Inflation is taking a toll on city budgets

Even with rising property and sales tax revenue, cities are planning for tighter spending

Photo by ben o'bro on Unsplash

Happy Finance Friday, readers! Yesterday, the National League of Cities (NLC) released its annual survey of city fiscal conditions, which highlighted how cities have managed spending and revenues through the pandemic recovery, as well as the economic uncertainty ahead.

“With ARPA [American Rescue Plan Act] funding set to expire in 2026, the question remains whether cities will be able to fully maintain the investments made with their ARPA funds using their own sources of revenue,” said NLC Executive Director Clarence Anthony in the forward to the report.

In this week’s newsletter, I’ll outline the key takeaways on city fiscal conditions and talk about why one perennial budget issue may be currently flying under the radar.

Inflation is wiping out revenue gains

The report notes that “higher than-expected sales, property, and income tax revenues, over the last two years have helped local governments balance their budgets and invest in critical public services, maintenance, and infrastructure.” In fact, total revenue in 2022 grew by 6% when compared to 2021.

• Philadelphia’s total revenue grew by a whopping 20% thanks to tax revenue increases and locally generated non-tax revenue. 

• Similarly, Albuquerque saw a revenue increase of 16%, primarily due to elevated sales tax receipts and a surge in property tax collections.

But when adjusted for inflation, the picture’s a lot different. In real terms, total city revenues have declined for three straight years and are expected to fall further — by 2.4% — in 2023.

It’s a far different picture than the record revenue growth states have enjoyed. So, what gives?

A lot of it has to do with the economic cycle of cities’ two main revenue sources: sales and property taxes. (About 10% of cities tax income, so we’re going to ignore that revenue stream right now.) Sales taxes are more responsive to the economy’s ups and downs while property tax revenue tends to lag the economic cycle by at least 18 months.

So, in 2020 property taxes still increased while sales tax revenue plummeted. The next two years, it was property taxes that fell while sales taxes dramatically increased. This year, property taxes are on the mend, but guess what’s falling again?

On the one hand, having revenue streams on different economic cycles means that city budgets don’t feel the full impact of a downturn all at once. But it also means cities need three or more years of economic stability before sales and property tax revenues are reliably in the black.

Big picture: These numbers show how pivotal Covid relief funding has been for cities. Without that money, it would have been much tougher for cities to adjust their budgets to respond to the needs of their community. 

There's also reason to believe cities have turned the corner. Farhad Omeyr, NLC’s head of research, said during a webinar Thursday the ultra-cautious budgeting approach adopted by many cities in 2023 may pay off. “The hope is that moving forward,” he said, “with most of the economists hoping for a soft landing in the economy rather than a recession, governments will end up in a better fiscal situation next year.”

But in this report, there’s a big red flag when it comes to budget pressures that is slipping under the radar: pensions.