balance

In this sample, sources (revenues and transfers in from other funds) exceed uses (expenditures and transfers out to other funds) by $578,000. Is this increase in fund balance good or bad? On the surface, since the result is positive, the answer might appear to be good. But the fact is that this question can only be meaningfully answered in the context of “compared with what?” And while “compared with last year” might be a useful reference, compared with the budget is likely to be much more relevant. As reflected in the example in Table 6, the same results could be very adverse: if the budget projected an increase in fund balance of $1,549,900, then this result is almost one-million dollars worse than estimated. And since this occurred almost solely on the revenue side, there are likely to be ongoing adverse impacts. In short, compared with where the agency expected to be, it has a one-million-dollar problem—which is likely to grow by this amount (or more) in the following year.

Changes in General Fund Balance

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Or this result could be even better than it is appears: in Table 7, fund balance was projected to decrease by $987,700, so the net change in fund balance was actually $1.5 million better than projected. Variance analysis of “budget versus actual” is a very powerful tool in answering the question of “how are we doing?” However, after answering this “how” question, the next one is “why.” And as discussed in the sidebar, this requires asking “why to the fifth level.” Tables 7 through 10 provide examples of this in answering “why was fund balance $1.5 million better than projected?” Changes in General Fund Balance

• Why 1: Table 7 shows that this favorable variance was caused by a combination of higher revenues and lower costs than projected. • Why 2: Why were revenues better than projected? Table 8 shows variances for the top ten revenues—which typically account for ninety percent of all General Fund revenues and would be expected to account for most of the variance. But they don’t: they only account for about seventy-five percent of the variance. • Why 3: This raises the question: what unusual revenue(s) account for the other twenty-five percent? In this case, it is unbudgeted reimbursements for disaster-related expenditures from the Federal Emergency Management Agency of $284,000. With this addition in place (which is likely to be a one-time, non-recurring revenue source), Table 8 now presents ninety-nine percent of the revenue variance. • Why 4: Why were expenditures less than budgeted? By focusing on key expenditures by function and type, Tables 9 and 10 help identify the key expenditure areas that account for most of the variances. 293

Guide to LocaL Government Finance in caLiFornia Asking Why to the Fifth Level

the concept of asking “why to the fifth level” was developed by toyota motor company as part of its manufacturing improvement process. Stated simply, asking “why” five times is likely to surface the real underlying cause of a problem. For example, if a car won’t start, the underlying cause is likely to be found at the fifth level of why:

•Why? the battery is dead. (First why) •Why? the alternator is not functioning. (Second why) •Why? the alternator belt has broken. (third why) •Why? the alternator belt was well beyond its useful service life and has never been replaced. (Fourth why) •Why? i have not been maintaining my car according to the recommended service schedule. (Fifth why—and root cause) Like the “Pareto Principle,” asking why to the fifth level is not a prefect policy prescription for exploring root causes. However, it does underscore the power of asking “why,” and that the surface reason given at the first “why” is rarely the “real” reason. Getting to underlying root causes requires asking why to at least the fifth level, which will often be as deep as needed.

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• Why 5: This requires following- up on the key—but few—remaining variances identified in Tables 7, 8 and 9. When “why at the fifth level” is to applied to the key variances in these tables, very solid answers to “why was the fund balance $1.5 million better than projected?” will emerge.

This set of examples reflects the combined use of three analytical principles:

• Data only has meaning in the context of something else: in this case, variances from expectations (the budget). • Find the fewest things that explain the most amount of stuff (revenues versus expenditures, top ten revenues, major sources of expenditures by function and type). • Ask “why” to the fifth level.

Presenting the Results. As discussed in the sidebar, providing timely, accurate data is an important part of financial reporting. But effectively telling your fiscal story means going beyond this and answering “what does it mean?” One effective way of doing this is to tell your story in three chapters via the “Data Triangle,” which uses a “pyramid” approach in presenting information to the community, policy makers and organization.

• The foundation for your fiscal story is the raw data, which needs to be timely and accurate—but it is not part of your story’s narrative because people tend to get bogged down when presented lots of detail, and they miss the main message. Where this needs to referenced at all in reports to the community, elected officials or senior management, it should be placed as an exhibit or appendix at the end of the report or as an on-line file.

appendix c: Presenting Financial information When the Results Are Not What You Expected

When the results are not what you expected, first assume that you’re right, the data is wrong. Why? Because the fact is that with thousands of general ledger accounts, the potential for posting errors is very high, even in the best-run finance operations (and this is especially true when so many closely related, significant sources come from the county on the same remittance with short, one-line descriptions). this can lead to attempts to explain large positive variances in property tax revenues (where salestax related “triple flip” revenues may have been posted, since they are funded by property tax related transfers from the education revenue augmentation Fund) and large unfavorable variances in sales-tax revenues (because this is where the “triple flip” revenues should have been posted).

• The next chapter of the story is to use summary tables, charts, and graphs in presenting the “fewest things that explain the most amount of stuff.” • And at the top of these chapters—and presented at the very beginning of the report or newsletter—should appear a concise and punchy analysis on what the results mean.

In many ways, leading first with conclusions is the opposite of how many of us were taught to write essays and other persuasive documents, where the arguments are built first, then followed by the conclusion based on them. This approach works fine for “whodunit” Agatha Christie novels, where the guilty party is exposed by Hercule Poirot at the end of the novel. However, presenting financial results is not a mystery novel: community members, policy makers, and organization should be presented with the results —“what does it mean”—early in your fiscal story. Unlike the board game Clue, they should get to know that it was “Colonel Mustard, in the study with a knife” at the beginning of the story. The purpose of the tables, charts, and graphs (and more detailed data as needed) is to then help support the report conclusions—but they aren’t the story: what they mean is.

in short, when significant unexpected variances occur, first make sure there aren’t errors in the data base. as dr, ray Hyman (Professor emeritus of Psychology at the university of oregon and noted critic of parapsychology) advises: “Before we try to explain something, we should be sure it actually happened.”

this notion is reinforced by mark twain’s observation that: “It ain’t what you don’t know that will get you in trouble. It’s what you know for sure that just ain’t so.”

However, after you are sure that the data is, in fact, correct, then proceed to asking “why to the fifth level.”

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Financial Analysis Tools and Approaches Summary. As discussed above, there are five key points to telling your fiscal story so you avoid the trap of trying to communicate complex numbers and instead communicate what they mean:

• Data only has meaning in the context of something else, such as comparisons with others, over time or what you expected. • Find the fewest things that explain the most amount of stuff (the “Pareto Principle”). • Ask “why” to the fifth level. • When the results aren’t what you expected, always assume you’re right and the data are wrong. • Consider the “Data Triangle.”

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Useful Information Sources Appendix D

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he following “resource matrix” provides an easy-to-use reference guide on where to find information on a wide variety of local government financial management topics. This matrix is organized into four sections:

Resources by Functional Area. Identifies professional organizations and state and governmental agencies that can assist with information on the topic area. The web site is provided for each organization. Key areas (with sub-areas in some cases) include: Accounting and Financial Reporting Budgeting Investing Debt Financing Payroll and Human Resources Retirement Fiscal Policies Redevelopment Agencies Risk Management Revenue Projections, Management, and Monitoring Revenue Limits State Takeaways State Mandated Costs Purchasing Utility Billing Economic Development Ethics Demographics 297

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Key State Constitutional and Statute Provisions. Identifies key state constitutional and statute provisions that govern local government finance in California. As noted in the matrix, the state maintains an on-line, searchable index of all state constitutional provisions and statutes by code at http://leginfo.legislature.ca.gov/faces/codes.xhtml. Key Publications. Identifies key publications about local government finance along with a brief summary of what it covers and from whom it is available. Organization Abbreviations. In several cases, the Resources by Functional Area matrix uses abbreviations for space reasons. This page provides the full name for all abbreviated organizations.

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Bibliography NOTE: See also Appendix D. Useful Information Sources Blakely, Edward J. and Nancy Green Leigh. Planning Local Economic Development, Fourth Edition, SAGE Publications, Thousand Oaks, 2010. California Debt and Investment Advisory Commission. California Debt Issuance Primer, 2010. California Debt and Investment Advisory Commission. California Public Fund Investment Primer, 2009. California Debt and Investment Advisory Commission. Local Agency Investment Guidelines, 2010. California Department of Finance, City/County Population Estimates, 2009. California Public Employee Relations Institute of Industrial Relations. Pocket Guide to the Basics of Labor Relations, University of California at Berkeley, 2009. California Senate Local Government Committee. What’s So Special About Special Districts? Fourth Edition, 2010. California Senate Local Government Committee. Revenues and Responsibilities: An Inventory of Local Tax Powers, Second Edition, 2010. California State Controller’s Office. Cities Annual Report (various editions). California State Controller’s Office. Counties Annual Report (various editions). California State Controller’s Office. Special Districts Annual Report (various editions). City of Atascadero. Atascadero Long-term Financial Analysis, 1992. Coleman, Michael. “Theoretical Comparison of Annual Costs and Revenues for Different Development Proposals,” 2016 at www.CaliforniaCityFinance.com. Coleman, Michael. California Municipal Revenue Sources Handbook, League of California Cities, 2014. Covey, Stephen R. The Seven Habits of Highly Effective People, New York: Simon and Schuster, 1989, 2004.

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Dropkin,Murray, Jim Haplin and Bill LaTouche. The Budget-Building Book for NonProfits: Step-by-Step Guide for Managers and Boards, San Francisco: Jossey-Bass, Second Edition, 2007. Giles, Susan L. and Edward J. Blakely, Fundamentals of Economic Development Finance, SAGE Publications, Thousand Oaks, 2001. Heikkila, Eric. The Economics of Planning, The Center for Urban Policy Research, Rutgers University, New Brunswick, 2000. Malanga, Steve. “The Beholden State: How Public Sector Unions Broke California,” City-Journal, Spring 2010. Malizia, Emil and Edward Feser. Understanding Local Economic Development, Center for Urban Policy Research, Rutgers, New Brunswick, 1999. Miles, Mike E. Gayle Berens and Marc A. Weiss. Real Estate Development: Principles and Process, Third Edition. Urban Land Institute, Washington, D.C. 2000. Mills, Edwin. Urban Economics, Scott, Foresman and Company, Glenview, IL, 1972. Nalbandian, John, “Professionals and Conflicting Forces of Administrative Modernization and Civic Engagement,” in The American Review of Public Administration, 2005. 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. National Opinion Research Center, for California HealthCare Foundation California Employer Health Benefits Survey, 2007. Nelson, Kevin. Zero-Based Budgeting, http://www.referenceforbusiness.com/management /Tr-Z/Zero-Based-Budgeting.html. Accessed August 2010. Solano, Paul and Marvin R. Brams. Management Policies in Local Government Finance, ed. Richard Aronson and Eli Schwartz,Washington D.C.: International City/ County Management Association, 1996. U.S. Government Accounting Office. State and Local Government Retiree Health Benefits: Liabilities Are Largely Unfunded, but Some Governments Are Taking Action, Report to the Special Committee on Aging, November 2009. U.S. Department of Commerce. U.S. Census of Governments, Economic Censuses, 1997, 2002 and 2007. Walters, Jonathan. Measuring Up: Governing’s Guide top Performance Measurement for Geniuses (and Other Public Managers Washington D.C.: Governing Books, 1998. Wildavsky, Aaron. Budgeting: A Comparative Theory of Budgetary Processes New Brunswick: Transaction Publishers, 2002. Wood,Len. Local Government Dollars and Sense, The Training Shoppe, Rancho Palos Verdes, CA, 1998.

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Glossary Accural Basis of Accounting An accounting method in which revenues are entered into the accounting system when they are payable even though the money may not have been received yet, and expenses are recognized when the commitment to pay is made even though no payment may yet have occurred. Admissions Tax Tax imposed on the consumer for the privilege of attending a show, performance, display or exhibition. Ad Valorem Tax A tax assessed based on the dollar value of an item or activity. Typical examples are property and sales taxes. Advance Refunding When restructuring or retiring outstanding bonds, the refunding is an “advance refunding” if the outstanding bonds will not be paid off until later than ninety days after sufficient funds have been deposited with a trustee. Generally, federal law limits advance refundings to one occurrence. See also “current refunding.” Annexation The process through which previously unincorporated territory is brought into an existing incorporated city or special district. Annexations must be approved by the county’s Local Agency Formation Commission (LAFCo).

Annual Financial Transaction Reports Reports submitted to the State Controller each year by local governments summarizing their revenues and expenditures. Appropriations Limit A maximum amount of revenues that may be appropriated by a government agency determined under California Constitution Article XIIIB and implementing legislation. Appropriations Subject to Limit Revenues defined as “proceeds of taxes” under California Constitution Article XIIIB and implementing legislation. Arbitrage A technique used to take advantage of price differences in separate markets. This is accomplished either by selling debt instruments at a low interest rate and investing the proceeds at a higher rate or by purchasing securities, negotiable instruments or currencies in one market for immediate sale in another market at a better price. Assessed Valuation The value of real property for the purpose of taxation. Assessment District A defined area of land which will be benefited by the acquisition, construction, or maintenance of a public improvement, within which charges are levied against properties in proportion to benefit to finance public improvements.

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Banker’s Acceptance A highly liquid and safe money market instrument created to facilitate international trade transactions whereby the risk of the trade transaction is transferred to the bank which “accepts” the obligation to pay the investor. Local agencies in California may invest up to forty percent of their portfolio in this type of security for a term of 180 days or less. BANs See Bond Anticipation Notes. Benefit Assessment Charges levied on parcels to pay for public improvements or services provided within a pre-determined district or area according to the benefit the parcel receives from the improvement or services. Binding Arbitration In a local government context, a method of resolving labor impasses adopted by some cities and counties in California whereby, rather than locally elected officials having final decision-making authority in resolving labor disputes, the two sides present arguments to an independent arbitrator who renders decisions that are binding. Block Grant Federal grant allocated according to pre-determined formulas and for use within a pre-approved broad functional area such as the CDBG (Community Development Block Grant). Bond Anticipation Notes (BANs) Short-term borrowings by a public entity appropriate to obtain financing for a project for which bonds are authorized but not yet issued. BANs permit the issuance of debt in increments as work on a project progresses and before some or all of the bond proceeds are available. Bonds A certificate of debt issued by an entity, guaranteeing payment of the original investment, plus interest, by a specified future date.

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Budget A financial plan, usually prepared annually, that estimates the revenues anticipated by an agency and that appropriates expenditures in specified amounts for various purposes. Business Attraction A component of many economic development programs that aims to bring new businesses to a community. See Business Retention. Business Improvement District (BID) A public-private partnership in which businesses in a defined area pay special taxes, fees and/or assessments to fund public facility improvements and programs in the area. Business License Tax A type of excise tax imposed on businesses for the privilege of conducting business within a city or county. The tax is most commonly based on gross receipts or levied at a flat rate. Business Retention A component of many economic development programs that aims to foster economic health and expansion of businesses already located in the community. California Debt and Investment Advisory Commission A public commission, administered by the State Treasurer’s office, that provides detailed information to public agencies on debt financing and investing surplus funds. California Public Employees Retirement System (CalPERS) The largest pension program in the country, providing benefits to most state and municipal employees in California. California State Board of Equalization (BOE) The California state agency responsible for the collection and administration of the state’s sales and use, alcohol, tobacco, and other taxes. California State Controller The Chief Fiscal Officer of the state, elected every four years and responsible for, among other duties, auditing

various state and local government programs and providing data regarding the financial transactions of city, county, and district governments. Cannibalization In the context of retail sales, the potential capture of sales occurring in a community’s existing stores by new stores. If all sales are “cannibalized” then no increase in sales or sales tax within the community would be expected from the new outlets. See Transfer Effects. Capital Improvement Program (CIP) Program in an agency’s financial plan or budget listing pending capital improvement projects, phasing, schedule and funding. Capital Outlay Expenditures which result in the acquisition of, or addition to fixed assets. Cash Basis Accounting An accounting method in which revenues are entered into the agency’s accounting system when the cash is received and spending is entered into the system when the agency makes payment. To comply with generally accepted accounting principles, local agencies must use accrual basis accounting, rather than cash basis. Categorical Grant Grant typically allocated either to qualifying applicants according to a formula or to applicants competing for project grants through an application process. Categorical grants are the most common form of federal aid. Certificate of Deposit Placement Service A service that allows local agencies to purchase certificates of deposit of more than $100,000 from a single financial institution and still maintain coverage by the Federal Deposit Insurance Corporation. The Certificate of Deposit Account Registry System (CDARS) is currently the only agency providing this service.

Glossary

Certificates of Participation (C.O.P.) A debt instrument to fund public facilities, equipment, or land that is an alternative to traditional voter-approved bond financing by allowing investors to buy into a share of the public improvements to be “leased back” by the agency, with payment to investors based on the pro-rata share of their investment in the improvements. Charter City A city that is governed by its own voter approved “constitution” (charter) rather than by the general laws of state government as they relate to governmental form, administration and policy. Charter cities are also sometimes called “home rule” cities. City Manager Form of Government A form of municipal government whereby a professional executive is hired by the elected governing body to advise that body and to implement their directions and policies. Citizens Option for Public Safety (COPS) A state subvention for local law enforcement initiated in 1996. See Section 6.04. Collateralized Bank Deposits A local agency investment tool, also known as collateralized certificates of deposit (CCDs), that are time deposits placed with banks and other financial institutions (such as savings and loans and credit unions) that carry penalties if redeemed prior to maturity. Deposits up to $100,000 are insured by the Federal Deposit Insurance Corporation, The state government code requires that certificates of deposit in excess of $100,000 must be collateralized by U.S. Treasury or Agency securities. There are no portfolio limits CCDs for local agencies in California; however, the term is limited to five years or less. Collective Bargaining The method of negotiating salaries, benefits, and working conditions with agency management through employee unions or other legally recognized employee organizations.

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Commercial Paper Short-term unsecured debt of corporations that local agencies in California may invest twenty-five to forty percent of their portfolio for a term of 270 days or less. Community Development Block Grant (CDBG) Federal grant allocated according to pre-determined formulas and for pre-approved purposes related primarily to housing, infrastructure or to the provision of certain social programs. Community Facilities District (CFD) See Mello-Roos Community Facilities District. Concessions Revenues received from concessionaires for privilege of operating a concession on city property. Construction/Development Tax An excise tax imposed on the privilege or activity of development and/or the availability or use of municipal services. Consumer Price Index (CPI) A statistical description of price levels provided by the U.S. Department of Labor used to measure the cost of living and economic inflation from year to year. Contingency In budgeting, an amount set aside to meet unforeseen circumstances. COPS See Citizens Option for Public Safety.

County Auditor-Controller The chief accounting officer of a county established to provide various accounting and property tax administration services to the county and other local governments within the county. County Treasurer-Tax Collector Administers the billing, collection, and reporting of property tax revenues. Countywide/Statewide Pools A system used to allocate local sales and use tax payments that cannot be identified with a specific place of sale or use in California, distributed to the local jurisdictions in proportion to taxable sales. Current Refunding When restructuring or retiring outstanding bonds, if bonds are paid off within ninety days of depositing either cash on hand or refunding bond proceeds, the refunding is a “current refunding.” See also “advance refunding.” Debt Financing The issuance of bonds and other debt instruments to finance municipal improvements and services. Debt Instrument A written pledge to repay debt such as bills, notes, and bonds. Debt Service The payment of principal and interest on long-term indebtedness.

Cost of Living Adjustment (COLA) A regular increase in salaries or wages to offset inflation.

Dedication The donation “dedication” of certain lands (or money) to specific public uses as a requirement for the approval of a development project. The dedications are typically justified as an offset to the future impact the development will have on existing infrastructure. Also called an “exaction.”

County Assessor An elected county official whose main duty is to set values on real property for the purpose of taxation within the county.

Development Impact Fees Fees placed on the development of land in order to fund the proportionate cost of public needs created by the

C.O.P. See Certificates of Participation.

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Glossary

development, such as infrastructure, facilities, housing, and open space. A legal “nexus” must be established between these fees and the public purpose that they are intended to fund (see Nexus).

Excise Tax A tax placed on a person for a voluntary act, making the tax theoretically avoidable. Includes sales and use tax, business license tax, transient occupancy tax, utility users tax, etc.

Discounted Cash Flow (DCF) A technique for evaluating a series of net expenditures versus incomes over time, whereby future values are discounted (reduced by certain factor) to give the equivalent present value.

Fee A charge to the consumer for the cost of providing a particular service. California government fees may not exceed the estimated reasonable cost of providing the particular service or facility for which the fee is charged, plus overhead.

Discretionary Revenues Those that can be used for any legitimate local government purpose; most general tax revenues are discretionary in nature. See also General-Purpose Revenues.

Fiscalization of Land Use Plans or development approvals that are primarily driven by fiscal considerations, while undervaluing other important social or environmental considerations.

Documentary Transfer Tax A tax imposed on documents recorded in the transfer of ownership in real estate, as distinguished from a Real Property Transfer Tax that may only be imposed by charter cities. Enterprise Municipal services that are funded through fees charged to partly or wholly cover the costs of the service provided by the “enterprise.” Roughly analogous to a private sector business; typical examples would include water delivery or sewage collection and treatment. Enterprise Funds Funds that separately account for the income and expenditures of municipal enterprises such as sewer, water, transit, parking, and refuse collection. Educational Revenue Augmentation Fund (ERAF) A fund established by the state legislature to receive shifts of property tax revenues from cities, counties, special districts, and redevelopment agencies prior to their reallocation to school districts. Encumbrance An anticipated expenditure committed for the payment of goods and services not yet received or paid for.

Fines, Forfeitures, and Penalties Revenues received and/or bail monies forfeited upon conviction of a misdemeanor or municipal infraction. First Source Agreement In exchange for some incentive offered by the local government to a business (for example, fee waivers or subsidies), the beneficiary agrees to consider qualified local job-seekers before filling employment positions. Fiscal Impacts In the context of municipal finance, refers to the comparison of the costs of providing public services to the revenues generated in support of those services. Fiscal impact analyses model the costs and revenues expected from development projects and/or future plans. Fiscal Year The period designated by the city for the beginning and ending of financial transactions. Nearly all city fiscal years begin on July 1 and end June 30 of the following year. Forfeiture See Fines, Forfeitures and Penalties. Franchises Fee paid to a municipality from a franchisee as “rent” or “toll” for the use of local public streets and rights-of-way.

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Functional Revenue Revenues that can be associated with and allocated to one or more expenditure function and which meet one of the following criteria: (1) the revenue is generated from direct services, such as revenues from fees or charges; (2) the revenue is associated with a specific service by external requirements, such as grant conditions, bond sale agreements, or statutory or charter requirements. Fund Accounting entity with a set of self-balancing revenue and expenditure accounts used to record the financial affairs of a governmental organization. Fund Balance Difference between the assets (revenues and other resources) and liabilities (expenditures incurred or committed to) of a particular fund. Full Cost Accounting Including in the cost of a municipal service, such as water, those of the auxiliary support functions such as the agency attorney, finance department, etc. to the extent that those support functions contribute to the actual provision of the municipal service. Full Faith and Credit A pledge made by issuer of general obligation bonds to bondholders that guarantees that “all available funds” will be used to pay bondholders should the project go into default. Full Service City A city that provides a broad spectrum of public services including police, fire, planning and building, parks, libraries, streets, drainage, and municipal utilities—i.e., sewer, water, solid waste collection. Services may be provided directly by the city and/or by contracting with the private sector for some of the services. GANs See Grant Anticipation Notes.

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Gann Initiative See Proposition 4. Gann Limit See Proposition 4. Gasoline Tax See Motor Vehicle Fuel Tax. General Fund In cities and counties, the fund that accounts for the discretionary funding that supports of such core services as police, fire and public works service and includes most tax revenues and associated expenditures. General Law City A city that has not adopted a charter and is, therefore, bound by the state’s general laws, even with respect to municipal affairs. See also Charter City. General Obligation Bonds (G.O. Bonds) Bonds issued through a governmental entity that have the legal authority to levy a tax on real and personal property located within the governmental boundaries at any rate necessary to collect enough money each year to pay for principal and interest due. General Purpose Revenues Those that can be used for any legitimate municipal purpose; most general purpose tax revenues are discretionary in nature and accounted for in the general fund. See also Discretionary Revenues and General Fund. General Tax A tax imposed for general governmental purposes, the proceeds of which are deposited into the general fund. A majority vote of the electorate is required to impose, extend or increase any general tax. See also Special Tax. Generally Accepted Accounting Principles (GAAP) Accounting standards set by the Governmental Accounting Standards Board to provide a professionally suitable framework for presenting financial information of an agency.

Glossary

G.O. Bonds See General Obligation Bonds.

Investment Earnings Revenue earned from the investment of surplus public funds.

Grant Anticipation Notes (GANs) Short-term borrowings of a public entity to eliminate cash flow deficits in anticipation of the receipt of a federal or state grant or loan.

Investment Pools Voluntary investment funds managed by a government agency under which funds are “pooled” with other government agencies. There are several pools in the state, including those managed by the State Local Agency Investment Fund (LAIF), counties, and joint powers authorities.

Grants Contributions of cash or other assets from another governmental agency to be used or expended for a specified purpose, activity, or facility. Highway Users Tax See Motor Vehicle Fuel Tax. Homeowner’s Property Tax Relief A revenue from the state to offset city loss of property tax for the state-imposed $7,000 per dwelling homeowner exemption. Home Rule The ability of local agencies to self-determine policies, projects, priorities, funding and so on, without preemption from the State level of government, often promoted through the adoption of local charters. Incentive Zoning Zoning standards or regulations that provide greater flexibility or greater development intensity to attract projects that bring with them important ancillary public benefits. Incorporation The process of creating a self-governing city from unincorporated county territory. Instrument In the context of agency debt financing, the type or method or borrowing (for example, General Obligation Bonds, Certificates of Participation, etc.).

Joint Powers Authority (JPA) The Joint Exercise of Powers Act authorizes local public agencies to exercise common powers and to form joint powers authorities (“JPAs”) for purpose of jointly receiving or providing specific services. LAIF See Local Agency Investment Fund. Land Banking Holding vacant or underutilized land in anticipation of its future development, usually for projects that will provide special benefits such as jobs or public amenities but which are not currently feasible. Landscaping and Lighting Act of 1972 The 1972 Act lets cities, counties, and special districts levy assessments for land purchase and the construction, operation, and maintenance of parks, landscaping, lighting, traffic signals, and graffiti abatement. Leakage In the context of retail sales or associated sales tax revenues, the losses that occur when local shoppers go outside a community to satisfy their retail needs or preferences. Sales that “leak” to other communities may potentially be “recaptured” if comparable retail outlets locate locally. Lease Revenue Bonds Bonds similar to certificates of participation and used for the same types of projects with main exceptions that: (1) lessor must be either a governmental entity with the power to issue revenue bonds or a nonprofit corporation that

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issues bonds on behalf of a political subdivision; and (2) the bonds constitute a direct debt of the lessor. See Certificates of Participation. Leverage The use of a relatively small amount of one’s own resources while borrowing larger amounts from others to effect a greater investment; potential for significantly greater returns than might be feasible with one’s limited resources, but also potentially risky. Levy (Verb) To impose taxes, special assessments, or service charges for the support of governmental activities; (noun) the total amount of taxes, and/or special assessments and/or service charges imposed by a governmental agency. Licenses and Permits Charges designed to reimburse city for costs of regulating activities being licensed, such as licensing of animals, bicycles, etc. Lien A claim on assets, especially property, for the payment of taxes or utility service charges. Limited Obligation Bonds Similar to general obligation bonds except that security for the issuance is limited exactly to the revenues pledged in the bond statement and not to the full faith and credit of the city. Line-item Budget A commonly used type of budget that focuses on cost and accounting details, including expenditure categories, amounts, and yearly comparisons rather than on goals and priorities. Most agency budgets, even if program and/or priority oriented, will include at least some level of this approach. Liquidity The ability to convert a security into cash promptly with minimum risk of principal loss.

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Local Agency Investment Fund (LAIF) A large voluntary investment fund that “pools” and invests the available investment resources of local agencies in California, managed by the State Treasurer’s Office. There are no portfolio limits for LAIF for local agencies in California. Maintenance of Effort (MOE) A requirement, often as a condition of an intergovernmental subvention, grant or supplemental tax, to maintain a level of spending at a certain level. Maintenance of Effort requirements are intended to prevent or limit the use of the additional revenues to supplant existing revenues such that the new revenues result in an increase in the level of program spending and services. Market Study An analysis of the likely demand for a product or type of development (i.e., housing, retail, hotel) within a certain area that considers, among other factors, the existing and future supply of similar products or development types by competitors. Marks-Roos Bonds Bonds authorized by the Marks-Roos Local Bond Pooling Act of 1985, which provide local agencies with extremely flexible financing powers through participation in joint powers authorities (JPAs). Maturity The point in time at which an investment returns to the investor the principal and yield promised at the time of purchase. For example, in the case of a bond the maturity date is the date when the issuer must return to the investor the face value of the bond. Medium Term Notes The unsecured, investment-grade senior debt securities of major corporations or financial institutions. Local agencies in California may invest up to thirty percent of their portfolio in this type of security if it rated at least “A” by a major credit rating agency for a term of five years or less.

Mello-Roos Bonds Bonds allowing cities, counties, school districts and special districts to finance certain public capital facilities and services, especially in developing areas and areas undergoing rehabilitation. Property owners in the Mello-Roos district pay an annual special tax, which is included on the property tax bill, and only imposed after a two-thirds vote of approval by property owners within the district. Mello-Roos Community Facilities District A special tax district created (usually at the request of property owners) to fund major public improvements, like schools and roads, in newly developing areas through the levying special non ad valorem taxes. Imposing these special “Mello-Roos Community Facilities Taxes” require a twothirds vote of approval by property owners within the district. Memorandum of Understanding (MOU) An agreement between two parties memorialized in a jointly approved document that may or may not be binding on the parties. For example, in a labor relations context MOUs are usually synonymous with formal contracts. In a development context, MOUs are sometimes used by agencies and developers to memorialize a shared understanding of the conditions that must be satisfied before the parties enter into a formal, more detailed binding contact. Meyers-Milias-Brown Act (MMBA) Landmark California legislation that requires local governments to meet and confer on matters related to employment conditions, such as wages, salaries, benefits, and working conditions. Mortgage Pass-Through Obligations Securities that are created when residential mortgages (or other mortgages) are pooled together and undivided interest or participations in the stream of revenues associated with the mortgages are sold. Local agencies in California may invest up to twenty percent of their portfolio in this type of security if it rated at least “AA” by a major credit rating agency for a term of five years or less.

Glossary

Motor Vehicle Fuel Tax Tax on fuel used to propel a motor vehicle or aircraft. Also called Highway Users Tax and Motor Vehicle Fuel Tax. Motor Vehicle License Fee (VLF) VLF is fee for the privilege of operating a vehicle on public streets. VLF is levied annually at 0.65 percent of the market value of motor vehicles and is imposed by the state “in lieu” of local property taxes. VLF is also called Motor Vehicle inLieu Tax. MOU See Memorandum of Understanding. Multiplier Effect Term used for the additional increase in jobs or income in an economy caused by the increase of jobs or income of a particular sector or set of sectors in that economy. A reverse multiplier implies the additional losses in an economy caused by losses in a particular sector. Mutual Funds An entity that pools the funds of investors and invests those funds in a set of securities specifically defined in the fund’s prospectus. Mutual funds can be invested in various types of domestic and/or international stocks, bonds, and money market instruments, as set forth in the individual fund’s prospectus. For most large, institutional investors, the costs associated with investing in mutual funds are higher than the investor can obtain through an individually managed portfolio. Local agencies in California may invest up to twenty percent of their portfolio in this type of security. Off-Highway Motor Vehicle License Fee Fee imposed for the issuance or renewal of identification for every off-highway motor vehicle. One-Time Expenditures Non-recurring costs that will not be repeated in future years as differentiated from routine, ongoing costs. Opportunity Cost The inability to use resources to pursue alternatives if those resources are used for a particular course of action. In the

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context of development, the forsaking of other possible projects or investments if a particular project is undertaken represents the opportunity cost. Negotiable Certificate of Deposit (NCD) Certificate of deposit solely guaranteed by the issuing bank, and as such, typically earns higher interest rates than collaterized certificates of deposit. Local agencies in California may invest up to thirty percent of their portfolio in this type of security for a term of five years or less. Nexus Most commonly used to describe the requirement of Government Code Sections 66000 et seq. that there be a reasonable connection (“nexus”) between the development impact fees charged to a developer and the cost impact of the development project in question. Also used to describe the minimum threshold of connection necessary within a taxing jurisdiction to allow taxing authority over out-ofstate individuals or businesses. Ordinance A formal legislative enactment by the governing board of a municipality. If it is not in conflict with any higher form of law, it has the full force and effect of law within the boundaries of the municipality to which is applies. Other Post-Employment Benefits (OPEB) A pension is a form of “post-employment benefit,” a benefit received by an employee after their service to the agency ends. Other forms of post-employment benefits include health insurance provided to retirees. Parcel Tax Special non ad valorem tax on parcels of property generally based on either a flat per-parcel rate or a variable rate depending on the size, use and/or number of units on the parcel. Parking Tax General tax imposed on occupant of off-street parking space for privilege of renting the space within the city.

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“Pay As You Go” Concept of paying for capital projects when the initial cost is incurred, rather than over time through the use of debt financing. Penalties See Fines, Forfeitures, and Penalties. Performance Budget A type of program budget that emphasizes measurable service delivery outputs in evaluating whether or not expenditures are effectively furthering the agency’s goals. Portfolio The collection of investments and other assets held by an individual or institution. Possessory Interest Taxable private ownership of interests in tax-exempt public property. Pro Forma A financial model usually involving a discounted cash flow to assess the economic feasibility of a development proposal. Program Budget A type of budget that organizes expenditures and revenues into functional services and programs, rather than by departmental categories, in order to emphasize broader purposes and goals in budget presentation and decisionmaking. An emphasis is placed on developing integrated program descriptions organized around services rather than on presenting budget information organized by arbitrary and narrow departmental and line-item categories. Property Related Fee A levy imposed on a parcel or upon a person as an incident of property ownership for property-related services provided by the levying agency. Property Tax An ad valorem tax imposed on real property (land and permanently attached improvements) and tangible personal property (movable property).

Glossary

Property Tax In Lieu of VLF Property tax shares and revenues allocated to cities and counties beginning in FY 2004–2005 as compensation for Vehicle License Fee (VLF) revenues previously allocated to cities and counties by the state. Referred to in statute as “Vehicle License Fee Adjustment Amounts.”

Proposition 42 (2002) Voter approved measure that directs the Legislature to “permanently” allocate revenues derived from the taxable sales of gasoline to certain transportation programs, including mass transportation, transportation related capital improvements, and street and highway maintenance.

Property Tax Increment See Tax Increment Financing.

Proposition 62 (1986) A 1986 proposition that implemented a majority vote requirement for general taxes. This portion of Proposition 62 was later ruled unconstitutional.

Proposition 1A (2004) Voter approved state constitutional amendment protecting most major city county and special district revenues from reduction or shifting by the state Legislature. Proposition 1A (2006) Voter approved state constitutional amendment protecting the local allocation of state transportation sales tax revenues under Proposition 42 from reduction or shifting by the state Legislature. Proposition 4 (1979) Also called the Gann Initiative, this initiative limits growth in government tax spending to changes in population and inflation and was drafted to be a companion measure to Proposition 13. Proposition 8 (1978) An amendment to Proposition 13, passed in November 1978 to allow county assessors to recognize declines in value for property tax purposes. Revenue & Taxation Code Section 51 requires the assessor to annually enroll either a property’s Proposition 13 base year value factored for inflation, or its market value as of January 1st, whichever is less. Proposition 13 (1978) Article XIIIA of the California Constitution, commonly known as Proposition 13, limits the maximum annual increase of any ad valorem tax on real property to one percent of the full cash value of such property restricts annual increases of assessed value to an inflation factor, not to exceed two percent per year.

Proposition 98 (1990) This measure establishes a minimum level of funding for public schools and community colleges and provides that any state revenues in excess of the appropriations limit be spent on schools. Proposition 111 (1994) Voter approved measure that increased the state Motor Vehicle Fuel Tax by $0.09 per gallon and made certain adjustments to the spending limits under Proposition 4 (1979). Proposition 172 (1993) A 1993 measure that places a one-half cent sales tax for local public safety in the constitution effective January 1, 1994. The tax is imposed by the state and distributed to cities and counties. Proposition 218 (1996) A voter approved state Constitutional amendment, self-titled “Right to Vote on Taxes Act” expanded restrictions on local government revenue-raising, allowing the voters to repeal or reduce taxes, assessments, fees, and charges through the initiative process; reiterating the requirement for voter approval for both “special taxes” and “general taxes,” and imposing procedural and substantive limitations on assessments of real property and on certain types of fees. Rating The designation used by investors’ services to rate the quality of a security’s creditworthiness.

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Real Property Land and permanently attached improvements.

Real Property Transfer Tax A tax imposed on the transfer of ownership in real estate, typically imposed instead of a documentary transfer tax. Only Charter cities may impose a real property transfer tax. Realignment Actions taken by the California Legislature in 1991 and 2011 making certain health, social service, criminal justice and mental health service programs county responsibilities, and related funding. Reimbursement for State Mandated Costs Article XIIIB, Section 6 of the California Constitution that requires the state to reimburse local agencies for the cost of state-imposed programs through a process commonly called “SB 90 reimbursement” (named after its original 1972 legislation). Cities and counties often believe that the state avoids implementing this provision by very narrowly defining what constitutes a “mandate.” Regulatory Fee A charge imposed on a regulated business or other activity to pay for the governmental cost of public programs or facilities necessary to regulate the business or activity. A regulatory fee does not include a charge on a property or a property owner solely due to property ownership; rather, the intent is to reassign the cost of regulating an activity from the general taxpayer to the business or party most responsible for creating the regulatory cost. The future of regulatory fees was clouded by Proposition 26 (2010). Rents Revenues received through the rental of public properties to private parties such as convention space and library facilities. Repurchase Agreement (REPO) A short-term purchase of securities with a simultaneous agreement to sell the securities back at a higher price. There is no portfolio limit for local agencies in California for

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repurchase agreements, but there is a maximum term of one year. From the seller’s point of view, the same transaction is a reverse repurchase agreement. Local agencies in California may place reverse repurchase agreements up to twenty percent of the base value of their portfolio for a term of ninety-two days or less. Resolution A special or temporary order of a legislative body requiring less formality than an ordinance. Reverse Repurchase Agreement See Repurchase Agreement. Revenue Bonds Bonds issued to acquire, construct or expand public projects for which fees or admissions are charged, such as toll roads, toll bridges, and stadiums. Bonds are repaid solely from the income (“revenue”) generated by use of the project or facility. Rough Proportionality Test Specific determination by the city for a specific development project that the dedication to be required is related both in nature and extent to the development’s impact. (Dolan v. City of Tigard (1994) 94 D.A.R. 8803). Royalties Revenues received from private companies for privilege of extracting natural resources from city property. Also revenues from bets placed at horse racing tracks located within the city, currently set by statute at one third of one percent. Sales Tax A tax imposed on the total retail price of any tangible personal property. See also Use Tax. SB 90 See Reimbursement for State Mandated Costs. Secured Property Property that serves as collateral for a secured debt in which the value of the real property, and potentially personal

property located on that real property, are sufficient to assure payment of the tax. Secured Roll That property tax list containing all assessed property secured by land subject to local taxation. Service Charges The charges imposed by a government agency to support or cover the full cost of the services provided, such as water services or fire safety inspection. The charges (sometimes called “service fees ”) are limited to the cost of providing the service or regulation required (plus overhead). Sensitivity Analysis The testing of a model to see how changes to the assumptions affect the results, such as the assumptions used to project the fiscal impact of a development project or to model agency fiscal health over time. If small changes to an assumption significantly alter the outcome, special attention to the reliability of the assumption is warranted. Short-Term Financing Methods Techniques used for many purposes, such as meeting anticipated cash flow deficits, interim financing of a project, and project implementation. Using these techniques involves issuance of short-term notes. Voter approval is not required. Special Revenue Funds Funds accounting for revenues that may be expended for only specific purposes; examples include development impact fees that may be used only for projects that mitigate infrastructure needs of new projects or grant revenues that can be used only to achieve the specific purposes of the grant. Special Tax A tax that is collected and earmarked for a special purpose and deposited into a separate account. A two-thirds vote of the electorate is required to impose, extend or increase any special tax. See also “General Tax.”

Glossary

Standby Charge A compulsory charge levied upon real property to defray in whole or in part the expense of providing, operating or maintaining public improvements. The charge is “exacted for the benefit that accrues to property by virtue of having water [or other public improvement] available to it, even though the water might not be used at the present time.” Proposition 218 classifies standby charges as “assessments” which must be imposed in compliance with Section 4.25 of California Constitution Article XIIID. Strong Mayor Form of Government A type of municipal governance in which the elected mayor has a significantly different authority than the rest of the city council and who is usually responsible for hiring department heads and administering the direction/policies of the agency. See City Manager Form of Government. Subvention A subsidy or financial support received from county, state or federal government. The state and county currently levy certain taxes that are “subvened” to cities, including motor vehicle license fees, state mandated costs, and motor vehicle fuel tax. Supplemental Property Tax In the event a property changes ownership, the county collects a supplemental property tax assessment in the current tax year by determining a supplemental value. In future tax periods, the property carries the full cash value. Tax A compulsory charge levied by a government for the purpose of financing services performed for the common benefit. Tax Allocation Bonds Bonds financed by property tax increment, issued to revitalize blighted and economically depressed areas of the community and to promote economic growth. See Tax Increment Financing.

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Tax Base The sum of, collective of, and within the jurisdiction of a government (e.g. parcels of property, retail sales, etc.). State law or local ordinances define the tax base and the objects or transactions exempted from taxation.

Transactions and Use Tax Also, known as an “add-on local sales tax,” a tax imposed on the total retail price of any tangible personal property and the use or storage of such property when sales tax is not paid.

Tax and Revenue Anticipation Notes (TRANs) TRANs are short-term borrowings by a public entity to meet cash flow needs in the general fund and other unrestricted funds of a public entity. TRANs are issued before expected receipt of taxes and other revenues during the same fiscal year.

Transfer Effect The retail sales in a new development that takes a portion of sales away from existing retailers rather than bringing in entirely new sales. The transfer effect of new shopping centers and/or individual retail outlets my be either large or small, depending upon the retail categories and outlets already present in a community. See Cannibalization.

Tax Increment Financing In redevelopment project areas, the use of tax revenue increases above a certain base to pay the debt service on the public improvements made within the project area. Note: The state dissolved redevelopment agencies in 2012. Tax Rate The amount of tax applied to the tax base. Teeter Plan Enacted in 1949, an alternative method for allocating delinquent property tax revenues in which the county auditor allocates property tax revenues based on the total amount of property taxes billed, but not yet collected. The county government then collects and keeps the delinquency, penalty and interest payments. Traffic Safety Fund A special city fund that holds all fines and penalties collected as a result of Vehicle Code violations issued by local law enforcement. By state law, this money must be used for traffic safety related expenditures including traffic enforcement and capital projects, such as traffic control devices and street improvements made to improve traffic safety. TRANs See Tax and Revenue Anticipation Notes.

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Transient Occupancy Tax Tax levied by cities on persons staying thirty days or less a hotel, motel, RV campground, or similar facility. Also called Transient Lodging Tax, Hotel Tax, or Bed Tax. Triple Flip Informal name given to the convoluted mechanism used to repay state fiscal recovery bonds pursuant to a complex, voter approved plan to shift revenues between levels of government and increase debt in order to help solve California’s budget problems. Under the Triple Flip, the local sales and use tax rate was reduced from 1.00% to 0.75% with the 0.25% diverted to repay state fiscal recovery bonds. Cities and counties were reimbursed for the lost revenue from a shift of property tax revenue. Transportation Tax Special tax imposed by counties for county transportation needs. Typically collected with the sales and use tax, some cities receive a portion of the transportation tax usually in one-quarter percent tax rate increments. Unsecured Property Real property in which the value of the lien is not sufficient to assure payment of the property tax. U.S. Agency Obligations “Shorthand” market terminology for any obligation issued by a government-sponsored entity (GSE) or a federally

related institution. Obligations of GSEs are not guaranteed by the full faith and credit of the U.S. government. U.S. Treasury Obligations Bonds, notes, and bills guaranteed by the faith and credit of the U.S. government. There are no portfolio limits for U.S. Treasury obligations for local agencies in California; however, the term is limited to five years or less.

Glossary

Utility Rate Typically represents the cost of a fee paid by the user of utility services, such as sewer, water, and electrical use.

Utility Users Tax Tax imposed on the consumer (residential and/or commercial) of any combination of electric, gas, cable television, water, and telephone services.

Use Tax A taximposed to prevent the loss of sales tax when tangible personal property is purchased in a non-taxing state in order to be used or stored by the purchaser in a state that imposes a sales tax. See also “sales tax.”

VLF See Motor Vehicle License Fee.

User Fee Fees charged for the use of a public service or program such as for recreation programs or public document retrieval. User fees for property-related services, such as sewer, water, and trash collection are referred to as property-related fees.

Zero-Based Budget (ZBB) A type of budget which, in its pure form, assumes that the agency will “start from scratch” each year. Therefore, rather than using past expenditure levels as the basis for budget analysis and decisions, every program and line item is completely reevaluated and may be raised or lowered without regard to the past.

Utility Connection Fee Utility connection fees or capacity fees are imposed on the basis of a voluntary decision to connect to a utility system or to acquire the right to use additional system capacity.

Yield The return on an investment.

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Index Page numbers for gray-shaded sidebars are identified in italics; page numbers for information in figure boxes are identified with suffix “f.”

A accountability, 2, 8, 102, 155–62. See also

reporting financial data. accounting. See fund accounting. accrual basis of accounting, 155–57 Allen v. City of Long Beach (1955), 111 allocation of resources. See budgets. American Reinvestment and Recovery Act (ARRA), 49 annexations and incorporations, 212 annual financial reports, 156–60 Annual Financial Transaction Reports, 14, 26, 157 appraisers and appraisals, 189, 205 arbitrage, 130 ARRA. See American Reinvestment and Recovery Act. assessment district bonds, 132 audits, financial, 159 award programs (GFOA & CSMFO), 69, 70, 160 awards of contracts, 117–19

B BANs. See Bond Anticipation Notes.

base or primary sectors of local economy, 167–68 bed tax, 37–38 benefit assessments (real estate), 27, 233 benefits, employee, 95, 104–9, 111–12, 247

best practices for local government purchasing systems, 7, 117–23 for preparation and presentation of budgets, 69, 70 BID. See Business Improvement District. bid documents, 119–20, 122 binding arbitration, 103 "Blue Book." See Governmental Accounting, Auditing and Financial Report. BOE. See California State Board of Equalization. Bond Anticipation Notes (BANs), 129 bonds. See also specific type of bond. issuing, 129–30 Joint Powers Authorities use of, 135 major types of, 130–32 municipal, 128–29 proceeds of, 141 rating system of, 128–29 specialists involved in issuing, 129–30 booking fees. See jail detention facility booking fees. borrowing, long-term, 128 borrowing, short-term, 129 Bradley-Burns Uniform Sales and Use Tax Act, 43n6, 225, 248 Brown, Jerry, 179–80 budget reporting, 159 budgets, 67–91 adoption of, 67–69 assumptions and estimates for, 69 best practices and award programs for, 69, 70 capital improvement plans and, 77, 125

debt service and, 20 as duty of local government, 2, 67–68 goal-setting and, 76–77 importance of, 7, 67, 89 labor as largest cost driver of, 93 line-item, 67, 69–71, 72, 75 long-term financial plans and, 68, 78 multi-year operating, 77–78 performance, 67, 69, 71–73, 72 preparation of, 68–69 program, 67, 69, 71, 72 public policy, political values and, 78– 83 public trust and, 79 traditional approach to, 75–78 transparency and community involvement and, 78 types of, 69–75 zero-based, 69, 72, 73–75 business attraction and retention, 169–70 Business Improvement District (BID), 173, 174, 177 business license taxes, 40 business-like funds. See enterprise funds. business visitation programs, 177

C CAFR. See Comprehensive Annual Fi-

nancial Reports. "Cal-Card" program (purchasing), 121 CalCPA. See California Society of Certified Public Accountants. California Committee on Municipal Accounting (CCMA), 161 California Community Redevelopment Act, 232

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California Debt and Investment Advisory Commission (CDIAC), 136n2, 150 California Economic Recovery Bond Act. See Proposition 57 (2004). California HealthCare Foundation, 18 California Land Conservation Act of 1965. See Williamson Act. California Municipal Financial Health Diagnostic, 88 California Municipal Treasurers Association (CMTA), 146, 150 California Public Employees Retirement System (CalPERS), 104–9, 247 California Redevelopment Act, 178–79 California Redevelopment Association, 179, 180 "California Rule," 111, 112 California Society of Certified Public Accountants (CalCPA), 161 California Society of Municipal Finance Officers (CSMFO), 69, 70, 161 California State Association of Counties, 120, 240 California State Board of Equalization (BOE), 35, 50n3, 199 California State Mediation and Conciliation Service, 102 California Supreme Court, 103, 111, 180, 229–30 CalPERS. See California Public Employees Retirement System. cannibalization and retail sales, 170, 199, 216 "Capistrano" Decision, 60 Capital Improvement Plans (CIPs), 125– 26, 127, 136 capital improvement projects, 125–36 budgeting and, 77, 125 cash methods of payment for, 126–27, 141 debt financing (instruments) for, 128– 36 definition of, 20, 125 fiscal impacts of, 210 fund accounts and, 27, 45, 50 overview of, 8 capital requirements for development, 191–92 Carter, Jimmy, 73 cash flow projections, 56–58, 142, 146– 47, 186, 194–97 CCMA. See California Committee on Municipal Accounting. CDBG. See Community Development

326

Block Grants. CDIAC. See California Debt and Investment Advisory Commission. Center for Performance Measurements, 74 Certificates of Participation (COP), 131– 32 charter cities binding arbitration and, 103 formation of, 11–12 public contracts code and, 115, 208n15 purchasing policies and, 122 real estate transfer tax and, 40 statewide concerns v., 225 taxes and, 34 charter counties, 16, 103, 115, 122, 208n15 CIPs. See Capital Improvement Plans. cities. See also Charter cities. budgets and, 67 as different from businesses, 63 as different from counties, 213 expenditures by function, statewide, 16f forms of governance in, 12–13 functional v. general revenues of, 13– 15 general fund expenditures, 31–32 general fund sources of funds, 32–42 as municipal corporations, 11 population distribution among, 1 reporting requirements for, 13–15 revenues by source, statewide, 15f, 39f services provided by, 12–13 types of, 11–12 Citizens Option for Public Safety (COPS), 46–47 City of Long Beach v. Allen (1955), 111 Clean Water Act. See U.S. Environmental Protection Agency's Clean Water Act (CWA) State Revolving Fund. CMTA. See California Municipal Treasurers Association. COLA. See Cost of Living adjustments. collective bargaining, 99–103 approaches to, 100, 101 binding arbitration and, 103 compensation and, 93, 95 decision-makers, 100–101 negotiators, 100 process of, 101–2 public employee unions and laws for, 99–100

settlement, 102–3 tentative agreement, 102 Community Development Block Grants, 26–27, 49 Community Redevelopment Act, 232 Community Redevelopment Agencies (RDAs). See Redevelopment Agencies (RDAs). Community Revitalization and Investment Authority (CRIA), 133–34, 181–82 community service districts (CSDs), 17 compensation for employees. See also collective bargaining; Labor and employment. benefits, 95, 104–9, 111–12, 247 composition of, 94–95 cost of living adjustments (COLA) and, 96 exempt or nonexempt basis for, 94–95 longevity awards and, 96–97 market force considerations for, 97– 99 pensions, 104–7, 111–12, 247 as percentage of municipal costs, 93– 94 performance based increases, 97 philosophy for, 111 post-retirement health care, 95, 108– 9, 247 promotions and, 96 situational and/or periodic adjustments and, 97 step increases and, 95–96 Comprehensive Annual Financial Reports (CAFR), 157, 160 conduit bonds, 136, 175 Constitutional Revision Commission (1996), 240 construction fund (bond proceeds), 141 construction loans, 193–94 contract awards, 117–19 contracting for services, 115–23. See also purchasing. cooperative purchasing, 120 COPs. See Certificates of Participation. COPS. See Citizens Option for Public Safety. cost allocation plan, 28, 55 cost control strategies, 110–12 Cost of Living Adjustments (COLA), 96 counties as different from cities, 213 expenditures by function, 18f

fiscal officers for, 37 forms of governance, 12 functions of, 15–16, 37 general law or charter, 16 revenues by source, 15, 17f, 39f, 225f 2011 state/local realignment, 234 transportation sales taxes, 45 unincorporated areas and, 15–16 "County Budget Act," 67 county transportation authority, 35, 135 countywide transportation sales tax, 45 Covey, Stephen, 67 credit cards, 120–21 credit ratings, 130, 154n2 credit risk, investment, 139–40 CRIA. See Community Revitalization and Investment Authority. CSDs. See community service districts. CSMFO. See California Society of Municipal Finance Officers. CWA. See U.S. Environmental Protection Agency's Clean Water Act (CWA) State Revolving Fund.

D Davis, Gray, 235, 242

Davis-Bacon Act, 201, 208n16 DCF. See discounted cash flow (DCF) models. debt financing and capital improvements, 128–36 federal and state low cost loan programs for, 128 instruments for, 130–36 municipal bonds and, 128–29 overview of, 8, 27 policies for, 130 real estate development and, 192–94, 207n5–8 debt service, 17, 20 debt service funds, 27, 141 defined benefit plans, 104 defined contribution plans, 104 dependent special districts, 16–17 developers. See also real estate development. debt financing and, 192–94 feasibility of projects and, 186–87 loans sought by, 193–94 local government as, 9, 185, 199–201 perspective of, 185–86 private-public partnerships, 201–6 role in development process, 188 development. See real estate develop-

ment. development impact fees, 45, 49–50, 126–28, 192 discounted cash flow (DCF) models, 186, 194–97 discretionary revenues fiscal impact analyses and, 209 general fund and, 31 property tax as largest source of, 35 sales tax revenue and, 237n12 vehicle license fee as, 41 Documentary Transfer Tax (DTT), 40 double counting and retail sales, 212, 216

E earmarking, 228f

econometric models (input-output), 169 economic development, 165–83 business attraction and, 169–70 business retention and, 170 definition of, 165 funding for, 174, 175 land use myths and, 171 multiplier effect and, 167, 168 overview, 8 players and partners for, 172, 173 as a public purpose, 165 reasons for, 166–67 redevelopment and, 178–82 sectors of local economy and, 167–68, 169 strategic planning for, 170–72 tools (practices) for, 174–78 Educational Revenue Augmentation Fund (ERAF), 48, 51n11, 51n14, 232–33, 236 EIFD. See Enhanced Infrastructure Financing District. Einstein, Albert, 116 eminent domain, 134, 165, 181 employment. See labor and employment. Enhanced Infrastructure Financing District (EIFD), 133, 180–81 enterprise districts, 17 enterprise funds expenditures by function, 55f financial accounting for, 26–29, 54– 56, 155 overview, 6–7 revenue collection for, 63–64 as share of expenditures, 54f enterprise services, 54–64 definition of, 54 rate approval, 62–63

index

rates, setting and reviewing for, 56–59 rate setting policies for, 61–62 rate structure, 58f, 59–61 similar to private sector, 6–7, 26, 54 types of, 53–56, 64n1 wholesale or retail, 56 environmental feasibility analyses, 187 e-purchasing, 120 equity pay adjustments, 97 ERAF. See Educational Revenue Augmentation Fund. exactions, 126–27, 192 expenditures basic types of, 115 budgets and authorization of, 68, 117–19 capital projects and, 17, 20 of cities (statewide) by function, 16f of counties (statewide) by function, 18f debt service and, 17, 20 of enterprise funds, 54f, 55f full-service city funds, 33f for operations, 17–19

F Fair Labor Standards Act (FLSA), 94–95

feasibility analyses, 125, 186–87, 194–97. See also Real estate development. fees booking (jail detention), 47, 51n10 cost of service delivery and, 43 enterprise services and, 59 functional revenue from, 14 general fund types of, 40–41 real estate development and, 192 reductions or waivers of, 176 fiduciary funds, 26, 29 finance reform. See reform of local government finance. financial advisors, 129–30 financial crisis of 2008, 49, 194, 207n5 financial data reports. See reporting financial data. financial feasibility analyses, 186, 194–97 financial health, 83–89 core components of, 84 diagnostic tool, 88 evaluating and diagnosing, 85–86 gauging local government, 83–84 indicators of, 86–87 legal constraints and, 88 management practices and, 89 subsidies as undue burdens on, 88

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unique aspects of California, 84–85 financial planning, 67–68, 78, 80. See also budgets. financial statements, basic audited, 157– 59 financial statements, comprehensive. See Comprehensive Annual Financial Reports (CAFR). financial transaction reports. See Annual Financial Transaction Reports. financing. See debt financing. fines, penalties, forfeitures, 42 "First source" agreements, 178 fiscal analysts, 205 fiscal impact analyses, 209–20 capital projects and, 210 consultants and third-parties for, 213 criticisms of, 217–18 development and, 209–10 land use planning and, 218 modeling results and, 210, 211f over time, 210–12 overview, 9 Proposition 13 and, 210, 211, 214, 218 techniques used in, 213–16 uses of, 212 fiscalization of land use planning, 9, 212, 218, 231, 253n4 fiscal policies, 7, 80–83. See also budgets. Fitch Ratings, 128 flexible fund. See General fund. flow of resources/working capital, 56–58 FLSA. See Fair Labor Standards Act. forfeitures, penalties, fines, 42 franchises, 42 full cost accounting, 28 full cost recovery enterprise, 62f, 64 full faith and credit pledge, 131 full service cities, 13, 33f, 37, 43n1, 94 functional revenues, 13–14 fund accounting, 25–30, 155–56 fund balance (reserve) definition, 86–88 fund-based financial statements, 157–59 funds, government. See also specific type of fund. concept of, 6–7, 155–56 types of, 26–29 fund statements, 156f, 157f

G GAAFR. See Governmental Accounting, Au-

diting and Financial Report. GAAP. See generally accepted accounting principles.

328

Gann, Paul, 230 Gann Initiative (limit), 230–31 GANs. See Grant Anticipation Notes. gas and fuels tax swap of 2010, 48 GASB. See Government Accounting Standards Board. gasoline and diesel taxes, 46, 50n4 gasoline sales tax, 46–48 general fund expenditures typically from, 31–32, 43n1 fund accounting and, 26, 29 local government use of, 25–26 overview, 6 Proposition 98 and, 238n13 reserve levels and GFOA, 88 revenue sources, 26, 32–42 subsidies of other funds, 88 general law cities, 11–12, 34 general law counties, 16 generally accepted accounting principles (GAAP), 25, 26–29, 54, 155–57 General Obligation bonds (G.O. bonds), 131, 132, 229 general-purpose revenues. See discretionary revenues. general revenues, 13–15 general taxes, 32–40 George Brown Act (1961), 99 GFOA. See Government Finance Officers Association of the United States and Canada. G.O. bonds. See General Obligation bonds. governance, forms of, 12–13 Governmental Accounting, Auditing and Financial Report (GAAFR), 160 Governmental Accounting Standards Board (GASB), 25, 70, 87, 108–9, 151, 153, 157–59, 161 governmental funds, 6–7, 26–29 Government Code Section 16429, 147 Government Code Section 27131(a), 151 Government Code Section 29000, 67 Government Code Section 37208, 122 Government Code Section 53600.3, 142 Government Code Section 53600.5, 137–38 Government Code Section 53601, 140, 144 Government Code Section 53635, 144 Government Finance Officers Association of the United States and Canada (GFOA), 67, 69, 70, 87, 88, 144, 169

government-wide financial statements, 157–59 Grant Anticipation Notes (GANs), 129 grants, 6, 46–47, 49 The Great Recession, 19, 83, 84, 109, 111, 252. See also financial crisis of 2008.

H health care benefits, 108–9, 112

highway users tax (motor vehicle fuel tax), 46–47, 50n4, 247–48 history of local government finance, 223–38 ERAFs in, 232–33 Gann Limit (Proposition 4), 230–31 overview, 9 Proposition 13 (era of limits), 226–30 Proposition 26 (tax redefinition), 233–35 Proposition 218 (right to vote on taxes), 233 Proposition 1A & 22, 235–36 revenue sources over time, 224, 225f state constitution importance in, 223–24 state retrenchment and local responses, 231–32 statewide v. home rule responsibilities and, 225–26 taxpayers' revolt and, 227 home rule, 12, 16, 103, 223, 225–26 housing affordable, 134, 175, 182, 210 "bubble" of 2008, 207n8 development fiscal impact analyses, 210 development market studies, 198–99 economic development and diverse, 176 Howard Jarvis Taxpayers Association, 233

IICMA. See International City and

County Management Association. IFB. See invitations for bids. incentive zoning, 174–75 incorporations, 11, 212 incubation centers, 175 independent special districts, 16 indirect cost allocation plan, 55 inflexible funds. See special revenue funds.

input-output econometric models, 169 instruments for debt financing, 8, 130– 36 interest-based bargaining, 101 interest rate risk (market risk), 139–40 interim financial reports, 156, 160–61 interjurisdictional service agreements, 212 internal controls, 122 internal rate of return (IRR), 197, 208n14 internal service funds, 27, 29, 141 International City and County Management Association (ICMA), 74 investment advisors, 148–50 Investment Primer (CDIAC), 150 investments, 137–54 allowable, 144, 145f authority and officers, 142–43 failures in management of, 138 liquidity and, 88, 137, 140, 147–48 Local Agency Investment Fund (LAIF), 147–48, 149 management of, 138, 143–44, 148–51 maturities match to cash flow, 146–47 oversight committees for, 151–52 overview of, 8 performance evaluation, 146 policies, 144–47 principles of, 137–40 reporting of, 144, 152–53 risks for, 138–40 safety of, 137, 138, 147 surplus funds and, 141–42 yields or return on investments and, 137, 140 invitations for bids (IFB), 119 IRR. See internal rate of return.

Jjail detention facility booking fees, 47, 51n10 Jarvis, Howard, 227, 233 Joint Powers Authorities (JPAs), 135 "just-in-time" inventories, 120 Juvenile Justice grants, 46

K Kelo v. New London, 165 L labor and employment, 93–113

collective bargaining and, 95, 99–103 compensation for, 95–99 cost containment of workforce, 110–13

cost of workforce and, 93–95, 109–10 exempt and nonexempt employees, 94–95 health care benefits and, 108–9 "new hires" v. "classic employees," 106 overview of, 7 pensions and retiree health costs, 104–9, 111–12, 247 Labor Relations Act (1935), 99 LAFCOs. See Local Agency Formation Commissions. LAIF. See Local Agency Investment Fund. land banking, 174 land use myths, 171 land use plans, 174, 218 law enforcement grants, 46, 50n7 League of California Cities, 120, 180, 240 leakage. See retail leakage. lease revenue bonds, 131–32 legal feasibility analysis, 187 Legislative Analyst's Office, 240 leveraging, concept of, 193 limited liability company (LLC), 193 line-item budgets, 67, 69–71, 72, 75 liquidity (investment portfolio), 88, 137, 140, 147–48, 195 Little Hoover Commission, 240 loan programs, federal and state, 128 Local Agency Formation Commissions (LAFCO), 171, 212 Local Agency Investment Fund (LAIF), 147–48, 149 Local economic development. See Economic development. Local Government Dollars and Sense (Wood), 69–71 local governments. See also specific type of local government. classes (three) of, 11–17 decline in revenue sources and actions by, 231–32 finance reform and, 239–52 financial duties of, 2, 67–68 land use myths and, 171 as municipalities, 1, 2 overview of, 6 as real estate developers, 9, 185, 199– 201 services provided by, 1–3 types of funds used by, 25–29 Local Public Safety Protection and Improvement Act (1992), 48 longevity awards, 96–97

index

M Management's Discussion & Analysis

(MD&A), 158 market feasibility analyses, 187 market forces and compensation, 97–99 marketing, shared, 178 market risk (interest rate risk), 139–40 market studies, 197–99 "Marking to Market," 153 Marks-Roos bonds, 135 maturities, investment, 146–47 MD&A. See Management's Discussion & Analysis. Mediation and Conciliation Service, California State, 102 Mello-Roos Special Tax Districts, 134 Memorandum of Understanding (MOU), 204 Meyers-Milias-Brown Act of 1968 (MMBA), 99 modified accrual basis of accounting, 155–58, 162n1 Moody's Investment Services, 128 motor vehicle fuels tax swap of 2010, 48 motor vehicle fuel tax (highway users tax), 46–47, 50n4, 247–48 motor vehicle license fee. See Vehicle License Fee (VLF). MOU. See Memorandum of Understanding. multi-function special districts, 17 multiplier effect (economic), 167, 168 multipliers, per capita, 214–15 multiplier stability, 217 multi-year operating budgets, 77–78 municipal bonds, 128–29 municipalities, 1, 2. See also specific type of municipality.

N Nalbandian, John, 82, 251

Nalbandian Assessment, 251 National Advisory Council on State and Local Budgeting (NACSLB), 70 negotiators, labor, 100 negotiators, real estate development, 205–6 New Deal programs, 224 New London v. Kelo, 165 non-base or service sector of local economy, 167–68 non-enterprise special districts, 17

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O officials, appointed and elected, 4, 67–68 one-stop permitting centers, 177 OPEB. See Other post employment benefits. Open Space Subvention Act, 48 operational expenditures, 17–19 opportunity costs, 195 other post employment benefits (OPEB), 108–9, 247 oversight committees (investment), 151– 52

P parcel taxes, 40, 45

pay. See compensation. pay-as-you-go capital project funding, 20, 126, 141 penalties, fines and forfeitures, 42 pensions, 104–7, 111–12, 247 PEPRA. See Public Employees' Pension Reform Act. per capita multipliers, 214–15 performance based pay, 97 performance budgets, 67, 69, 71–73 periodic compensation adjustments, 97 permanent funds, 27 permits and licenses, 41, 192 physical feasibility analysis, 187 political feasibility analysis, 187 political values, 82–83 Pooled Money Investment Account (PMIA), 147 population distribution, 1, 1f positional bargaining, 101 post employment benefits, 108–9, 247 post-retirement health care benefits, 95, 108–9, 112, 247 prevailing wages, 201, 208n16–17 Priest v. Serrano, 229 primary or base sector of local economy, 167–68 private sector economic development and, 173 enterprise services similar to, 6–7, 26, 54 partnering in real estate development, 201–2 players in development, 188–90 pro forma. See discounted cash flow (DCF) models. program budgets, 67, 69, 71, 72 promotions, employee, 96

330

property taxes. See also Proposition 13. distribution of, 38f fragmented allocation of, 245 historical view of, 224–25, 237n2 relief from, 227–28 revenues from, 39f as source of funding, 35–37 proposal evaluation criteria, sample, 119 Proposition 1A (2004), 35, 235–36, 238n15, 243 Proposition 4 (1979), 226, 230–31. See also Gann Initiative. Proposition 8, 228 Proposition 13 autonomy at local level and, 230 beneficiaries of, 230 effects on local finance of, 85, 199, 224, 229 ERAF and, 232–33 fiscal impact analyses and, 210, 211, 218, 219 G.O. bonds restrictions and, 132, 229 governmental responses to, 231–32 institutional opposition to, 227–29 property taxes and, 37, 210, 211, 214, 226–30, 237n5–6 redevelopment and, 179 summary of, 231 tax categories and, 32, 34 taxpayers revolt and, 227 voter approval of, 227–29 Proposition 22 (2010), 149, 179–80, 235–36 Proposition 26 (2010), 233–35 Proposition 42 (2002), 48 Proposition 46 (1986), 229 Proposition 47 (1986), 41, 242 Proposition 57 (2004), 35 Proposition 62 (1982), 233 Proposition 98 (1990), 234, 238n13 Proposition 111 (1994), 230 Proposition 172 (1992), 48, 51n14, 232– 33 Proposition 218 (1996), 32, 34, 60, 62– 64, 132, 233, 235, 247 proprietary funds, 26, 27–29, 155, 157f. See also enterprise funds; internal service funds. PSAF. See Public Safety Augmentation Fund. Public Employees' Pension Reform Act, 2013, 104–7 public employee unions, 99–100 public policy and political values, 82–83

public policy and resource allocation (budgets), 78–83 Public Policy Institute of California, 240 public-private partnerships. See also real estate development. complex nature of, 201–2 government roles and responsibilities in, 202, 203–4 managing risks in, 202–3, 204–5 policy justifications and, 202, 203 process considerations in, 202 team members in, 205–6 Public Safety Augmentation Fund (PSAF), 48 public safety sales tax, 48 public services and facilities, 176 public trust and finances, 79 public works, 13, 201, 208n15 purchase orders, agreements and encumbrances, 121 purchasing, 115–23 basic tasks in, 116–17 best practices, 117–23 bidding and contract awards, 117–20 in budget context, 115–16 centralized v. decentralized, 119 competition and, 117 with electronic documents, 119–21 governing body approval and award in, 117–19 overview of, 7, 115–16 Preferences for local, 122 register of warrants, 122–23 roles and responsibilities for, 117 "standard model" for, 121 system overview, 118

R rates for enterprise services, 6–7, 56–64

RDAs. See redevelopment agencies (RDAs). real estate development, 185–208 assumptions and sensitivity analyses for, 197, 217–18 capital requirements for, 191–92 debt financing and, 192–94, 207n5–8 developers perspective of, 185–86 feasibility analyses for, 186–87, 194– 97 fiscal impact of, 209–12 government roles and responsibilities in, 203–4 legal or regulatory analysis for, 187 by local governments, 185, 199–200

market studies for, 197–99 overview, 9 policy justifications for, 202, 203 public-private partnership of, 201–6 public v. private, 200–201 retail leakage analysis, 199 risk management in, 195, 202–5 team of players in, 188–90, 205–6 Real Estate Investment Trusts (REITs), 193 realignment plan of 2011, 234 real property transfer tax, 40 reasonable rate of return, 148 receipt of proposals, 119–20 recession of 2008. See Great Recession. reclassifications, employee, 97 Recognized Obligation Payment Schedules (ROPS), 180 redevelopment, economic, 178–82 redevelopment agencies (RDAs), 20n1, 133, 178–80, 218, 232, 236 reform of local government finance, 239–53 barriers to, 249 challenges to, 241–44 defining the problem of, 246–48 efforts for, 240–41 flaws in efforts to, 244–46 foundation of, 239–40 overview, 9–10, 239 principles of fiscal, 249–52 Register of Warrants, 122–23 regulatory feasibility analysis, 187 regulatory fees and permits, 41 REITs. See Real Estate Investment Trusts. replacement funds, 141 reporting financial data, 155–62 annual financial reports, 14, 156–60 audited basic financial statements, 157–59 audits, 159 Comprehensive Annual Financial Report (CAFR), 157, 160 fund accounting concepts and, 25– 30, 155–56 government wide and fund based statements, 157–59 interim financial reports, 156, 160–61 notes to financial statements, 158 overview, 8 required supplementary information (RSI), 158–59 timely and accurate data for, 83 reporting of investments, 144, 152–53

requests for proposals (RFPs), 119, 150 required supplementary information (RSI), 158–59 reserve (fund balance) policies, 86–88, 141 residential development. See housing. resource allocation. See budgets. retail leakage, 168, 199, 210 retiree health care benefits, 95, 108–9, 112, 247 retirement obligation funding progress report, 159 retirement pensions, 104–7, 111–12, 247 return on investment (yield), 56, 137, 140 revenue bonds, 131 revenues discretionary, 31, 35, 41, 209, 237n12 from enterprise services, 53, 63–64 functional, 13–14 general, 13–15 general fund, 25–26, 32–42 sources for cities, 13–15, 15f, 224f sources for counties, 15–16, 17f, 225f sources over time, 224, 225f special districts sources of, 17 revenue-sharing agreements, 212 RFP. See requests for proposals. Right to Vote on Taxes Act. See Proposition 218 (1996). Roosevelt, Franklin D., 99 ROPS. See Recognized Obligation Payment Schedules. RSI. See required supplementary information.

SSafe Drinking Water Act (SDWA) State

Revolving Fund, 128 sales and use taxes, 33–35, 36f, 225, 248 sales tax bonds, 135 sales taxes, 33–35, 39f, 216, 231, 237n12 Schwarzenegger, Arnold, 235, 242 SDWA. See Safe Drinking Water Act (SDWA) State Revolving Fund. sectors of local economy, 167–68, 169 Senate Bill 90, 226 Senate Bill 402, 103 sensitivity analyses, 69, 197, 217–18 Separation of Sources Act (1910), 223– 24 Serrano v. Priest, 229 service or non-base sector of local economy, 167–68

index

service or user fees, 41 service population and fiscal impact analyses, 213–15 The Seven Habits of Highly Effective People (Covey), 67 single function special districts, 17 situational and/or periodic compensation adjustments, 97 skill banks, 178 skills gap, 251 SLESF. See Supplemental Law Enforcement Services Fund. SLY (Safety, Liquidity, Yield) investment principles, 8, 137–40 small business assistance centers, 177 sole source purchases, 120 Speaker's Commission on State and Local Government Finance (1999), 240 special districts budget requirements for, 67–68 community service (CSDs), 17 enterprise or non-enterprise, 17, 54 independent or dependent, 16–17 multi-function or single function, 17 taxes and, 34, 40 types and functions of, 2, 19f special revenue funds, 45–51 American Reinvestment & Recovery Act as, 49 Community Development Block Grants and, 26–27, 49 definition and examples of, 26–27 development impact fees and, 45, 49– 50, 126–27 fund accounting and, 26–27 local special taxes and, 45–48 overview, 6 state subventions and, 46–48 special taxes, 32–33, 34, 45–48, 134–35 speculative buildings, 175 staffing. See labor and employment. Standard and Poors Financial Services, 128–29 State constitution of California, 223–24 state/local realignment of 2011, 234 step increases (compensation), 95–96 strike, right to, 99, 103 subsidies, 88, 176 subventions, 41, 46–48, 231 succession planning programs, 110 Supplemental Law Enforcement Services Fund (SLESF), 46–47 Supplementary information, financial statement, 158–59

331

Guide to LocaL Government Finance in caLiFornia Supreme Court of California, 103, 111, 180, 229–30 surplus funds, 141–42 sustainability of community plans, 212

V values, political, 82–83

T tax allocation bonds, 132, 133, 179, 180 W Tax and Revenue Anticipation Notes Walters, Jonathan, 74

(TRANs), 129 taxes. See also specific type of tax. general, 32–40 local special, 45–48 special, 32–33, 34 tax increment financing, 132–33, 179– 80 taxpayer revolt, 227 tax reductions, 175 TDA. See Transportation Development Act (1971). third-party custodial agreements, 150–51 time-value of money, 195 TOT. See transient occupancy tax. towns. See Cities. training and education programs, 178 TRANs. See Tax and Revenue Anticipation Notes. transaction and use taxes, 33, 35, 45 transfer effects. See cannibalization. transfer tax, documentary, 40 transient occupancy tax (TOT), 37–38, 210 transparency, 2, 78, 250 transportation authority, 45, 135 Transportation Development Act (1971), 28, 159 Transportation Sales Taxes. See countywide transportation sales tax. treasurers, 142 Triple Flip, 35 trust, public, 79 trust funds, 141

U unincorporated areas, 15–16, 20n2, 213

unions, 99–100. See also collective bargaining. U.S. Environmental Protection Agency's Clean Water Act (CWA) State Revolving Fund, 128 U.S. Securities and Exchange Commission, 150 user or service fees, 41 use taxes, 33–34 utility user tax (UUT), 38

332

Vehicle License Fee (VLF), 41, 225, 231, 241, 242–43

Warrants, Register of, 122–23 water and sewer services as enterprise examples, 27–29 rates for, 56–63 wholesale or retail, 56 Wildavsky, Aaron, 79 Williamson Act, 37, 48 Wood, Len, 69–71 workforce. See labor and employment. working capital/flow of resources, 56–58

Y yield (return on investment), 137, 140 Z zero-based budgeting (ZBB), 69, 72, 73–

75 zoning for economic development, 174– 75