Nearly a year ago, the once-proud city of Detroit declared bankruptcy. As a professor, I prefer to analyze a situation once the dust has settled, as I’ve done for the past few months with the Affordable Care Act. The situation with Detroit, the largest municipal bankruptcy in the history of the United States, was more complicated than I expected it to be. Still, there are clear lessons for all of us so this won’t happen to our household, town, state or country.
A very thorough review was completed by the team at the Detroit Free Press. Their primary conclusion is that “elected officials and others charged with managing its finances repeatedly failed — or refused — to make the tough economic and political decisions that might have saved the city from financial ruin.”
Trying to increase revenue by increasing taxes just backfires. The more Detroit raised taxes, the more businesses and people left the city.
In 1969, Detroit doubled the city income tax rate, causing a spike in revenue the first year because people can’t adjust assets and move houses immediately.
By 1973, the revenue was back to what was raised under half the tax rate. By 1974, the revenue raised by the doubling of the tax dropped by 25 percent from the previous year.
The same dynamic occurred when the income tax was later raised by 50 percent, and when new utility and casino taxes were added.
Despite consistent increases in taxes and tax rates, tax revenue actually dropped by 40 percent from 1962 to 2012.
Borrowing money to pay your ongoing expenses is another really bad idea. If you do this, don’t wipe your brow and let out a sigh of relief. This is not a real solution.
Immediately cut your expenses drastically. All borrowed money must eventually be paid back. When an entity such as a government does this, it is a very selfish act because the people who receive the benefit are requiring their own children and grandchildren to pay a debt they did not incur.
There will always be good times and bad times. In good times, it is absolutely critical to create savings and reserves which can then be used during the bad times.
If you spend everything you bring in during a good year, you are setting yourself up for trouble. Since the stock market did very well in the late-1980s, Detroit’s pension became over-funded.
Instead of realizing that money should stay invested for the lean years, the city paid out a “13th paycheck” from 1985 to 2008 to retirees and active city workers. The union pensioners and employees became so “addicted” to this check that it was paid out even in years when the market underperformed.
Today, the city has debt and unfunded pension and health care liabilities of $20 billion. If the pensioners wonder why their retirement benefit will be cut, it is because the money was already paid out for those 23 years.
They slowly strangled the goose that was laying the golden eggs.
Unfortunately, what happened to Detroit can also happen to your household, city, county, state and country. In good economic times, municipalities, states and the federal government should probably save as much as 10 percent of the revenue for bad economic times.
The beauty of this strategy is that it will also reduce recessions. Recessions are compounded now because when the private sector contracts, the public sector does as well because the money that came in during the good times has already been spent.
I am hopeful that the bankruptcy of Detroit will serve as a wake-up call for all levels of government. Illinois is the state to watch because it is most likely to declare bankruptcy. It has taken steps to shrink its deficit, but when you have dug a deep hole you need to start filling the hole, not continue digging at a slower rate. That is true with any person or government in debt.