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Conservative Myths on Reserve Funds

June 15, 2009 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis
 
In an effort to put lipstick on a pig, Governor Pawlenty is currently attempting to fabricate a policy rationale for the large unallotment of local revenues that he is expected to propose within the coming weeks.  His latest ploy points to local governments with budget reserves as a justification for the anticipated unallotments.

After refusing to compromise with the legislature on a balanced solution to the state's deficit, Pawlenty put himself in a position to unilaterally cut $2.7 billion from state's FY 2010-11 biennial budget.

The governor has been working overtime to convince Minnesotans that local governments have ample reserves to deal with aid cuts without having to make deep budget cuts or significant property tax increases.  Most of his comments in this regard have been directed toward cities, although many of the arguments can (and possibly will) be used against counties.  Responding to legitimate concerns from city mayors regarding the magnitude of the pending unallotment of local revenue, the governor quipped "Many, if not all [cities], have reserve funds, or rainy day funds, and they should use them."

At first blush, the fund balances of cities may appear large.  Based on 2007 data from the Office of the State Auditor (OSA), the aggregate unreserved fund balance for Minnesota cities with a population more than 2,500 is 48 percent of non-capital expenditures.* However, this statistic needs to be considered in light of several facts.

The OSA reports city fund reserves on December 31, at the very end of the city fiscal year.  At that time, city reserves are at a high point because cities have just received half of their annual property tax and state aid payments.  The next payment will not come until five to six months later.  Thus, on December 31 cities will need to have sufficient funds on hand to pay for operations for the next several months.  The League of Minnesota Cities puts it this way: "The timing [of the December 31 reserve] is equivalent to measuring your personal wealth on the day after payday-before you've paid the mortgage, car loan, and other bills."

In recognition of this fact, the OSA recommends that "at year-end local governments maintain an unreserved fund balance... of approximately 35 to 50 percent of fund operating revenues or no less than five months of operating expenditures, which should provide the local government with adequate funds until the next property tax revenue collection cycle."

The OSA goes on to state that while a fund balance outside of the 35 to 50 percent range does not denote impropriety, local governments should be able to explain fund balances beyond this range.

On factor that can justify a fund balance outside of this range is the use of a portion of unreserved fund balances to pay for projects.  For example, a city may choose to build up its reserves in order to pay for road improvements or a new library rather than incurring debt.  The personal finance equivalent to this would be saving up to purchase a new car as opposed to borrowing for it.  The advantage of this approach is that borrowing costs are avoided and the ultimate price tag for the project is reduced.

It would be foolhardy for the state to require local governments to drain designated funds for financing public projects in order to make up for excessively large state aid cuts.  It would be even worse to target aid cuts to local governments who have build up reserves for this purpose; cities and counties should not be penalized for adopting prudent fiscal strategies that reduce public costs over the long term.

In addition to cash flow and project finance, reserves are needed so that local governments can respond to unforeseen events such as tornados or floods.  Depletion of local reserves could leave local governments unprepared to respond to emergency situations.

Healthy reserves also help local governments maintain a favorable bond rating.  A good bond rating enables local governments to borrow at a lower interest rate, thus reducing the cost to taxpayers.  Adequate reserves are a key factor that bond houses examine when determining the credit rating of a local government.

The State of Minnesota offers a cautionary lesson of what happens when a government draws its fund balance down too far.  During Pawlenty's first year as governor, the state drew down its reserves and relied too heavily on one-time revenue to address its budget problem.  As a result, the state lost its Aaa bond rating from Moody's Investors Service; the state has yet to regain its Aaa rating from Moody's.

The 2009 report of the bi-partisan Minnesota Budget Trends Study Commission has recommended that the state build up its budget reserves and cash flow account in response to an increasingly unstable revenue outlook.  All members of the Commission, including the five appointed by Governor Pawlenty, endorsed this recommendation.

It is ironic that Pawlenty is calling on local governments to draw down their reserves at the same time that a bi-partisan panel of experts is calling on the state to increase its reserves.  The downside risks that jeopardize the state revenue flow will also affect local governments.  In the midst of the short-term and long-term financial instability threatening the state and national economies, it would be imprudent for local governments to draw down reserves.  As noted by Winona Mayor Jerry Miller and Hibbing Mayor Rick Wolff, "Adequate cash-flow reserves allow a city to responsibly manage daily operations and avoid budgeting from crisis to crisis, unlike the state's budget practices."

The depletion of local government reserves would undermine the fiscal stability of local governments and merely delay the further property tax increases and local funding cuts that will result from massive unallotment of local revenue.  During Pawlenty's tenure as governor, local government revenue has already fallen more rapidly than state revenue, as the governor has shifted a disproportionate share of the state's budget problems on to cities, counties, and school districts.

Rather than propping up failed policies with a flimsy rationale, Pawlenty would be well advised to change course.  After all, a pig with lipstick is still a pig.

*City fund balances at the end of 2008 will almost certainly be less than fund balances at the end of 2007.  In December of 2008, the governor unallotted $66 million of city revenue.  With only about a week left in their fiscal year, many cities were forced to draw down reserves in response to this unallotment.



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