Monitoring local government fiscal health: Michigan's new 10 point scale of fiscal distress.

• Author: Kleine, Robert

In difficult economic times, state and local governments become increasingly cognizant of balancing their budgets and avoiding fiscal difficulties. Yet it is often difficult for states to assess the fiscal conditions of their localities and, more importantly, to recognize local difficulties before they become severe. While nearly a third of states report using indicators to monitor the fiscal health of their local governments, a number of these states report some level of dissatisfaction with their performance. (1) One of the states that uses indicators but is seeking to improve them is Michigan.

Michigan has two laws (Public Act 70 of 1990 and Public Act 34 of 2001) intended to provide an early warning of fiscal distress. Together, these statutes contain 30 triggers that, if tripped, initiate a review process that can ultimately result in a state takeover of local government finances. In some cases, however, state officials were not alerted until serious difficulties had already occurred. To remedy this situation, the Michigan Department of Treasury contracted with the Institute for Public Policy and Social Research at Michigan State University to identify new measures that could better predict fiscal distress. (2) This article outlines the composite devised for Michigan and how it builds on previous work, including a composite measure proposed by Ken Brown and published in the December 1993 issue of Government Finance Review. (3)

SHORTCOMINGS OF MICHIGAN'S INDICATORS

Michigan's set of 30 indicators was viewed as ineffective on many fronts:

* Frequent, publicly available, and uniformly collected data do not exist for many of the triggers.

* Most of the triggers do not have theoretical validity, but instead focus on technical violations or requests for review.

* There is no degree of proportion reflected by the 30 triggers in the two acts. If a government is violating lust one of these conditions (by perhaps being a month late in delivering a financial report), then it appears to be as technically "fiscally distressed" as one that is in violation of several and more serious triggers. This provides little ability for early warning, since there is no sense of gradation in the level of distress that a government is experiencing.

* In terms of early warning, Michigan's indicators do not appear reliable from either a Type I (false positive) or Type II (false negative) standpoint. False positives could easily occur, and units headed for trouble could routinely escape detection even as they are headed for a fiscal emergency.

* Several, if not most, of Michigan's indicators are more suited to defining rather than predicting fiscal distress. By the time many of these triggers are violated, the government is in serious fiscal straits.

Although several other measures of fiscal distress were available, many suffered from limitations that prohibited their use for Michigan's purposes. (4) One of the measures that most closely approximated Michigan's needs was that presented by Brown 10 years ago in Government Finance Review. (5) In the few states that monitor and evaluate local government financial condition through ratio indicators, Brown's index has been explicitly acknowledged as influencing their system.

BROWN'S 10-POINT TEST

Brown suggested that 10 ratio measures be computed, equally weighted, and aggregated to provide an overall picture of a government's financial condition. Exhibit 1 shows the formulas for computing each of the 10 ratios. The ratios are computed for all of the local governments in a state and then assigned to quartiles. Governments receive points for each ratio depending on the quartile in which the ratio falls: two points for each ratio in Quartile 4 (75 to 100 percentile), one for Quartile 3(50 to 75 percentile), zero for Quartile 2(25 to 50 percentile), and minus one for Quartile 1 (0 to 25 percentile). Under this grading system, governments can earn as many as 20 points or as few as minus 10.

Brown's financial condition test provided a positive innovation in that it attempted to provide an overall assessment of local government financial condition using a straightforward test based on generally available data. While this test most closely approximated Michigan's needs for an early warning system, numerous practical and theoretical difficulties required that the state seek a different tool. Here we discuss some of the limitations of Brown's model.

Relativity. Brown's test rewards or...