Not all budget imbalances are alike.
Around the country, many government leaders and policymakers are addressing state and local government budget shortfalls. A relatively new phenomenon for some areas, and a continuing thorn for others, budget imbalances generally fall into two categories: cyclical and structural. Identifying the type of budget imbalance a governmental unit is facing is a critical first step in developing appropriate strategies to resolve it.
In the interview that follows, Christopher Mier, CFA, managing director and head of the Analytical Services Division at Chicago-based Loop Capital Markets, explains the difference between a cyclical and structural budget imbalance, as well as their respective implications for governments and municipal bondholders.
MuniNet: What is a cyclical budget imbalance?
Mier: The economic cycle typically encompasses four phases:
- Recovery and expansion,
- an economic peak,
- decline (the point we refer to as “recession”),
- a low point, called a trough, from which recovery begins again and the cycle repeats itself.
The economic, or business, cycle has the potential to impact the revenue stream of a state or local government. When the economy slows, government revenues usually decline as well, leading to what we call a cyclical budget imbalance.
Ideally, during times of economic expansion, state and local governments save for the downturns in the cycle. In reality, however, many governmental units fail to do so, leading to tough times during the low points, when people are earning less, spending less, and infusing less money into the local economy.
MuniNet: How is a structural imbalance different? What factors might cause a structural imbalance?
Mier: A structural budget imbalance exists when a tax regimen fails to keep pace with changes in the economy. The result is that expenditures exceed revenues over time, as a result of factors beyond the economic cycle. This scenario can occur when a government’s expenses remain constant, but revenues decline as a result of a changing economy.
Take the example of a city whose employment base shifts to lower-paying jobs. This city may have the same number of employed residents, but their average income may have declined, thereby affecting its tax base. In this type of situation, a city might also see an increase in expenses due to a ripple effect, more citizens needing social services, food subsidies, etc.
Likewise, if a city that once experienced a high growth rate – say five percent – experiences a slowdown of growth, it could find itself in a position where the revenues have declined but the expenditures have remained constant-a structural deficit.
An out-of-date tax system is another factor that might cause a structural imbalance.
MuniNet: Can you point to examples of outdated tax practices?
Mier: Twenty years ago, sales tax revenue was an accurate reflection of the sales of goods and services in a state or municipality. With the boom of online commerce over the past two decades, however, more and more consumers are making purchases through the Internet, often avoiding sales taxes. The rise of Internet commerce is a perfect example of how the economy is changing, but the tax system has not kept pace and revenue yields are being impaired.
A flat state tax structure, where all residents are taxed at the same rate, is another system that may no longer make sense. A flat tax system doesn’t allow for economic growth as people in higher income brackets begin earning more. A graduated tax system is likely to be more effective in keeping revenues growing at the same rate as personal income.
It is a healthy practice for governments -whether state or local – to periodically review their system of taxation to ensure that their revenue stream is growing at or above the rate of the economy.
MuniNet: How are the solutions to a cyclical vs. structural budget imbalance different?
Mier: Whereas a cyclical imbalance will very likely resolve itself once the economic cycle improves, a structural problem requires a structural solution. State and local leaders need to assess the situation to determine the underlying causes of the imbalance, and then respond accordingly. If the problem is deemed structural, officials need to find ways to reduce expenses, increase revenues, or both. A structural imbalance calls for an implicit reevaluation of the role of government – perhaps finding a need to collapse or expand its size to meet the needs of its residents.
MuniNet: Do cyclical versus structural imbalances have different implications for municipal bondholders?
Meir: Investors should educate themselves to recognize the difference between the two types of budget challenges. Bondholders with investments in governmental bodies experiencing a cyclical budget imbalance probably have less cause for concern. On the other hand, a structural budget imbalance may foreshadow more serious credit implications, meriting further evaluation by current and potential investors.
About the Expert
Christopher Mier, CFA, brings over 30 years of experience to his role as a Municipal Strategist for Loop Capital Markets, where he provides portfolio analytics to its sales, trading and underwriting professionals. He also generates client-specific ideas to enhance secondary market activity and fixed income strategy. Prior to joining Loop Capital Markets, Mr. Mier was a portfolio manager with MFS Investment Management, Scudder Kemper Investments, and Comerica Bank.
Mr. Mier holds a Masters of Management in Finance from Northwestern University’s Kellogg Graduate School of Management, a Bachelor of Arts in Economics from the University of Michigan, as well as a recently earned Master of Arts in Economics from the University of Illinois at Chicago.