The case for more federal oversight of state and local budgets

Hundreds of billions of dollars for pandemic recovery, infrastructure projects, economic development and climate programs that Congress and President Biden have approved for states, cities and counties during the past two years has drawn a great deal of attention.

But even before the Covid-era spending boom, the federal government was directing more than a $1 trillion annually in grants and tax incentives toward states and localities, as a new report from the nonprofit Volcker Alliance points out. Despite that degree of financial aid, the authors of the report argue that Congress and presidential administrations have "demanded surprisingly little in continuing, high-level oversight" of state and local budgeting and borrowing.

The report goes on to make a case for why it's time for lawmakers and regulators to tighten up standards around state and local government finance, and it offers recommendations for how they can go about it.

For one, the alliance says the federal government should provide states and localities incentives to switch to producing budgets with what's known as a modified accrual-based system, used under Generally Accepted Accounting Principles, or GAAP. Currently, most governments rely on "modified cash" or cash-based techniques.

Cash-based accounting methods are fairly straightforward, with revenues and expenses recorded when they're received and paid. The accrual approach, on the other hand, counts income once it can be accurately estimated and is expected to be received within a set period of time, while expenses are tallied as they are incurred.

"Annual cash budgeting allows governments to make short-term spending decisions without accounting for their medium-to-long-term implications, which opens the door for fiscally unsustainable tactics to achieve balance," the report says. 

Examples of those tactics, according to the authors, include maneuvers like shifting revenue and expenses between years, skipping pension payments and borrowing to cover operating expenses. Today's usual budgeting techniques also allow for governments with giant pension fund shortfalls, or worn out infrastructure that will eventually require large sums to upgrade, to claim that their budgets are balanced despite those long-term unfunded costs.

The report also suggests that federal lawmakers should take a more active role in overseeing the roughly $4 trillion municipal bond market. Muni bonds are the primary financing tool used for most of the nation's public infrastructure. A federal tax exemption for interest earned on the bonds serves as a subsidy to keep rates lower for government borrowers, but will also cost the U.S. Treasury about $382 billion in lost revenue over the coming decade, according to the report.

Matt Fabian and Lisa Washburn of Municipal Market Analytics, two of the nation's leading voices providing insight on municipal finance issues, authored the report. They distilled their recommendations for discussion and possible reforms into a six-point agenda listed below (more detail on each component can be found in their report).

1. Set goals for sustainable state and local budgetary disclosure.
2. Require a credible estimate of how a budget will change a state or local government’s long-term liabilities.
3. Provide regulatory or statutory financial incentives for a transition to GAAP or modified accrual-based state and local budgeting.
4. Consider bringing state and local financial disclosure more in line with the type and frequency of information provided in the corporate market, as appropriate to issuers.
5. Weigh compelling states and localities to hew to common disclosure practices in annual financial reports.
6. Encourage voluntary cooperation with regulators by state and local governments, whether or not governments borrow in public capital markets.

Fabian and Washburn say tackling these issues could improve transparency into government finances for residents, businesses and bond investors, strengthen the fiscal stability of states and localities, and help to prevent financial problems at all levels of government.

They acknowledge that the types of changes they're recommending could "take years to achieve and will not be cost-free." But they add, "further discussion of—and action on—these pressing issues is vital" and "may be worth a considerable investment of time and money."

The Volcker Alliance is a good government group, named for the late Federal Reserve chairman Paul Volcker, that promotes a slate of state and local budgeting best-practices among other initiatives.

"For too long, the federal government has maintained an indifferent posture on oversight of or uniformity in state and local budgeting and borrowing practices despite doling out over a trillion dollars a year in aid," William Glasgall, senior director of public finance at the alliance said in a statement. "Now is the time for Congress and regulators to step in and implement sound, sustainable budgeting and borrowing practices nationwide," he added.

The group's report comes after Biden signed a law last month that will require states and localities to report financial data in a standardized, machine-readable format–as opposed to publishing it in PDF documents as many now do. The law directs the Securities and Exchange Commission to set the specifics for these new standards and calls for states and localities to comply with them by 2027.

This change, while far-less sweeping in scope than what is floated in the Volcker report, drew opposition from local government groups, like the National League of Cities, who criticized the new requirements as an "unfunded mandate" imposed by the feds.

A full copy of the new Volcker Alliance report can be found here.