Midwest Economy Blog

Alternative financing for state and local governments: Do ‘managed competition’ and asset sales or leases make sense?

February 24, 2012

State and local governments are finding themselves in a fiscal bind. According to the National League of Cities’ annual fiscal survey, city governments report that their general revenues will decrease by 2.3% in 2011 and they anticipate a further decline in 2012. In particular, property taxes are falling (estimated to decline by 3.7% in 2011), with additional declines expected in 2012 and 2013. Compounding matters for local governments is the fact that their tax revenue declines are coupled with decreasing or frozen aid from state and federal governments.

State governments don’t seem a whole lot better off. The Center on Budget and Policy Priorities estimated that 29 states face budget gaps for fiscal year (FY) 2012, totaling $44 billion; and it expected this total budget gap to grow throughout the spring as revenue growth slows. This comes in the wake of the previous four years during which cumulative deficits reached $500 billion.

Given this stress on core revenues, it isn’t surprising that state and local governments may be looking to unconventional financing measures to shore up budgets. Two ideas that are frequently mentioned are “managed competition” (the idea of allowing existing government services to be competitively bid out) and asset sales or long-term leases. In the case of managed competition, discrete government services are put up for bid and often existing government units are allowed to bid against outside providers for providing a service such as collecting trash or processing permits or licenses. In the case of asset sales or leases, the idea is to immediately monetize the value of a particular asset that in many cases is not directly related to the core function of local government. In both cases, a clear objective is to improve the efficiency with which either a program or an asset is managed and to free up resources for government to focus on central operations. For example, in the case of Chicago’s lease of the Chicago Skyway, a guiding question was should the city be operating a toll road (i.e., would a city government be more efficient at operating a toll road than a private company and could resources devoted by a city government to maintaining a toll road be better spent elsewhere).

On March 14, the Civic Federation and the Federal Reserve Bank of Chicago will co-sponsor a conference called Beyond Parking Meters—The Future of Public and Private Partnerships in Illinois. (for agenda and registration– click here). This half-day conference will examine how local and state governments should approach these types of alternative financing and what the pros and cons of these types of arrangements are. Specifically, the program will examine what types of government activities might be best suited to competitive service delivery, as well as what management and labor have learned from such programs. In examining asset sales and leases, key questions will include how to properly value public assets and structure and manage either an asset sale or lease to ensure that taxpayers are protected.

Fortunately, several previous studies are available to help guide any discussion about the privatization of either a public service or an asset by a government. In 2010, the Chicago Council on Global Affairs’ Emerging Leaders Program issued a report titled “No Free Money: Is Privatization of Infrastructure in the Public Interest?”

The key findings from the report were:

  • Financial realities mean that privatization will continue;
  • An effective policy would balance financial and equity consideration and define what constitutes “the public interest”; and
  • Privatization is neither good nor bad but an economic tool that can be used well or badly.

In addition, the report suggests that proper oversight is critical for evaluating the long-term impact of any privatization. A concern is while the upfront savings might be significant, privatization may constrain future government actions. In the case of an asset sale, the asset can only be sold once, and after the proceeds from the sale are spent, future programs might be in jeopardy if they had previously relied on the revenue stream that the asset produced when it was owned by government. Similarly, there may be equity concerns if public access to an asset (such as a toll road) is suddenly limited by higher tolls imposed by the private firm now managing the asset.

When it comes to managed competition, the Government Finance Officers Association (GFOA) issued a best practice statement in 2006.

The statement lists key factors in considering managed competition: service level, cost, efficiency, effectiveness, quality, customer service, and ability to monitor the service providers’ work. The statement emphasizes the need to address stakeholders’ concerns and, in particular, to correctly estimate the in-house versus outsourced cost of providing the service. To do this correctly GFOA suggests governments address the following four factors:

  • Determine and use a service definition that includes an analysis of service levels and performance standards to be used.
  • Calculate the in-house costs that could be avoided in outsourcing the service. An important element includes estimating the direct and indirect costs related to the service. In some cases, some indirect costs may still exist even if the service is contracted out.
  • Estimate the total costs of outsourcing, including the contractor’s bid price, the government’s contract administration costs, any transition costs, and any impact the contract might have on revenue.
  • Finally, compare the cost savings from contracting out with the costs incurred to evaluate whether the savings will be significant.

A final source for framing privatization issues comes from the Illinois Commission on Government Forecasting and Accountability. The commission’s report titled “Government Privatization: History, Examples, and Issues” does a particularly good job at providing national and international examples of privatization and describes common measures for correctly valuing assets, such as appraising the net present value, estimating the internal rate of return, and calculating the weighted average cost of capital. These technical measures are critical to getting the valuation of the asset right.

Clearly, local and state governments will increasingly look to alternative financing structures over the next several years to help balance their service and revenue needs. Making alternative financing arrangements correctly requires appropriate accounting and asking the right questions at the beginning of the process. If you would like to find out more, please join us on March 14.

The views expressed in this post are our own and do not reflect those of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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