Investor Alert

Nov. 4, 2021, 11:30 a.m. EDT

‘Trying to strangle local governments’: What happens when states and their cities become adversaries?

Andrea Riquier

Last September, presenting his proposed 2021 municipal budget , Milwaukee Mayor Tom Barrett laid out a somber picture of his city’s finances.

Even before COVID-19 hit, Barrett said, “our budget challenges reached a crescendo.” Just weeks earlier, the city sustained a debt-rating downgrade, in part because it was spending down reserves.

“We’ve [spent those reserves] to maintain our vital services without any growing revenue,” Barrett continued. “This, of course, is a direct result of our relationship with the state of Wisconsin and legislature in particular.”

The state’s revenue had increased 61% over the past two decades, yet Milwaukee would receive $272 million in 2021, less than the $284 million the state shared in 2003 , when the city’s general fund was 25% smaller.

Over the years, Barrett has given up on securing a bigger slice of state revenue and has focused more of his efforts on trying to raise revenue locally. “Finally I said, please take the handcuffs off and let me generate revenue from sales tax,” he said in an interview with MarketWatch.

But the state legislature, citing an opposition on principle to raising taxes, won’t allow that. As its income dwindles, Milwaukee has lost 160 sworn police officers, or nearly 10% of its force, over the past few years.  

“Without a doubt, the most effective defunder of the police in Wisconsin is the Republican-led legislature,” Barrett, a Democrat in office since 2004, told MarketWatch. “I’ve been arguing for years to give me more resources. They’re essentially trying to strangle local governments.”

It’s not unusual for a state legislature to set limits on what cities can do. In the American system of federalism, cities are subsidiaries of the state, and plenty of states have restrictions in place similar to the one Barrett struggles with. But the issue, sometimes called “pre-emption,” is getting more attention as some statehouse moves are increasingly seen as being motivated by politics, or even a racial enmity.

A 2018 National League of Cities report noted that state legislatures had used pre-emption more aggressively in recent years. “Explanations for this increase include lobbying efforts by special interests, spatial sorting of political preferences between urban and rural areas, and single-party dominance in most state governments,” the report said.

More to the point, the report noted, “Recent pre-emption has pitted rural- and suburban-dominated state legislatures against cities with large populations of low wage earners and ethnic minorities.”

Milwaukee is a majority-minority city, according to data from the Census Bureau , and about 25% of its residents live below the poverty line. It votes decisively Democratic . The state legislature, in contrast, is heavily Republican , and overwhelmingly white. (In last November’s elections, Democratic candidates for the state Senate and Assembly won 47% and 46% of all votes, respectively, but secured just 38% of seats in each chamber. )

Asked whether he thought the legislature’s actions were racially motivated, Barrett said, “I hope not. I think it’s a winning political philosophy for the rest of the state to be pitted against Milwaukee and Madison,” which also leans Democratic but is much whiter.

“Pre-emption happens all the time,” said Matt Fabian, a partner with Municipal Market Analytics. “It becomes an issue when nonrational reasons drive decisions or where the state sees the city or its residents as an adversary. There can be a certain tribalism that hinges on race or how people vote.”

Fabian, whose firm offers research for municipal bondholders, calls politically motivated pre-emption “an underappreciated risk in the muni-bond market. In general when cities default it’s less about finances and more about what the state does to not help the city navigate a situation. The political factor, the relationship and potential antagonism between a city and its state, is widely underinvestigated.”

Municipal-bond defaults are vanishingly rare , but conflict between city and state is a common thread in many recent episodes of municipal distress, which have often occurred in places where the city’s residents are primarily Black.

Many public-finance observers believe Detroit was hustled into its 2013 bankruptcy by a state government intent on imposing its will on the citythe same dynamic that caused years of financial distress and a public health emergency in Flint, Mich.

From the archives (July 2013): Detroit’s Chapter 9 filing sets stage for biggest-ever U.S. municipal bankruptcy

Two years before Detroit, what was then the largest municipal bankruptcy in American history took place in Jefferson County, Ala. The state Supreme Court ruled a county occupational tax unconstitutional — “pointlessly,” in Fabian’s words — a step that ushered it into insolvency.

Starving the beast

Napoleon Wallace and Activest, a research firm he co-founded, are working to price what it calls “fiscal justice risk” in the municipal market.

Read: A new investing strategy aims to influence racial justice, from the ground up

“When state legislatures limit the agency and capacity of local government to meet the demands of their residents, the result is generally a broken fiscal environment that harms communities of color and restricts [cities’] ability to operate in the best interest of their residents,” Wallace said in an interview.

He pointed to not just the high-profile fiscal blowups of Detroit and Flint , but also Ferguson, Mo., and Louisville. And he doesn’t agree, he said, that state-level policy has what’s often called “unintended consequences.”

“In a lot of areas, the role of state pre-emption and the ability to limit taxing at the local level is a very well-constructed apparatus that allows for gerrymandered state legislatures to impose their will on diverse cities,” he said. When states limit cities’ policy-making abilities, “you make it hard for progressive interests even when they have support among residents. You hamper their ability to finance progress.”

The conservative notion of “starving the beast” — limiting taxation both for its own sake and so that governments don’t have revenue to spend on programs –– isn’t new . But it gained a foothold on the state level in the past decade or so, perhaps most notably when supply-side crusader Arthur Laffer began advising Kansas Gov. Sam Brownback.

Kansas tax cuts enacted in 2012 blew a hole in the state’s budget, its economy and its bond rating, as the legislature cut funding to higher education, public schools, transportation and more. As Wallace noted, more often than not, the stripping away of social safety nets has a disparate impact on communities of color.

Don’t miss: Wisconsin Gov. Tony Evers clawing back Foxconn state tax breaks

The fault lines of inequality exposed by the COVID-19 pandemic have also thrown the pre-emption issue into starker relief. A 2020 report from the left-leaning Economic Policy Institute notes that legislative moves are “disproportionately harming the same communities that have been pre-empted from taking local action, limiting their ability to effectively combat the public health crisis.”

The report, which focuses on the South, characterizes pre-emption as “embedded in a racist history.” Pre-emptive laws “are passed by majority-white legislatures and tend to create barriers to economic security in cities whose residents are majority people of color.”

Throughout the pandemic, state lawmakers have pre-empted local measures, like masking policies or shutdown orders, that would help keep vulnerable people safe, even as people of color were more likely to be “frontline” workers or employed in jobs that didn’t allow them to work from home, the report notes.

A just-released report from the Pew Charitable Trusts looks at the limitations states impose on local taxation through the lens of the COVID economic downturn.

“The pandemic has created significant economic uncertainty for local leaders, with many experiencing large revenue shortfalls that make balancing budgets all the more difficult,” the Pew report notes.

“When local governments struggle, states pay a price, too — because of lost jobs, reduced tax collections, diminished services and, in extreme cases, costly state bailouts. To minimize harm during economic downturns and support localities’ financial stability over the long term, states could review any policies that restrict local budget flexibility.”

See: In one chart, how U.S. state and local revenues got thumped by the pandemic — and recovered

But to Barrett it’s ironic that Wisconsin finished fiscal 2021 with a $2.6 billion surplus , and expects an even larger surplus in 2022, yet legislators can’t find a way to share any of that with locals. And lawmakers don’t seem any more inclined to “review” their restrictive policies than they were before the pandemic.

“They have a surplus, and they won’t throw us a bone,” Barrett told MarketWatch. “They’ve won. They strangled us. We don’t have much left.”

Read on: What good is a commuter tax in a work-from-home world?

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