Municipal Debt: The Next Crisis?
The Wall Street Journal recently highlighted the city of Menasha, Wis., and a failed steam plant project as evidence that municipalities may be the next financial crisis. Although the primary purpose of the article was to warn investors about the risks of holding municipal bond debt, it also serves to illustrate that many municipalities are spending outside of their means. From the article:
The housing crisis was fueled by cash-strapped homeowners who walked away from their mortgages. Some analysts and investors now are worried about the same problem happening with debts of cities and towns. […]
The tangle underscores concern in the municipal-debt world about the longstanding assumption that local governments will do whatever it takes to repay their debts—including raising taxes—because failing to do so would make it more expensive or even impossible to turn to investors for future financing.
Such cases are rare but could increase in number as municipal governments struggle to meet their obligations on projects that have run into trouble. The greatest default risk is in small municipalities with overleveraged projects buffeted by the recession. Those places also might need to access credit markets less in the future than big cities, making it easier to walk away from their debt.
Placing additional taxes on income — such as earnings taxes and additional fees for service (i.e., trash fees) — is not a sustainable, long-term solution to the problem because it doesn’t address the problem of excessive spending. A municipality can increase marginal tax rates on income and it can establish regional sales taxes, but these policies will encourage a marginal number of people to relocate outside of the region and leave the tax base. Additionally, as we have discussed previously, there are diminishing marginal returns and negative consequences to taxing income.
Reforming expenditures at the local level is a more sustainable solution to preventing a muni-debt crisis. For instance, the city of Saint Louis could prevent a debt crisis if it stopped carving out special exemptions in its tax base, abating property held by private parties and nonprofit organizations, holding thousands of parcels of land vacant, and promising pension and benefit plans without funding them.
