Faculty Forum - Featured Post Posted on Wednesday, July 24, 2013

Detroit’s Bankruptcy: How Did We Get Here, and What’s Next?

[Professor Emeritus] Howard Chernick Professor Emeritus of Economics

Rather than compensating for the increased fiscal pressure on one of America’s poorest cities, the fiscal response of higher level governments has exacerbated the fiscal situation in Detroit.

The filing for bankruptcy of the city of Detroit on July 18, 2013, represents the largest municipal bankruptcy in the history of the United States.  While bankruptcy of private corporations typically allows a restructuring of debt obligations, the legal terrain in the case of public sector bankruptcy is murky.  The emergency manager of the city, Kevyn Orr, appointed in March by the governor of Michigan in the face of persistent financial crisis, is faced with two daunting tasks: the first is to determine the full extent of the financial obligations of the city, in comparison to its actual and expected fiscal resources.  The second and more difficult task is to negotiate agreements with the two principal holders of the financial obligations of the city; those who lent the city money by buying its bonds, and current and retired municipal workers, who have accrued pension and health care coverage obligations as part of their negotiated compensation packages.  The current estimate of debt is about $18 billion dollars.

How did Detroit arrive at this difficult position?   The underlying problem has been a persistently weak economy, as evidenced by declining population, employment, and income levels. Between 1950 and 2011, Detroit lost over a million people, with a population decline from 1.8 million to 707,000.  Since the year 2000, Detroit has lost more than 26 percent of its residents.  Only a little more than a third of the residents (36 percent) are employed.  In 2008 the average for all big cities was 46 percent.

Poverty rates in the city of Detroit are extremely high. In 1982, 32.4 percent of the population fell below the poverty line.  The comparable number for all 109 cities in a sample of the largest central cities was 19 percent.  Poverty rates in any year reflect both the secular economic trends within cities and national economic conditions.  As the following graph shows, poverty rates fell from 1997 to 2001 in Detroit, as well as in all big cities.  How did Detroit do relative to other cities? In the strong economy of the late 1990’s, relative poverty rates fell.  However, in the weak recovery from the brief national recession of 2001, Detroit economic position, both in absolute and relative terms, weakened again.  By 2008, poverty rates in Detroit were at 32.3 percent, compared to the big city average of 19 percent.

Chernick

Detroit suffers from the classic U.S. pattern of an extremely poor center city, surrounded by relatively wealthy suburbs.  In 2008, per capita income in the suburbs of Detroit was almost twice as high as city income (1.93).  This compares to the average for all big cities of 1.38, i.e. average suburban income is typically about 38 percent higher than city income.  While Detroit city’s population has declined precipitously, the population in the Wayne county has remained stable, at about 1.1 million persons.  This means that the city’s share of the total population of the county has declined, from 53 percent in 1977 to 40 percent in 2010.  However, the fact that the population in the rest of the county has not increased indicates that population losses in Detroit have not been offset by population gains in the suburbs.  This pattern is consistent with recent evidence of the increasing interdependence of cities and suburbs.  Weak city economies tend to be associated with weak suburban areas.[1]  This economic weakness extends to the entire state of Michigan, which has suffered enormously from the decline in the U.S. automobile industry and manufacturing in general.  Though the automobile industry is now growing again, employment is still only a fraction of what it was at its peak. Michigan was also among the states hardest hit by the great recession of 2007-2009, with the decline in taxable income among the top fifth of all states.

What about the public finances of Detroit? Is the bankruptcy a result of lavish public spending, imprudent pension promises, or fiscal mismanagement?[2]  To address these issues, I draw on a special data set on the finances of big cities that two colleagues and I have constructed using the U.S. Census Bureau’s quinquennial Census of Government Finance and their Annual Surveys of State and Local Government Finance.[3]  By taking explicit account of the different fiscal roles played by cities, counties, school districts, and special districts in different cities, this approach is the first to allow meaningful fiscal comparisons among all big cities in the U.S.[4],[5]

Detroit’s fiscal condition has suffered much more than the typical city from the 2007-2009 Great Recession.  Between 2007 and 2010, general revenue fell from over $5.022 billion to less than3.994 billion, a drop of more than 20 percent.  Adjusting for population change and inflation, the drop in (inflation adjusted per capita revenues) in this brief period was 11.7 percent.  This compares to an average decrease of 2.9 percent for all big central cities.  Thus what was already one of the fiscally weakest cities in the U.S. was hit with a decline in real fiscal resources during the great recession that is more than four times as great as the national average.

The hit to Detroit’s revenues was across the board.  While federal aid remained constant in nominal dollars, state aid dropped by almost 18 percent.  Local taxes, mainly the property tax, declined by 19 percent.[6]  So rather than compensating for the increased fiscal pressure on one of America’s poorest cities, the fiscal response of higher level governments exacerbated the fiscal situation in Detroit.

Intergovernmental assistance, from the federal government, and particularly the state, is an   important sources of revenue for cities.  In 2010, (the latest year for which we have comparable data), among all big cities, state aid comprised 32 percent of general revenue.  For direct federal aid to local governments, the share was 6.4 percent.[7]  In Detroit the comparable shares were 46.4 percent for state aid, much higher than the typical city, but only 4.6 percent for federal assistance.  It is quite remarkable that one of the poorest U.S. cities gets a smaller share of its revenues from the federal government than many richer cities.  For example, Boston’s direct federal share was 11.4 percent, while Baltimore, whose economic and demographic profile is similar to Detroit, got 15.8 percent.  Thus the federal government’s role in equalizing fiscal capacity across its major cities appears to be de minimis, and in some cases is actually counterequalizing, providing less aid to the neediest cities than to more fiscally healthy places. This de facto allocation scheme is both inequitable and inefficient.

Detroit gets a relatively high share (46.4%) of its revenues from state aid to the city, school district, and overlapping county.  Only a few cities (mainly in California, Massachusetts, and New York) have higher state shares.  It is useful to compare the recent fiscal experience of Buffalo and Detroit.  Both are older industrial cities that have been devastated by the decline in manufacturing in the U.S.  Both cities are in perilous fiscal condition.  However, when one compares the role of the state of NY versus the state of Michigan, the stories are quite different. In 2010, 57.3 percent of   (fiscally standardized) Buffalo’s general revenue came from the state. Between 2000 and 2010, inflation adjusted state revenues per capita declined by 13.7 percent in Detroit, while in Buffalo they increased by 45 percent.  In the recession period alone (2007 to 2010), state aid to Detroit went down by 8.2 percent, but went up by 7.2 percent in Buffalo.  Thus a big difference between these two structurally similar cities is the economic and fiscal environment and fiscal choices made at the state level.  Had New York treated Buffalo in the same way fiscally as Michigan dealt with Detroit, Buffalo, which is already teetering on the edge of fiscal crisis, might have been forced to declare bankruptcy as well. Of course, Buffalo benefited from belonging to the same state fiscal unit as the relatively prosperous New York Metropolitan area, whereas Detroit has had no such luck.  The secular and cyclical economic downturn in Michigan has been statewide.

Despite large deficits, spending has also declined precipitously in Detroit.  Between 2003 and 2010, inflation adjusted per capita spending fell by 28 percent.  However, for some municipal services, it typically takes some time for spending to adjust to declining populations.  For example, per capita spending on the core service of public safety (police, fire, ambulance services) in 2010 was 25 percent higher in Detroit than the average for big cities ($888 versus $708).  By contrast, in 2000 Detroit’s spending on this core service was only 8.5 percent higher than the national average.  Despite this increase in spending in Detroit, the quality of services has deteriorated dramatically. For example, it has been widely reported that police response times average above 50 minutes for Detroit in 2013, versus about 8 minutes nationwide.  These very high response times are undoubtedly related to the spread out geography and low density of Detroit.

As bankruptcy proceedings move forward, what are steps that could be taken to minimize the hardship imposed on Detroit’s already overburdened residents, and help Detroit to regain economic vitality?  Though far from exhaustive, a few possibilities are:

  1. The state and city polities should address corruption and mismanagement in a forthright way.  Corruption, though not a major contributor to Detroit’s fiscal woes, has a corrosive  effect on public confidence and political support for helping Detroit.
  2. Fiscal mismanagement should be addressed immediately.  This may require investment in  modern computer systems for revenue collection, and human resource policies to retain and increase the number of skilled managers.
  3. The unfairly low contribution that direct federal aid makes to Detroit’s revenues should be reexamined.  A one-time federal bailout, accompanied by stringent conditions for reform, would be appropriate to correct this resource misallocation.  Though the situations are obviously different in terms of cause, it should be recalled that New York City received an enormous amount of federal aid in the aftermath of the 9/11 attack on the World Trade Center, aid which continued to be at higher levels than most other cities at least through 2009.  New York City and its region also benefited enormously from the federal bank bailout of 2008-09.  Unfortunately, the political stance of the Republicans in Congress offers little hope for such an adjustment.   (See the New York Times, July 24, 2013)
  4. The surrounding suburbs of Detroit should contribute more to the fiscal health of the city.  As Prof. Inman has shown, it is in the long-term interest of the suburbs to do so.  One way would be through some form of revenue sharing with the Detroit metro area. The most politically feasible way to do this would be to transfer some fiscal responsibilities from the city of Detroit to Wayne County.  An alternative would be to increase the share of state aid that goes to Detroit.
  5.  Already promised public pensions should not be reduced.  The typical municipal pension in Detroit is smaller than the national average.  Low level employees get about $18,000 per year.  These are far from lavish benefits.  Also, many municipal workers do not get social security.  Pension commitments were negotiated in good faith by city workers, and Michigan state law precludes reducing pensions to current pensioners.
  6. Special attention should be paid to effective implementation of the Affordable Care Act of Detroit.  This will help to relieve the burden of uncompensated care for the poor in hospital and emergency rooms. In general, encouraging the participation of those eligible for benefits under the federal safety net programs  – Food Stamps, the Earned Income Tax Credit,  and other programs – will reduce poverty and help to bring income into the community.
  7. Detroit desperately needs jobs and economic development.  The rebound of the automobile industry from the crisis of the Great Recession provides some hope for manufacturing job growth in the Detroit metropolitan area.  To the extent that federal policies such can influence this rebound, for example by increasing fuel requirements on new cars and accelerating the retirement of old cars, such policies should be encouraged. The Detroit area has an extensive base of skilled workers in manufacturing.  Tax subsidized industrial parks, financed by federal loan guarantees, could be created in  some of the areas with very low population densities. Existing roads, and water and sewer lines would reduce the cost of such ventures.
  8. The costs of providing basic services in Detroit are very high, because of extensive poverty and severe population loss.  The long-term decline in population has left density very low in many areas of the city.  Reduced density increases the cost of providing basic services – police, fire, building inspections, sewerage treatment and water, garbage collection.  The extremely slow response times for police are an illustration of the problem.  Detroit (and the state of Michigan) should consider explicit policies to increase density in the center city.  One possibility would be federal or state subsidies to purchase homes in outlying areas, and to fund denser development in more populated areas.

[1] See Haughwout, Andrew and Robert P. Inman. 2002. “Should Suburbs Help Their Central City?Brookings-Wharton Papers on Urban Affairs: 45-94.

[2] For example problems in the collection of taxes are discussed in a  report on National Public Radio (7/25/13).  taxes.

[3]  The data set is described in: Fiscally Standardized Cities database.

[4] While a few city governments are responsible for the financing of a full array of public services for their residents, other city governments share the responsibility of providing services with a set of overlying governments. For example, Baltimore has no independent school districts or county governments. The municipal government is responsible for providing both core municipal services and education, public health, and other social services. In cities such as  Miami, however, only about one-quarter of public spending on local government public services is carried out by the municipal governments, with the remaining three-quarters of spending the responsibility of one or more independent governments serving city residents.

[5] The methodology used to construct what we call Fiscally Standardized Cities is described in Chernick, Howard, Adam Langley, and Andrew Reschovsky. 2011a. “The Impact of the Great Recession and the Housing Crisis on the Financing of America’s Largest Cities,Regional Science and Urban Economics 41, Issue 4, (July): 372-381.

[6] Weak fiscal management in Detroit has led to a big gap between taxes due and taxes actually collected.  (National Public Radio report, 7/25/13).

[7] A portion of federal aid to cities goes first to the states, then is passed through tol cities and other local governments.  Because such pass-through funds are treated as state aid by The Census of Governments,  we are unable to determine the full amount of federal aid to cities.


Howard Chernick is Professor Emeritus of Economics at Hunter College and the Graduate Center of the City University of New York. He is a research affiliate of the Institute for Research on Poverty at the Univ. of Wisconsin, a board member of Citizens for Tax Justice, and a past member of the board of the National Tax Association. Research interests include fiscal federalism, urban public finance, anti-poverty policy, and tobacco taxation. In addition to cities in the United States, including his hometown of NYC, Professor Chernick has studied the finances of cities around the world, including Montreal, Stockholm, and Kolkota, India.