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Government and People
Assessing the District of Columbia's Financial Position
A Report to the Federal City Council by McKinsey & Company, Inc.
March 14, 2002
As the books closed on fiscal year 2001, the District of Columbia had much to celebrate: its fifth consecutive operating surplus, the end of the Control Board, successful efforts to stem resident flight, a substantial decrease in debt per capita, and an enhanced credit rating. With these accomplishments and others, the city's leadership has earned the type of credibility that has long eluded the DC government.
Yet, the city continues to face significant challenges. Some of these challenges are all too familiar to DC and other large cities across the country - the negative effects of an economic downturn, the difficult task of controlling Medicaid costs, and the continuous struggle to improve the public schools. Others - the terrifying events of September 11th and the anthrax incidents that followed in their wake - would have seemed unimaginable just over 6 months ago.
In this context of pride in the recent past but concern for the future, the Federal City Council asked McKinsey & Company to assess the District of Columbia's financial situation. Building on previous studies of the city's financial and structural challenges that we conducted for the Federal City Council and DC Agenda, we conducted a 2-month assessment of the city's financial position and prospects.1 DC's Chief Financial Officer provided us with access to key financial data and experts, and we interviewed over 25 DC government leaders and financial experts. We also benefited from the input of Federal City Council members and key thought leaders on DC's economic, structural, and management challenges, including Elijah Rogers of the Federal City Council, and Philip Dearborn and Alice Rivlin of the Brookings Institute. It is important to note that we did not conduct a comprehensive review of DC's financial situation.
We have concluded that despite the economic successes of the last several years, DC is on a path that will lead to a budget deficit of at least $500 million by 2005. A substantial decrease in the rate of revenue growth in 2002, which in turn leads to reduced revenue expectations for 2003 through 2005; coupled with unbudgeted spending increases in several key areas, including the public schools, Medicaid, and the Washington Metro Area Transit Authority (WMATA), set the stage for a $500 million deficit in 2005. An unforeseen event, such as a slow economic recovery, a cap on the city's debt level, or another major security event, could increase the number significantly.
We believe that DC can and must take steps to address the situation. Failure to do so risks either the return of a control board or, more likely, substantial cuts in city services.
Action is needed on three fronts. First, DC must aggressively improve management efficiency. While the city has made real strides in the way it manages itself, our work points to an additional annual cost reduction opportunity of $110 million to $160 million by 2005. Second, the city should explore the potential trade-off between deferring planned tax cuts for several years and achieving the desired growth in the city's population. For example, deferring the planned cuts in individual tax rates for 2002 through 2004 would add $150 million to 2005 revenue assuming that the deferral of these cuts does not lead to significant resident flight. Finally, DC will need to seek additional financial relief from the federal government. Despite the significant help provided as a result of the 1997 DC Revitalization and Self-improvement Act, DC still faces substantial structural constraints and burdens by virtue of its status as the nation's capital. These structural constraints and burdens include the city's high percentage of federal and other tax-exempt land, the federal law prohibiting DC from taxing wages that are earned in DC by nonresidents, and arguably certain "state" services that DC continues to provide. The annual opportunity cost of these structural challenges is at least $500 million to $650 million.
* * *
In the balance of this report, we discuss our assessment in further detail. Chapter 1 describes the drivers of the expected deficit, and Chapter 2 outlines the actions needed to address it.
1 - POTENTIAL DEFICIT OF AT LEAST $500 MILLION BY 2005
Our work points to a likely budget deficit of $500 million by 2005. This number could increase significantly if the city has to deal with unforeseen events, such as a slow economic recovery, a cap on its level of debt per capita, or another major security event.
$500 million deficit is likely by 2005
We believe that DC could face a deficit of at least $500 million by 2005, a shortfall that would represent about 13 percent of the projected local funds budget (Exhibit 1).2
Actual and projected local fund revenues and
*Difference in graphs in 2001 due to different accounting methods-GAAP Basis used in 7997-2007; 7997 and 7998 figures excludes Federal Payment
Given diminished revenue expectations in fiscal 2002 and further unbudgeted spending increases that are likely to occur, the city may face a deficit as early as this year. More likely, the city will avert a deficit in fiscal 2002 by tapping into the 2001 surplus, budgeted cash reserves, and the tobacco settlement fund. These short-term solutions will not, however, solve DC's fiscal problems. They will only postpone their impact.
The drivers of the city's looming financial troubles are two-fold: a drop in projected revenue of up to $150 million per year by 2005 and unbudgeted expense increases of about $500 million per year by 2005. Based on these projections, DC is likely to face a deficit of about $500 million per year by 2005, instead of generating the $125 million surplus originally projected for 2005.
1. Drop in projected revenue of up to $125 million to $150 million per year between 2002 and 2005. Like most cities, DC was not expecting last year's economic downturn. DC's economy flourished in the late 90s and, as a result, tax revenue grew substantially.3 As of January 2002, DC revenue projections for 2002 through 2005 assumed continued expansion of the local economy, including robust growth in the taxable income of DC residents and in the city's sales tax base.
The combined effect of the regional recession that began in June 2001 and the economic consequences of September 11th will be a revenue shortfall of up to $125 million in fiscal 2002. The lower-than-expected fiscal 2002 revenue level will, in turn, result in reduced revenue expectations of up to $150 million per year for the next several years, even assuming growth rates quickly return to their projected levels.
The shortfall is already evident. As of this writing, DC is not expecting any growth in local revenue in 2002. DC's expected revenue for fiscal 2002 is about $75 million below original projections, due primarily to reduced sales tax and individual income tax collections in the first quarter of the fiscal year (which ended on December 31, 2001).4 The significant sales tax decline occurred in the aftermath of September 11th, when business at DC's hotels, restaurants, and retailers - already slipping due to the recession - dropped significantly due to the decline in travel and tourism in the city. The decline in individual income tax collections is the result of both the general downturn, which hit the local technology sector particularly hard, and the effects of September 11th on employment and income levels in the hospitality and retail sectors.
Depending on how quickly growth in sales and individual income tax collections rebounds and on the level of growth in other revenue streams, revenue could be up to $125 million below expectations by the end of fiscal 2002 - a drop that represents about 4 percent of the local funds budget.5 The rebound's pace will depend in part on the extent and speed with which increases in federal spending on defense and homeland security benefit DC (as distinct from the Virginia and Maryland suburbs).
Even assuming revenue growth in fiscal 2003 through fiscal 2005 reaches originally projected rates, the lower revenue base that we project for fiscal 2002 will result in continued revenue shortfalls of up to $125 million to $150 million per year during this period.6
2. Increase in projected expenses of about $500 million per year by 2005. DC has already announced significant and unbudgeted spending increases in fiscal 2002, including over $80 million in cost overruns at DCPS, driven primarily by higher than expected special education costs, and over $40 million in additional Medicaid costs that did not meet federal Medicaid reimbursement criteria.7
Our work indicates that, unfortunately, these overruns are only the beginning. DC will incur substantial expenses that are not reflected in the current budgets for fiscal 2002 through 2005. These additional unbudgeted expenses will exceed DC's budgeted cash reserves by up to $500 million per year by 2005, roughly 13 percent of the projected local funds budget.8 While the specific numbers for each year may vary, given the unpredictability of certain expenditure categories and the city's ability to defer certain expenditures, incremental unbudgeted expenditures of this magnitude are likely over the next several years. Any additional expenses for improvement projects (e.g., expanding Metro's reach to Dulles airport, revitalizing the city's waterfront) or enhanced service levels for those who use city services would, of course, increase the number.
The public schools, Medicaid, and WMATA are the most significant drivers of the unbudgeted expenditure growth that we are projecting over the next several years. By 2005, expenditures in these three areas alone will be more than $350 million over budget. Another roughly $150 million in unbudgeted expenditures will result from expected increases in population and labor costs, cost increases at the Child and Family Services Agency, and a number of other smaller items not accounted for in DC's budget.
More than half of the $350 million in unbudgeted expenditure growth in the three most significant categories comes from the public schools. The remainder is split fairly evenly between Medicaid and WMATA.
Unforeseen events could increase projected deficit significantly
An unforeseen (albeit plausible) event, such as a slow economic recovery, a cap on DC's debt per capita, or a major security event in 2002 could increase projected annual deficits by as much as 25 to 45 percent. A combination of these events could, obviously, increase these deficits even further.
1. A slow economic recovery could increase the projected deficit by $80 million to $130 million per year. Our projections assume growth in DC's sales and individual income tax collections returns to originally projected rates by the fourth quarter of fiscal 2002 (i.e., beginning in July 2002). As discussed earlier, under these circumstances, DC's revenue will fall short of originally projected levels by up to $125 million to $150 million per year.
If, however, the effects of the recession last 6 months longer, DC would face a significantly greater revenue shortfall over the next several years. More specifically, if growth in DC's sales and income tax collections does not return to originally projected rates until the second quarter of fiscal 2003 (i.e., January 2003), DC's annual sales tax collections would be $20 million to $30 million lower and the city's annual income tax collections would be $60 million to $100 million lower.
Thus a slow economic recovery could increase projected deficits by $80 million to $130 million per year, creating a deficit of approximately $600 million by 2005.
2. A cap on DC's debt per capita could increase the projected deficit by $180 million to $220 million per year. DC's debt per capita in 2001 was more than twice as high as the average for 5 peer cities.13 Moreover, this high level does not reflect full funding of the city's capital improvement plan. In fact, DC has historically funded only 35 to 60 percent of its capital improvement plan (suggesting that the city may be under-investing in infrastructure), apparently due to the DC government's insufficient project management capacity.14
Despite its high debt per capita, the city should be able to finance its projected capital spending and the resulting debt per capita level over the next several years without jeopardizing its bond rating - assuming the city's financial performance remains strong).15
On the other hand, if the prospect of a substantial deficit becomes a reality, DC's ability to raise incremental debt without putting its bond rating at risk could be constrained. Without access to incremental debt, the city would be forced to choose between dramatic cuts in planned capital spending and a significant increase in operating expenditures to fund planned capital investments.
If DC were obliged to maintain its debt per capita at the 2001 level and fund incremental capital spending from the operating budget, projected annual deficits over the next several years would increase by $180 million to $220 million per year. This would put the projected 2005 deficit in the $700 million range.
3. A major security event in 2002 could have about a $100-million impact on the 2002 budget and increase the projected 2005 deficit by about $20 million. An additional security event in 2002 with a financial impact comparable to that of September 11 th could have an impact of about $100 million in 2002 and increase the projected 2005 deficit by about $20 million. Additional security costs and investments in security infrastructure, both of which we assume would be paid for in part by the federal government, would account for two-thirds of the impact in 2002.16 A temporary drop in sales tax collections and a surge in social services expenditures driven by a decline in the city's hospitality, restaurant, and retail sectors would account for the remainder of the impact. A major security event in any subsequent year would have roughly the same financial impact.
2 - NEED FOR ACTION ON THREE FRONTS
Unless civic, city, and federal leaders move quickly and decisively to prevent the projected deficits; DC could find itself facing the return of a control board, or more likely, the need to make dramatic cuts in service levels.
As indicated earlier, we believe that DC must take action on three fronts: reduce costs aggressively through improved management efficiency; explore the potential trade-off between deferring planned tax cuts and achieving the desired growth in the city's population; and seek additional financial relief from the federal government to compensate for the city's remaining structural constraints and burdens.
Reduce costs aggressively through improved management efficiency
DC has already made important strides in improving management efficiency. In 2000, the city identified over $25 million in personnel savings through a combination of retirements, the elimination of vacant positions, and overtime reductions. DC identified another $13 million in savings associated with contract services and equipment purchases.
Our benchmarking analysis and our analysis of DCPS indicate that the city can do even more. Improved management efficiency in four key departments and at DCPS could yield an incremental $110 million to $160 million per year by 2005, a 4 percent decrease in the local funds budget. Likely cost savings opportunities in other areas, including the city's administrative functions, could lead to an even greater number.
Capturing annual savings of $110 million to $160 million per year by 2005 will require a high degree of collaboration among city and civic leaders and aggressive action beginning in 2002.
Explore the potential trade-off between deferring planned tax cuts and achieving the desired growth in the city's population base
Since the $110 million to $160 million in management improvements only begin to address the potential $500 million deficit, DC should also reconsider planned tax cuts. More specifically, the city should explore the impact of deferring certain tax cuts on its ability to increase the size of DC's resident base.
Generally, total individual tax liability for DC residents remains above individual tax liability levels in Maryland and Virginia. Full implementation of the tax cuts provided for under the Tax Parity Act of 1999 over the next several years would make tax liability in DC roughly comparable to that in Maryland and Virginia for most classes of residents (Exhibit 2).
Total tax liability for married couple with $120k annual income*
*Analysis assumes couple rents their residence
Thus DC must weigh the potential short-term benefit of any deferral of
the planned cuts in individual income tax against the risk that higher tax
levels could undermine the city's efforts to increase its population.
Total tax liability for business-services firm with $100M in revenue
Thus deferring planned cuts in corporate income tax rates (or otherwise increasing tax liability for DC corporations) probably does not merit consideration at this time.
As of this writing, it seems that the economic downturn has already triggered the deferral of planned 2002 cuts in individual income tax rates. Moreover, given concern about DC's financial prospects, some are already suggesting the deferral of incremental cuts planned for 2003 and 2004.
Assuming that a deferral of cuts in individual income tax rates planned for 2002 through 2004 would not lead to a significant reduction in the tax base, such action would increase DC's projected revenue by about $150 million in 2005, an increase of about 4 percent.
Seek additional financial relief from the federal government to compensate for remaining structural constraints and burden
Even if the city- is able to capture $110 million to $160 million in savings from management improvements and chooses to defer planned cuts in individual income tax rates for 2002 through 2004, increasing revenue by about $150 million per year by 2005, DC will still face a deficit of about $200 million to $250 million in 2005. This projected deficit would, of course, be even higher if one of the unforeseen events discussed earlier were to occur or if the city were to take on additional improvement projects (e.g., expanding Metro's reach to Dulles airport, revitalizing the city's waterfront) or increase service levels.
To close this gap, DC will need to seek further financial relief from the federal government to compensate for the structural constraints and financial burdens associated with being the nation's capital. We believe that DC has the basis for justifiable federal relief sufficient to avoid the projected budget shortfall.
As we noted in our 1997 report on the city's financial position, the 1997 DC Revitalization and Self-improvement Act was a significant step in the right direction, but it did not address all the challenges associated with being the nation's capital.18 These challenges include the high level of federal and other tax-exempt property in the city, the federal law prohibiting DC from taxing wages earned in DC by nonresidents, and arguably, the cost of providing certain state services for which DC continues to be responsible.19 These challenges have an annual opportunity cost of at least $500 million to $650 million.
The estimated opportunity cost associated with DC's higher-than-average level of federal taxexempt property is about $100 million to $200 million.20 While DC collects no tax revenue from tax-exempt federal property, it must, of course, provide standard city services to this property. Our review indicates that the portion of tax-exempt federal property in DC is significantly higher than the average level of federal and state tax-exempt property in the other cities that we examined.21 DC's overall level of tax-exempt property is also high relative to most of the other cities that we examined.22
The federal law prohibiting DC from taxing the wages earned by nonresidents who work in DC but commute home to the Maryland or Virginia suburbs is another significant structural constraint. We estimate that the prohibition on taxing the wages of nonresidents who work in DC has an opportunity cost of $400 million to $450 million per year.23 The prohibition on taxing nonresident wage-earners is unique to DC and represents a significant burden as nonresident wage-earners account for over 65 percent of the income earned in DC.24
Federal relief to compensate for the $500 million to $650 million annual opportunity cost associated with these two constraints alone would be more than sufficient to avoid the projected shortfall (Exhibit 4).
Federal relief to compensate for structural constraints and burdents would be sufficient to avoid projected shortfall: -High level of federal tax exempt property ($100-200M), -Prohibition on taxing non-residents earning wages in DC ($400-450M), -Other.*Assumes deferral of planned Tax Parity Act cuts in individual income tax rates
We are encouraged by the fact that there are already many viable federal legislative options on the table for providing DC with financial relief (Exhibit 5).
Some of these options, individually or in combination, could provide DC with the magnitude of financial relief required to address the projected deficit.
We believe that civic, city, and federal leaders should work together to identify the best approach to providing the city with the additional federal relief needed to compensate for its remaining structural constraints and burdens.
* * *
No single initiative will enable DC to avoid the $500 million deficit that we believe the city is headed toward in 2005. But, by aggressively improving management efficiency, exploring opportunities to defer planned tax cuts without jeopardizing the growth of the city's resident base, and seeking further relief from the federal government, DC can build on its recent successes and create a sound financial platform for the future.
1. We conducted our analysis between mid-November 2001 and mid-January 2002. Our projections are based on financial data as of January 2002.
2. Our projected deficits for 2002 through 2005 already assume the use of the fiscal 2001 surplus and budgeted cash reserves of $120 million in 2002, $70 million in 2003, and $50 million in 2004, but not the use of contingency and emergency reserves or other earmarked reserves.
3. DC local source general fund revenue grew at a compound annual growth rate of 6.5 percent between 1997 and 2001.
4. This estimate assumes that the Tax Parity Act cuts in individual income tax rates planned for 2002 are not deferred. If we assume the cuts will be deferred, DC revenue for 2002 is running about $40 million below original revenue expectations.
5. Fiscal 2002 revenue levels would fall up to $125 million short of original projections if growth in sales and income tax collections does not return to projected levels until the 4t' quarter of fiscal 2002 and the individual income tax reductions planned for 2002 as part of the Tax Parity Act are implemented. Deferral of individual income tax reductions planned for 2002 would increase DC revenue in 2002 by about $35 million according to DC government estimates.
6. As of January 2002, DC projected that local source general fund revenue would grow at a compound annual growth rate of about 3.5 percent between 2002 and 2005.
7. These Medicaid costs were incurred by the Department of Mental Health and DCPS.
8. Budgeted cash reserves total $120 million in 2002 and $70 million in 2003; cumulative cash reserve for fiscal 2004 totals $50 million. We have assumed no budgeted cash reserve is available in 2005. The projected deficit assumes the use of these budgeted cash reserves and the 2001 surplus, but does not assume the use of contingency and emergency reserves or other earmarked reserve funds.9. Estimated additional expenditures already reflect DCPS's projected efficiency savings of $17 million per year.
10. We have projected that special education students, who currently account for 18 percent of the total student population, will represent 20 percent of the total student population by 2005, the percentage of special education students seen in Boston. This level of growth is somewhat lower than the high growth rate experienced in DC over the last several years.
11. Medicaid is a state-administered program funded jointly by state and federal governments. In DC, the program is locally administered and eligible services are reimbursed by the federal government at 70 percent of prescribed rates. Experts project that Medicaid costs across the country will grow at an annual rate of 8 to 12 percent over the next several years.
12. This annual figure would increase in subsequent years.
13. Peer cities include Baltimore, Chicago, Detroit, Philadelphia, and San Antonio.
14. DC expects to fund 100 percent of its capital improvement plan by 2005.
15. Debt per capita is only one of a number of criteria determining a city's bond rating and access to debt. Others include debt service as a percentage of local fund revenues, macroeconomic conditions, the strength of a city's leadership, and its financial performance.
16. We have assumed that the federal government reimburses 50 percent of these expenditures.
17. For purposes of this benchmarking analysis, we compared DC's costs in health and human services to those in Baltimore, leveraging the 1997 study on this topic by Philip Dearborn and Carol Meyers, "The Necessity and Costs of District of Columbia Services," and compared DC's public safety and transportation costs to those in Philadelphia.
18. Through the 1997 DC Revitalization and Self-improvement Act, the federal government assumed responsibility for DC's prisons and its courts - two services that would not fall on DC's shoulders if it were part of a state. The federal government also increased its contribution to DC's Medicaid costs, took responsibility for DC's unfunded pensions, and provided additional incentives for economic development.
19. We have not attempted to identify and quantify all the structural constraints and burdens associated with being the nation's capital.
20. In estimating the opportunity cost of DC's high level of federal tax-exempt property, we focused on the amount by which DC's level of federal tax-exempt property exceeds the average level of tax-exempt federal and state property in the other cities we examined. The opportunity cost is about $100 million if estimated based on the cost of services and about $200 million if estimated based on foregone tax revenue on DC's higher-than-average portion of tax-exempt state/federal property.
21. Over 25 percent of the assessed value of the property in DC is associated with federal property that is exempt from taxes. This compares to an average of 10 percent federal and state tax-exempt property in the seven other cities we examined (which included Baltimore, Boston, Detroit, and Philadelphia).
22. Over 40 percent of the assessed value of property in DC is tax-exempt, compared to 15 to 30 percent in most of the other cities we examined.
23. We calculated this opportunity cost by estimating the revenue that DC could collect if it were to tax the adjusted gross income of its nonresident wage earners at 2 percent. We believe that this 2 percent rate is a reasonable basis for the estimate, as nonresident commuter income tax rates in the ten cities that we reviewed varied from 0.5 percent to 4 percent of income.
24. The Orphaned Capital by Carol O'Cleircacain, Brookings Institute (1997).
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