Explainer: Municipal bankruptcy

Why states can’t — and Pennsylvania municipalities don’t — declare bankruptcy

Puerto Rico has spent the last few decades getting deeper and deeper into debt, to the tune of $70 billion. The background story will sound familiar to anyone in Pennsylvania: declining tax base, billowing pension obligations and social service costs, and bad deals made by local leaders.

Speaking at the Brookings Institute in July, Puerto Rico Governor Alejandro Garcia Padillo said his territory’s experiences should serve as a wake-up call for U.S. states.

“We are only ahead of the curve — the curve that looms for many states and municipalities. We are forced to try the route that others have not tried before, to knock on the doors that others may need to approach in the not-so-distant future,” he said, according to Governing.

Puerto Rico received a federal bailout. There were few other options, since territories, like states, can’t file for bankruptcy. That, Padillo says, is the crux of the problem.

Pennsylvania is staring down a $2 billion budget deficit and the second most underfunded state pension system in the country, short $50 billion. With growing mandated costs, like Medicaid and pensions, and a hesitation by the state legislature to raise taxes, that number could continue to grow over time.

The commonwealth is one of a handful of states with budget deficits in the billions, joining the likes of Alaska, Illinois and Louisiana. What would happen if Pennsylvania’s debt grew so large that it couldn’t pay the bills?

Why states can’t go bankrupt

There are some legal reasons. For one thing, Chapter 9 bankruptcy wouldn’t apply, as states are their own sovereign governments, not legal corporations like municipalities. Also, if a state declared bankruptcy, it would be under control of a federal court, which would violate the state’s rights clause in the Constitution.

And then there are financial concerns, like the municipal bond market. States can borrow at reasonable rates because the investments are secure — there is no mechanism to allow them to default. If states are allowed to go bankrupt, that security disappears across the board.

As independently governed, taxing entities, states should have the tools to overcome financial distress. Former federal reserve chair Ben Bernanke isn’t alone when he argued, in 2011, that most state funding issues are political more than financial. Offering bankruptcy protection could reduce the pressure for decisive budget action.

Coming out of the Great Recession, legislators and analysts seriously discussed the possibility of allowing states to declare bankruptcy. Advocates for state-level bankruptcy would like to avoid the Puerto Rico outcome, where the federal government intervenes with a bailout at the expense of the other fiscally-solvent states.

Former Speaker of the House Newt Gingrich told Bloomberg, “We want to cut off the politicians from assuming that at the end of their wild overspending they can just dump the responsibilities on other taxpayers.”

Gingrich and Jeb Bush wrote an op-ed in 2011 called “Better off bankrupt,” in which they appealed for a change in bankruptcy law. They wanted states to be allowed to voluntarily enter into bankruptcy, renegotiate their debt payments with lenders and dissolve their contractual pension obligations to unions.

Municipal bankruptcy

If Puerto Rico is the example of state-level debt, Detroit is the prime example of municipal bankruptcy. In 2013, Detroit entered Chapter 9 bankruptcy, making it both the largest U.S. city to file for bankruptcy and the one with the largest municipal debt to enter the proceeding at $18.5 billion.

The same year, the city of Stockton, California filed for bankruptcy, due to ballooning city costs and a declining housing market and tax base. In 2011, Jefferson County, Alabama, home to the city of Birmingham, filed for bankruptcy after an expensive sewer system upgrade that resulted in municipal bond debt.

Underfunded pensions, declining tax base, expensive infrastructure improvements — these problems will sound all too familiar to people in Pennsylvania cities. But there have only been two bankruptcy filings in the commonwealth since the 1994 Bankruptcy Reform Act (which required municipalities to get specific permission from the state to file): Westfall Township in 2010 and the City of Harrisburg in 2011.

Harrisburg entered bankruptcy proceedings due to a failed incinerator investment that resulted in $300 million in debt for the city. There were other issues that had plagued the city for decades, like a shrinking population and a large number of tax-exempt government buildings, but this major debt put the city under water. The decision was controversial: the mayor at the time, Linda Thompson, disapproved, saying bankruptcy would be a blemish on the city and raise borrowing costs.

The city council filed without her vote, saying it was a better alternative than selling off all the city’s revenue-generating assets.

Ultimately, the filing was dismissed since Harrisburg had not sought specific permission from the state to begin bankruptcy proceedings. The city entered receivership and had to do what it once sought to avoid, sell off the incinerator and lease out parking garages.

Pennsylvania’s plan to avoid bankruptcy: Act 47

With all the challenges facing Pennsylvania municipalities, why have so few of them filed for bankruptcy protection? The answer lies in the state’s program to assist and protect municipalities in distress, called Act 47.

As we’ve reported, Act 47 allows a municipality to modify its tax code, revert to Home Rule and seek aid from the state. Cities have five years to exit Act 47 or they are in danger of entering receivership. Harrisburg is the only city to enter that stage so far.

The program is intended to help cities avoid bankruptcy. There are 18 municipalities in the program currently, and 11 have exited the program successfully. While that doesn’t always mean the city is booming, it usually means they are back on firm ground financially — and far from bankruptcy.

But Act 47 doesn’t allow the same “Get Out of Jail Free” card that bankruptcy can. For example, the municipality is still responsible for union obligations, a lesson the city of Scranton learned the hard way.

The city believed, incorrectly, that Act 47 took precedence over union contracts for police officers and firefighters. City leaders cut salaries and capped longevity pay in 2002. A decade later, the state Supreme Court ruled in favor of the unions. After years of negotiations, the city recently agreed to pay $30 million in backpay to officers and firefighters.

In an effort to move further from the possibility of financial insolvency, Scranton has also leased out parking garages and sold the sewer system to a private investor, an unpopular but common move among distressed cities. Some residents, like local activist Gary St. Fleur, author of SaveScranton.com, would rather see the city file for bankruptcy.

But as the city of Harrisburg learned, though, that’s not happening without the permission of, well, Harrisburg.