For states, there may be good reason to stop cities from going bankrupt

Researchers find that states with programs that make it harder for cities to go bankrupt see several benefits, including economic stability.

What happens when a city can’t pay its debt? In some states, the city could file for bankruptcy. That’s been done across the country, in Detroit, San Bernardino, Central Falls, Rhode Island, and other municipalities.

But some states, including New York, New Jersey, Ohio, and Pennsylvania, try to intervene before that happens. Now, research from the University of Notre Dame and the University of Illinois finds that states with programs that make it harder for cities to go bankrupt see several benefits, including economic stability.

The draft study finds that programs that stand in the way of municipal bankruptcy prevent “contagion,” the ripple effects that a bankruptcy could have on the rates other municipalities pay to borrow money. In contrast, the study finds, in states that allow their municipalities to file for bankruptcy with no barrier, the cost of borrowing increases for at least a year.

Avoiding contagion is part of the purpose of Act 47, a Pennsylvania law passed in 1987 to help cities avoid bankruptcy. Under the law, Pennsylvania administers a program that allows municipalities to modify their tax codes and seek aid from the state. The idea is to give these local governments a chance to get their finances straight, because even one local bankruptcy could cause ripple effects throughout the state.

Former Pennsylvania Governor Ed Rendell made that case in 2010, when Harrisburg was on the verge of missing a $3.3 million bond payment. Doing so, Rendell said, “would devastate not only the city, but the school district, the county, and Central Pennsylvania’s reputation as a great place to live, work, and play.” Instead, the city entered Act 47, and the state helped with the bond payment.

The study found another benefit of programs like Act 47: in states that have them, municipalities pay less when they borrow money than they would in a state that just lets its municipalities go bankrupt.

There is a potential downside to these rehabilitation programs; in some cases, states take on the risk that their cities won’t be able to pay their debts. That means the borrowing costs for the states themselves actually increase, the researchers found.

That’s not the case in Pennsylvania. Although the state sometimes gives loans to municipalities or participates in their financial deals, the state doesn’t directly guarantee local debt, says Joe Boyle, senior research associate at the Pennsylvania Economy League. “We don’t take on their credit, we don’t take on their debt, and we don’t put ourselves in their place,” Boyle said. “We do assist them in trying to get their fiscal house back in order.”

Even though filing for bankruptcy might seem less complicated than participating in a program like Act 47, it’s not necessarily, Boyle said. “One of the things we’ve learned in our Act 47 work and in looking at the general issue of bankruptcy is that Chapter 9 is a very difficult process,” he said. “It’s expensive, it’s time consuming, and we’re not sure that it ultimately benefits a municipality.”

Bankruptcy also carries a stigma, and cities will want to avoid that, he said.

Despite the upside of Act 47, not everybody’s a fan of the program; some charge that it’s been ineffective and is difficult for cities to leave. There are currently 17 municipalities in the program. Twelve municipalities have exited since the Act 47 law was passed in 1987.