Flatlined - Harvard University

IBM Global Business Services White Paper

Flatlined Rethinking the local government business model for a future of zero revenue growth

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Flatlined: Rethinking the Local Government Business Model for a Future of Zero Revenue Growth

Table of contents Executive summary

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The local government business model

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The business model 101 Is the business model of cities broken?

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Fixing the business model: How cities can shape a sustainable future 13 A new focus on the top line: Make revenue growth an explicit strategic goal Take an ROI approach to spending, supported by advanced analytics Reduce operating costs and improve performance Invest in infrastructure using funds generated from operating savings

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Conclusion 18 IBM and smarter government

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For more information

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About the authors

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Footnotes 19

IBM Global Business Services

Executive summary Over 80% of Americans now live in cities. As Edward Glaeser points out in his recent book The Triumph of the City, the future prosperity of the country (and the planet for that matter) is inextricably tied to the health of our urban areas. Yet little national attention is being focused on the dire fiscal condition of our cities. Without question, we need highly functioning and financially stable municipal governments if we are to have confidence in the nation’s future. We believe that the financial stability of our cities can be restored, but it will require the adoption of a new approach to how local governments are organized, managed and motivated. The Congressional Budget Office estimates that the Federal Government will run an annual structural budget deficit of between $500 and $700 billion dollars over the next ten years. The nation’s debt and the threat that it poses to the country’s long-term prosperity was a prominent issue in the 2010 elections. Last year, the National Commission on Fiscal Responsibility and Reform issued a report that asserted that “if we do not act soon to reassure the markets, the risk of a crisis will increase, and the options available to avert or remedy the crisis will both narrow and become more stringent.”1 This fear of a financial crisis is shared by virtually every prominent economist, many of whom warn of the serious economic consequences for the country of a failure to aggressively confront its spiraling national debt. Almost unremarked upon in this conversation is the fact that the Government Accountability Office (GAO) estimates that local governments will run an average annual deficit of $225 billion over the next ten years, which is approximately 12% of their total spending (see Figure 1). No national commissions have been formed. No major economists are issuing warnings that these deficits will undermine the national economy and America’s global competitiveness. Yet the shortfall in local government funding rivals the Federal deficit in size and potential impact.

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Percent of GDP 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0%

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Source: Czerwinski, Stanley J., and Thomas J. McCool. Rep. no. GAO-10-358. State and Local Governments' Fiscal Outlook: April 2011 Update. United States Government Accountability Office, April 2011.

Figure 1: State and Local Budget Deficits

Local governments constitute 7% of our national economy and employ nearly one out of every ten Americans. These governments are generally required to balance their budget each and every year. In order to close budget deficits and balance their budgets, local governments have been laying off teachers and police officers, shuttering parks and pools, and canceling or postponing much-needed investments in public infrastructure. If local governments eliminate the projected $225 billion annual deficit by cutting spending, it will act as a drag on the national economy of nearly 2% of GDP per year. At a time when the private economy is struggling to create jobs, the contraction of local governments is acting as a considerable drag on the economy. Restoring the fiscal stability of local governments should-in our view-be a national priority. Our nation needs financially sustainable cities that can make the investments needed to support future growth and job creation. The question is how.

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To begin with, local governments need to recognize that the root causes of their problems are structural and not simply a result of the national economic slowdown. In other words, the local government business model is broken: the infrastructure and services that local governments are expected to provide cannot be financed based on existing revenue streams and current approaches to government operations.

5. Apply the savings generated by efficiency programs to invest in neglected infrastructure. This will allow cities to rebalance spending on capital and services after decades of starving infrastructure to fund services. Revitalized infrastructure will provide new productive capacity that will spur future growth in private investment and residential populations.

Municipal governments need to transform their business models. To ensure that they are fiscally sustainable over the long term, cities need to:

The local government business model 101

1. Focus on revenues by making revenue growth an explicit strategic goal. They need to adopt policies and programs that drive improved top line performance.

A business model is the means by which any organization achieves its mission by investing in a series of activities that produces something of value that someone is willing to pay for.

2. Adopt a return on investment approach to all spending, supported by advanced analytics. Local governments need to evaluate alternative capital and operating spending options in terms of their impact on their fiscal sustainability. All expenditure decisions should be based on their long- term net impacts on revenue and expenses. The ability of local governments to do this has deepened dramatically with the expansion in available data and the ability to apply advanced analytics to that data. Most cities already have the data; they just need to turn it into insights that can drive decision-making.

What does the local government business model look like? Something like this:

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Restructure long-term operating cost structures by institutionalizing efficiency and effectiveness programs. Drive continuous improvement in capital and labor productivity across the local government enterprise.

4. Recalibrate service levels as targeted outcomes are achieved. Cities need to assess how their investments deliver targeted outcomes and adjust those investments over time as those outcomes are achieved.

Since the local government business model is broken, it might be helpful to define what it is we mean by 'business model':

A local government achieves its mission (of improving the quality of life of its residents) by investing in a series of activities (public infrastructure and municipal services) that produces something of value (desirable municipal outcomes) that someone (residents) are willing to pay for (through taxes and user fees). Revenues

Local government revenues are almost entirely dependent on the level of economic activity conducted within their geographic footprint (see Figure 2). The largest source of revenue is property taxes. Property taxes are based on property values, which are in turn dependent on the demand for property in the jurisdiction. If people want to live and work in your city, property taxes will grow. If they don’t, then property tax revenue will stagnate or decline.


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* Excluding Federal and State Support. Source: Bureau of the Census, State and Local Government Finance Summary Report, 2008.

Figure 2: Locally Generated* Revenue Sources for Local Government

Sales taxes are based entirely on the amount of commerce that is being conducted locally. The growth in retail sales are basically dependent on population growth (the more people buying, the more sales generated); income growth (the more money people have, the more they are likely to spend); and the size of the commercial base (you want that money spent inside your city). If a city’s population is growing and prospering and it has robust commercial districts, then sales tax revenues will increase.

Of course, local governments have strong incentives to keep tax rates and fee levels low. Cities operate in competitive environments and residents and businesses can move if the local tax burdens are too high. In other words, cities need to balance their need to grow their revenues to finance their business models with the effect that rising tax burdens will have on the economic activity upon which they depend. Operating expenses

Operating expenses are those direct costs that are incurred to deliver services. Local governments are in a wide variety of businesses (see Figure 3). Most of these businesses are labor-intensive. In that sense, spending on services is a primarily a consumption activity – once the funds are spent there is no remaining asset.

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The good news is that local governments have some flexibility to determine how much revenue they can extract from the local economy. They are usually free to set property tax millage rates, for example. They can also add new sources of revenues if they elect to (although in many cases they need authorization from their State governments).

Housing & Community Development Transportation Debt

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In some service areas, such as schools and human services, State and Federal sources of revenue play a critical funding role. But as most mayors will tell you, relying on those sources of revenues as a means to achieve a secure fiscal future is not a wise strategy. Ultimately, local governments must stand on their own feet.

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Source: Bureau of the Census, State and Local Government Finance Summary Report, 2008.

Figure 3: Local Government Expenditures

Operating expenses also take several forms. First, there are those operating expenses associated with capital investments. Streets need to be maintained, traffic lights need to be repaired, schools need to be heated. Once a city chooses to make a capital investment, it is usually choosing to take on an operating expense as well. Too often, the scope and scale of the operating expense is not adequately accounted for in future spending plans.

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Second, there are operating expenses associated with direct services. Police officers respond to 911 calls. Teachers stand in front of students. These expenses are where the bulk of labor costs reside, and they have an important longitudinal element to them. When cities hire these workers, they are simultaneously making a long-term commitment in the form of health care and retirement benefits. These long-term liabilities create funding demands not unlike those associated with capital investments. Finally, there are overhead expenses. These are expenses associated with management and operations that are not directly tied to service delivery (although they are often critical to the efficient and effective delivery of those services). These include back office operations such as finance, human resources, and information technology. Capital expenses

Capital spending generally takes three forms. First, local governments need operating capital. Firefighters need fire engines, corrections departments need prisons, judicial agencies need courtrooms, and so forth. The primary purpose of this type of capital spending is to enhance the productivity of the labor it is intended to support. Since nearly 80% of local government service delivery cost is labor related, the effectiveness of the capital spending upon which labor depends is a critical driver of the overall efficiency of the government. The second type of capital spending is public infrastructure. Public infrastructure comprises those capital assets that the public uses directly, such as streets, airports, parks and transit systems. In general, public infrastructure is intended to either improve the productivity of the private economy (by providing efficient transportation systems, for example) or to enhance quality of life (e.g., bike trails, swimming pools, parks). The third major component of capital spending is economic development. Local governments make capital investments to attract or stimulate private economic activity. Local governments can fund these capital investments “directly” by issuing bonds to finance the projects, or “indirectly” by using incentives – such as tax increment financing, subsidies, tax credits, or tax breaks – to promote desired private investment.

A business model in balance

A successful business model is a sustainable one. For a company, a sustainable business model is one where revenues are sufficient to cover capital and operating costs while at the same time providing an attractive return to the providers of the invested capital. The business model of a local government is considered sustainable when the revenues it collects are adequate to fund a desired level of service levels and infrastructure investments. One of the greatest threats to the sustainability of the local government business model is inflexibility. Local governments struggle to adapt to rapidly changing financial conditions. While municipal revenues tend to fluctuate with trends in the larger economy, the demand for services does not. Since municipalities cannot borrow funds to close revenue gaps, and since they are legally required to balance their budgets each year, they face a unique management challenge: how do you align revenues and expenditures not only in a single year, but across the entire business cycle? The answer is pretty clear. Most localities set up rainy-day funds to offset swings in revenues. In essence, this requires setting aside some portion of revenues generated at the peak of the business cycle to support government capital and services spending at the bottom of the business cycle (see Figure 4).

Revenue Surpluses (Add to Reserves)

Steady expenditures Revenue Shortfalls (Spend Down Reserves)

Course of Business Cycle Figure 4: Maintaining City Expenditures Over the Course of a Business Cycle


By spreading revenues and expenditures/investments over the business cycle, a local government can secure greater consistency in the level of services it provides to citizens. For rainy day funds to be effective, localities need the political will and management acumen to make financial choices with the medium and long term health of the local government in mind. The bottom line is that if, over the course of the business cycle, a city can maintain consistent service levels and continue capital investments, then its business model is sustainable.

Is the business model of cities broken? Local governments certainly feel broke. Most local governments around the country are in the fourth or fifth year of “austerity budgets.” Anyone who works in local government is familiar with the drill. About four months prior to formal release of the city’s proposed budget, a short memo is sent to all department heads asking for budget reduction scenarios for the upcoming fiscal year. In a good year, budget directors might be soliciting scenarios envisioning 3% or 5% cuts; in tougher years we have seen reduction scenarios in the double digits.

These budget reduction exercises are both painful and demoralizing. They are painful because no organization finds it easy to absorb program reductions and job cuts year after year. And they are demoralizing because managers and employees know that no matter how hard they try to minimize the impact of these cuts, their ability to accomplish the missions that they have committed their careers to achieving is steadily being eroded. To compound matters, regardless of how much they cut, city governments have largely been unable to dig themselves out of their fiscal holes. This fact is evident in the announcements we are seeing from local chief financial officers and budget directors. Once cities manage to pass their “balanced” budgets and start a new year afresh, they are soon issuing warnings of the impending deficits they face for the next fiscal year. (see Figure 5). As much as local governments would like to solve these deficit issues once and for all, the temptation to rely on one-time sources of revenue or cost savings is very strong. Based on an assessment IBM recently conducted on local government budget-reduction efforts, we estimate that 30-60% of the actions that local governments are taking to close budget deficits are “one-off” measures that fail to address the structural revenue and cost drivers of their financial problems.

“The San Jose City Council is already bracing for a major budget deficit for the next fiscal year, which will bring pension reform back to the forefront. This comes after the council closed a $115 million budget shortfall for the fiscal year that started on July 1. - KCBS San Francisco “Even with a recovering San Francisco economy, The City’s operating costs will "steadily outpace" revenue increases for years to come, according to a new report released Tuesday by Mayor Ed Lee.” - San Francisco Chronicle

“The mayor [Detroit Mayor Dave Bing] said today that the city’s $155 million current- year deficit could balloon to $1.2 billion by 2015 without spending discipline” - Bloomberg News

“In is "State of the City" address New York City Mayor Michael Bloomberg warned that more spending cuts are needed close multi-billion dollar budget shortfalls in the city budget.” - Fox News New York Figure 5: 2011 Budget Warnings

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“Mayor [Parker] warns of more layoffs in State of the City address” - Houston Chronicle

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To finally solve this problem, we need to fully understand the root causes. City business models are broken, but why?

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A future of zero revenue growth

In the local government business model, revenues are the critical "forcing function." Because local governments need to balance their budgets each year, revenues define the space within which they operate. Regardless of the economic conditions they face, the long-term health of local governments is ultimately dependent on their ability to generate revenue at the rate needed to finance capital investments and fund service levels at some desired level. Historically, local governments have rarely needed to worry much about growth in their revenues. For decades, local government revenues expanded at a rate that exceeds income growth, with growth merely slowing during recessions (rather than actually shrinking). Between 1992 and 2008, for example, local government revenues increased by 6.1% a year on average. This rate of growth is significantly higher than per capita GDP growth over that period. In fact, for as long as statistics on aggregate local government revenues have been kept, growth in local government revenues has exceeded growth in national income almost without exception. That is why local government spending as a percent of GDP has increased from 2% in 1900 to 5% in 1960 to 7% today (see Figure 6).

Municipal governments need to develop a new business model that is fiscally sustainable over the long term.

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*Revenue from local sources only (excludes intergovernmental transfers) Source: Bureau of the Census

Figure 6: Local Government Spending* as a Percent of GDP

But something unusual happened in 2008: local government receipts actually declined by nearly 4% that year (see Figure 7). A nominal reduction in revenue is a rare occurrence for local governments and they have struggled to cope with it. The question for our purposes is: was this simply an unusually sharp cyclical decline or is something more fundamental going on? 14% 12% 10% 8% 6% 4% 2% 0%

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-2% -4% Source: Bureau of the Census

Figure 7: Local Government Revenues(% Change from Prior Year)

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This is particularly true of the period of rapid revenue growth that has just ended. Two of the major revenue sources for local government are sales and property taxes. Together they account for nearly half of all local government receipts. Each of these revenue streams benefited from an unusual confluence of events over the past 20 years. Let’s start with sales taxes. Sales tax revenue is obviously highly sensitive to trends in consumer behavior. More specifically, these revenues are directly related to the degree to which people spend their income on consumer goods as opposed to putting it into savings. As it happens, the savings habits of Americans changed dramatically in recent years. On average, Americans reduced the percent of their household income dedicated to savings from just under 12% in 1982 to about 1% in 2008 (see Figure 8). At the same time, American households took on large quantities of debt. Household debt as a percent of income more than doubled between 1982 and 2008. Much of this new debt was spent on sales-tax-generating consumer goods.

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Household Debt % of GDP Personal Savings Rate Source: US Bureau of Economic Analysis

Figure 8: US Household Debt vs. Personal Savings

It should surprise no one that sales tax receipts grew rapidly during this period. Sales tax revenue increased on average by 9% annually between 1992 and 2008. Since real income growth in the United States increases at around 2% per year, the 9% increases in recent years is clearly an incongruity that could not be sustained. In the long run, we should not expect sales tax revenue to grow any faster than consumer spending, and consumer spending should track closely with real growth in incomes. Of course, this relationship between income growth and consumer spending assumes that the savings rate holds steady. As we turn the corner out of the deep 2008 recession, personal savings rates have in fact risen as Americans reduce debt and “deleverage.” Americans are now saving at rates that more closely approximate the long-term average.

Household debt % of GDP

It is important to remember that the historic growth in local government revenues is not the product of a conscious public choice to dedicate an increasing share of our wealth to local government. Instead, the expansion of spending on local government services is really just the cumulative impact of many small, incremental decisions made over a long period of time.

Personal savings rate


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To compound matters, the decline in home prices – exacerbated by the foreclosure crisis – has severely reduced the borrowing capacity of American households, which will in turn impede their ability to borrow for consumption purposes. It is therefore not unreasonable to assume that sales tax revenue growth will, for the foreseeable future, more closely approximate or perhaps even fall below growth in real incomes. That is to say, real growth in sales tax revenue is likely to be flat for the foreseeable future. Much like sales taxes, property tax revenue has also been the beneficiary of an historic anomaly. Over the past century, investments in real estate have shown only modest returns overall, generally advancing in value at the same rate of income growth. However, beginning in the late 1990’s, prices rose at an extraordinary rate, far outpacing historical growth patterns (see Figure 9).

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expanding the tax base against which property tax millage rates are applied. Finally, much of this activity in real estate generated additional fee income – in the form of real estate transfer taxes, building permitting income, and other propertyrelated fees – which further expanded the local government revenue base. As Figure 9 shows, real estate values still exceed the historic long-run average despite several years of declining prices. The recovery from the real estate led recession will take many years, and from a local government perspective it would be prudent to plan on close to zero real growth in property tax revenues in the medium to long term. These two unusual historical factors – low savings rates and a property bubble – delivered two decades of abnormally healthy revenue growth for local governments. If we assume that these factors have effectively played themselves out – and in worstcase scenario will reverse themselves to a point where they actually act as a drag on revenue growth – then local governments need to rethink their entire approach to their top lines. In fact, rather than being passive recipients of revenues, we believe that local governments must now actively drive economic growth and new revenue.

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The inexorable rise of operating expenses

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Source: Robert J. Shiller, Irrational Exuberance, 2nd. Edition, Princeton University Press

Figure 9: Indexed Real Home Prices (1890-2010) (1890=100)

The real estate bubble had three impacts on local government revenues. First, it increased the value of existing property, which meant that even when millage rates held steady, local government revenues grew. Second, rising real estate prices attracted new capital inflows from speculative investors and property developers. This inflow of capital simultaneously pushed prices higher and led to a construction boom, further

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The healthy revenue growth that local governments have enjoyed over two decades effectively masked a variety of problems arising on the cost side of their ledgers. Perhaps the least discussed but most impactful driver of local government costs is the tendency for the political process to stimulate an increasing demand for services. The demand for local government services increases regardless the progress made in achieving desired outcomes. This occurs across almost all government services, but is perhaps best illustrated in police services. As described in IBM’s recent white paper Cashing the Public Safety Dividend,7 local government spending on police services has increased at an average rate of over 7%


over the past 20 years despite the dramatic reduction in crime over that period. Even though many cities in the country now have crime rates similar to those we experienced in the 1950's, few city leaders are suggesting that we return our police spending to the levels that predominated during that decade. Similar tales can be told in other areas of municipal services. Fire events nationally are down by 60% since 1977, but try asking city leaders to close a fire station. Municipal governments find it very difficult to reduce service levels despite dramatic improvements in outcomes. This needs to change. Long term liabilities are no longer "long term"

Local governments have been making long-term obligations – such as employee retirement and health care benefits – that cannot be financially sustained. That local governments have committed themselves to long-term obligations that they cannot afford is no longer a secret. Collectively, local governments have $554 billion6 in unfunded financial liabilities, mostly in the form of pension and healthcare benefits to employees. Many local governments find themselves unable to meet these obligations in full. Across the country local governments are re-negotiating labor agreements or unilaterally changing the terms of those agreements in order to reduce their financial burden. Clearly, the re-calibration of these commitments will be critical to reducing cost growth to sustainable levels. Postpone capital investments at your peril

One of the responses to the dire fiscal conditions is for local governments to cut investments in capital and economic development in order to protect service levels. When given a choice between laying off a police officer and postponing an investment that will increase the efficiency of an entire department, our local government officials almost invariably choose the latter. A typical response is one instituted by Mecklenburg County in North Carolina, which put itself on a “debt diet” last year. The notion is that to protect service levels, long-term investments should be postponed.

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The challenge posed by starving capital investments to feed services is that it undermines the long-term sustainability of the local government business model. If local governments fail to replace aging operating infrastructure, for example, the result will be a less productive workforce. Employees cannot perform their duties if their vehicles are unreliable or their communications equipment is failing. As we have discussed, less productive workers mean higher costs and lower service levels. Similarly, if local governments fail to maintain or replace capital infrastructure they will largely offset any savings they generate from reduced debt service obligations by increasing their operating costs. Filling potholes, fixing traffic signals and repairing street lights costs money too. Perhaps more importantly, failing to invest in infrastructure curtails future revenue growth by acting as a constraint on overall economic growth. To grow, counties, cities, and states need to invest in quality infrastructure – transportation systems, water systems, greenspace, etc. – to support and continually attract private investment and commercial activity. By postponing or canceling those investments, those governments are undermining their long-term revenue prospects. A city is a capital intensive business. The only reason we can concentrate millions of people within a few square miles is because of the infrastructure – specifically energy, water, sewer and transportation systems – that provide power, clean water, sanitary living conditions, and mobility. On the other hand, cities depend on services – utilities, police, fire, solid waste collection, and others – to support commerce, maintain public order, promote public health and deliver a variety of other essential services. Making trade-offs between these two competing priorities – infrastructure and services – is not always easy.

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More recently, governments at all levels have chosen services over infrastructure. By now we are all familiar with the growing concern over the quality of our nation’s infrastructure. Collapsing bridges, congested roads, aging power generation and distribution, and failing flood control systems are increasingly common. The deterioration in the nation’s infrastructure can largely be explained by the fact that we are spending less of our wealth on it.

Improving Police Productivity In Richmond Better use of crime statistics and geospatial mapping allowed the City of Richmond, VA to reduce crime and reduce costs. In 2004, the city of Richmond was the ninth most dangerous city in the U.S. In 2005, the situation worsened and Richmond climbed to fifth most dangerous city. This prompted the Richmond Police Department to search for more innovative ways to combat crime, rather than just throwing more people and dollars at the problem. The city found a large part of the solution in predictive analytics software. This software analyzes historical crime information and predicts when and where future criminal activity is likely to occur. By revealing geographic-based crime patterns, police departments can anticipate crime rather than simply respond to it. Before deploying this new analytics capability, the city’s police department put it to a test on a day that historically saw a large spike in crime: New Year’s Eve. By using historical crime data, Richmond forecasted where and when police officers would be most effectively positioned to prevent crime. The test was a success, with random gunfire incidents dropping by 49% and the number of weapons seized rising by 246%. And because the department was able to more efficiently deploy its resources, it saved significantly on overtime costs. According to senior Richmond police officials, “There were real benefits to be gained by using…technology to give us insights into where to put officers to get the biggest impact.” From there, Richmond’s crime rates began plummeting, and Richmond has since dropped from fifth on the most dangerous cities list to 99th.

Annual spending on public infrastructure in the United States has declined from over 5% of GDP in the middle of the twentieth century to less than half of that today. By comparison, European countries spend 5% and China spends close to 9% of their annual income on infrastructure. Of the $780 billion dollars contained in the 2009 Federal economic stimulus bill, less than 10% was dedicated to infrastructure. According to the American Society of Civil Engineers (ASCE), our nation’s public infrastructure requirement – what we need to spend to renew the health of aging and decaying public infrastructure – now stands at $2.2 trillion over 5 years, of which 50% is currently unfunded. This leaves a public infrastructure deficit of over $1.1 trillion - just to maintain the infrastructure that we already have.2 But while we tend to allocate the blame for our deteriorating infrastructure on the Federal government, local governments are equally complicit. Historically, Federal and State government have each provided approximately 25% of the funding for public infrastructure. The remaining 50% has been provided by local governments.3 This suggests that local governments are running a five-year infrastructure deficit of $550 billion, or an annual deficit of around $110 billion.4 How did this deficit arise? In 1992 local governments dedicated 16.6% of their revenues to capital spending; by 2008 that had fallen to 12.7%. This represents a 25% reduction in capital spending over that period or $61 billion less every year that local governments are devoting to their public and operating infrastructure. That's more than half the problem right there.


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By 2008, state and local spending on infrastructure stood at 30% of the US total investment. To be sure, private funding sources have picked up some of the slack. But subway systems, drinking and wastewater systems, and roads bridges and tunnels that were originally built to last 30-50 years, are now well past their expected lifespan. According to the 2009 ASCE report, “Years of delayed maintenance and lack of modernization have left Americans with an outdated and failing infrastructure that cannot meet our needs.”

Fixing the business model: How cities can shape a sustainable future

This is a problem for several reasons:

IBM has developed a six-point program for cities that wish to make revenue growth a core strategic imperative. Collectively they constitute a series of organizational and operational changes that should improve revenue growth:

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As infrastructure deteriorates, it becomes a threat to health and public safety. As examples, think of the Minneapolis bridge collapse in 2007 or Washington, DC’s problems with lead in its drinking water.

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As infrastructure deteriorates, it becomes more expensive to maintain. So while cities save money by not financing the debt needed to replace infrastructure, they wind up spending increasing amounts of money to fill pot holes, repair bridges, and keep aging transit systems operational.

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The failure to maintain and improve infrastructure decreases productivity and increases costs, which limits residential and commercial growth, and retards the expansion of the tax base.

The bottom line is that a capital intensive enterprise that does not prioritize capital spending is placing its long term financial viability at serious risk. And yet this is precisely what local governments are doing. Many of our local governments today have shelved capital maintenance and new capital (e.g. infrastructure) investments in order to protect service levels. This approach is not sustainable. The “squeeze and pray” approach to budget management (as in, squeeze costs and pray for revenues to return) is doomed to fail. The only way to break the budget cutting cycle is to dramatically redesign the business approach of local governments. It is time to rethink the model.

In order to build a business model where the growth in capital and operating expenses is sustainable in the face of flat revenue growth, local governments need to strategically rethink how they address revenues, operating expenses, and capital expenses. Let’s take them one at a time.

A new focus on the top line: Make revenue growth an explicit strategic goal

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Appoint a Chief Revenue Officer. Local governments need to elevate the importance of revenue enhancement within their organization. In IBM’s recent study – Smarter, Faster, Cheaper: An Operations Efficiency Benchmarking Study of 100 American Cities – we could not identify a single city that had created an organizational function dedicated to revenue generation. As a point of comparison, private companies typically dedicate 10-15% of their revenues to functions focused specifically on driving revenue growth. While cities dedicate resources to revenue collection, they do not invest significant resources in activities that will stimulate revenue growth. Local governments need to create a Chief Revenue Officer responsible for developing and implementing a strategy for improving revenue performance.

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Restructure taxes and fees so that they maintain their value over time. Cities are generally not focused on ensuring that the revenue streams upon which they depend are structured in a way that ensures that they maintain their value over time. Too many fees, for example, are charged on a flat-rate basis, which means that their value relative to general inflation inevitably erodes over time. Instead, local governments should be structuring their revenues so that they increase automatically over time, perhaps by indexing them to general inflation.

A capital intensive enterprise that does not prioritize capital spending is placing its long term financial viability at serious risk.

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Update cost-based fees every year and make sure they are recovering fully-allocated costs. Local governments are also lax in updating the cost justifications for their user fees (which constitute 22% of all local government revenues). As result, fee revenues do not grow at the rate commensurate with increases in underlying costs. Private companies, for example, often add surcharges to their fees to deal with spikes in energy costs. Local government fees too often lag behind despite legitimate increases in the costs to deliver the services that those fees are designed to recover.

4. Stimulate revenue generating activity on the part of the public. Local governments do not do enough to stimulate revenue-generating economic activity. Regulatory barriers to starting businesses and developing property, for example, reduce revenues by inhibiting business investment. Only rarely are a local government’s regulatory rules reviewed on the basis of their impact on revenues; such reviews should become institutionalized and rules that cannot be cost-justified should be modified or eliminated. 5. Stimulate revenue generating activity on the part of the government. Local governments do not do enough to encourage their own revenue generating activities. More rigorous enforcement of traffic and parking laws, code enforcement regulations, and business license requirements can generate significant revenues. The City of Atlanta will triple the net revenue it earns from on-street parking by outsourcing the entire program to a third party provider. 6. Create municipal marketing programs. Finally, local governments do not extract full value from their assets. Few cities have municipal marketing plans designed to maximize revenues from their physical and intellectual assets. Outdoor advertising, corporate partnerships, and naming rights can be lucrative sources of revenues with almost zero investment required by the local government. The City of San Diego has generated $16 million over the past decade through various municipal marketing programs.

Take an ROI approach to spending, supported by advanced analytics By improving their understanding of the long-term economic impact of the spending decisions that they make, local governments can make decisions that generate short and long-term economic and revenue benefits. Many government officials do not see their enterprise as a value-creating engine. They collect revenues and spend those revenues on the services and capital they think will generate public value. It is important that local government officials come to appreciate that those services and capital generate value that can be measured, and that alternative uses of those revenues could be compared based on how much value they will generate. We call this “maximizing returns on investment.” In a recent IBM white paper, we describe how local governments can calculate returns on spending by measuring its impact on neighborhood health.8 If applied appropriately, this approach will drive funds towards those investments that not only maximize the quality of life of the citizenry, but also accelerate revenue growth. In other words, municipal governments need to rigorously evaluate their spending decisions based on the net returns they will generate. And thanks to the wealth of data local governments now collect regarding the impacts of their operations, they are now – for the first time - in a position to conduct this type of evaluation. Turning data into insights

In many ways this is a fortuitous time to be reinventing the local government business model. For decades local governments delivered public services without having any real way of understanding the impact of those services. It was only in the past 20 years or so that we have introduced the means to collect true performance data and the tools to analyze it. It is time to put those tools to use.


We are now in a position to understand how local government spending and investment impacts the quality of life of our residents. Most local government activities are now tracked and geo-coded. Down to the individual parcel, we know what costs are being incurred and what revenues are being generated. We know that the construction of a park will increase the value of adjacent properties by around 15%. We know that crime spikes in certain parts of town at certain times of day. We know how after school programs affect graduation rates. We know how sidewalks impact public health. IBM is documenting these relationships and developing predictive analytic models that can quantify the impact of services and infrastructure investments collectively. We call these techniques ‘advanced analytics,” but what they really do is connect once disparate sources of data and align them in a way that generates insights. These models can not only inform specific spending decisions, they can reveal the collective impact of a series of seemingly independent investments. Today, most cities justify investments in streets, police services, and after-school programs based on the linear impacts that they can anticipate within the silos those functions operate. A new street will enhance mobility. More police officers will improve 911 response times. After school programs lead to better test scores. The fact is, however, that those investments interact in a meaningful way. An investment in a park, for example, while achieving the linear goal of expanding public access to greenspace, may also have a public safety impact by eliminating a once-blighted region of the city. By understanding how these interactions occur, cities can optimize investments and maximize the returns they generate.

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What we are suggesting here is silo-busting through the application of advanced analytics. Rather than making spending decisions in vertical silos, cities should make them based on their horizontal impacts on the urban outcomes they are trying to generate (see Figure 10). Applying this approach to resource allocation will radically change government budget processes. For the most part, local governments make budget decisions in silos: this much money for police, this much for fire, this much for parks, etc. Those decisions are made based on the case that the leaders of those departments have made for their isolated sets of activities. Few municipal governments have a means to understand how

Police

Siloed spending on... Parks Streets

Other

But collectively this spending drives...

Response times

Access to Mobility greenspace ...drive linear outcomes

Desired urban outcomes

Other

Figure 10: Silo busting through advanced analytics

spending decisions will collectively impact outcomes. By using advanced analytics, cities can begin to understand how alternative investments in silos will advance overall outcomes. They will be able to assess how a dollar invested in police, streets, parks and after school programs impacts public safety. They will also know how that same dollar impacts school performance. And, perhaps best of all, they will know

Municipal governments need to rigorously evaluate their spending decisions based on the net returns they will generate.

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how much that same dollar generates in property tax revenue. This enables leadership to begin reshaping budgets to reflect leadership priorities by starting with outcomes and working backwards to the investments that generate the highest return towards that outcome. Many cities already have the data; they just need to turn it into insights.

Reduce costs and improve performance Drive efficiency reductions in operating expenses The Building Blocks of a Sustainable Business Model How does a city adopt a sustainable business model? There are four key elements: Medium and long term revenue forecasts are required to effectively project funding availability. It is critical that these forecasts be “business cycle baselined,” meaning that rather than simply assume that revenues will grow at a steady state, the forecast assumes a recessionary event within every 10 years or so. A capital investment plan needs to be established that projects the level of investment that will be needed to replace the operating and public infrastructure of the city. The projection should also include investments in new infrastructure to support future growth (if growth is anticipated in the revenue forecast). Service levels need to be set at a level that will not require funds beyond those that can be projected over the course of the business cycle (and only those funds that remain once capital investments are funded). In other words, service levels need to be established that reflect the resources that will be available given the outputs of Steps 1 and 2. Finally, the city needs a cash reserve (or fund balance) plan that steadily grows during economic expansions and is tapped when recessions hit. The size of this cash reserve should be calibrated in a way that allows service to be maintained at a reasonably steady level across the entire business cycle. No local government can credibly claim that it has a sustainable longterm financial plan without each of these four central elements. Does your city have them?

Cities need a consistent focus on improving operations. IBM’s recent study Smarter, Faster Cheaper: An Operations Benchmarking Study of 100 American Cities found that the average city spends roughly $705 per capita to provide core municipal services. Half of all cities spend more than this amount, and the highest-spending cities spend greater than 50% more than average. Cities have an enormous opportunity to reduce operating costs while maintaining service levels. How might cities do this? IBM has worked with clients to develop an integrated approach to identify cost savings opportunities for local governments. Some of the areas we have found to look for savings include: 1. Consolidate Information Technology (IT) Infrastructure: Significant savings—often in the range of 20-30 percent—can be realized if departments and agencies employ proven methods to reduce overall costs of IT ownership. 2.

Streamline Government Supply Chains: By leveraging strategic sourcing and other commercial best practices in their supply chains, local governments can generate efficiencies of 10-20 percent.

3.

Reduce Energy Use: There are a range of ways that local governments can reduce their energy related expenditures including call center consolidation, using collaboration tools to reduce travel costs, and using smarter technology to reduce energy consumption for fleets and buildings. Taken together, these initiatives have the potential to reduce costs by 10-20 percent while enhancing the sustainability of local operations.


4. Move to Shared Services for Mission-Support Activities: By shifting IT, finance, legal, human resources and procurement operations to shared services state and local governments have the potential to generate 20-30 percent savings, while improving the efficiency of business processes. 5. Move to Electronic Self-Service and Improve Business Processes: By moving customer service touch points to electronic platforms and rationalizing their field operations footprint, local governments can significantly reduce costs and improve citizen’s experience. Reexamining business processes in major cost centers can also lead to lower costs and more efficient service delivery. 6.

Rightsize Organizations: local governments have a significant opportunity to generate efficiency gains by identifying overlaps in service delivery and personnel. By developing an understanding of where inefficiencies may exist, local governments can achieve savings of 10-15 percent while enhancing the quality of service delivery.

Improve labor and capital productivity

A key means for improving the cost position of local governments will be through improvements in labor productivity. Traditionally, local government services are resistant to improvements in productivity. This is particularly true in the “big three” areas of local government services: education, police and fire, which constitute over 60% of local government employment. These functions are subject to Baumol’s cost disease whereby each year these activities require more resources to offset their relative lack of productivity growth.5 Local governments need to apply new methods and approaches for leveraging labor in these and other municipal services. The City of Chicago has installed a comprehensive video surveillance system which is increasing the reach of the Chicago Police Department. Some cities have started using handheld mobile devices to document construction code violations and allow inspectors to cover more territory with less paperwork. This move away from paper based processes to all-electronic processes speeds process time and reduces errors and rework.

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In addition to improving labor productivity, cities have an opportunity to improve the efficiency of other assets as well. For example, cities that are less efficient in their public infrastructure operations have the potential to generate savings by improving the overall operating performance of utility systems. Both the DC Water and Sewer Authority and the San Francisco Public Utilities Commission are using a combination of asset monitoring technologies, geospatial mapping tools, and workforce management tools to reduce customer calls and service delivery times. Initiatives like these can reduce labor costs, improve mission performance, and also help delay capital investments as existing systems are better maintained.

Invest in capital infrastructure using funds generated from operational efficiency gains As discussed earlier, local governments have been starving capital investments in order to maintain services. Furthermore, according to the ASCE, that nation needs to invest $2.2 trillion in infrastructure over 5 years, of which $1.1 trillion in investments are needed just to maintain the infrastructure that we already have. It will be up to local governments to fund $550 billion of this, which suggests that local governments need to find a way to fund $110 billion annually in capital infrastructure. On its face, this might seem improbable, if not impossible. Where can cities find these funds when they are facing structural deficits that stem from revenue declines and continued growth in services and long-term liabilities. Can local governments increase capital investment without slashing services? We think that they can. IBM’s benchmarking work with cities and our experience with both private-sector and government clients to improve operating efficiencies and reduce costs indicate an ability for cities to save between 5% and 15% on operating costs.

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In 2008 local governments spent $1.2 trillion in operating expenses, not including utilities or debt service. Achieving efficiency-driven cost reductions in local government operating spending of 9% would free up $111 billion in funds annually. Cities could use these annual savings to fund investments in infrastructure, and the estimated savings could fully address the size the of the estimated local infrastructure deficit. Using sustainable operating savings to dramatically increase capital investments in infrastructure will benefit local economies in the long term. It can help create a virtuous economic cycle, whereby capital investments can help boost local economic activity, which, in turn can attract more private capital investment to a city and also boost local government revenues.

Conclusion While we like to talk about the future, we are largely chained to our past. For all the talk of re-inventing government that has occurred over the past 20 years, our governments look remarkably unchanged. They collect the same types of revenues, deliver the same types of services, and their unchanged economics mean that they are continuing to absorb a larger portion of our economy. The only real difference between now and 20 years ago is that we appear to be reaching the limit of our capacity and willingness to finance this type of government. One option local governments have is to hope that the public will continue to dedicate a larger portion of its wealth to support it. In the past century, the public has increased the proportion of its income it is willing to contribute to local government from 2% to 7%. Who says that the public is not willing to contribute 10%, or 12%?

Municipal governments find it very difficult to reduce service levels despite dramatic improvements in outcomes. This needs to change.

The public may very well be willing to do that. But a local government that bases its long term strategy on that assumption is taking a substantial risk. We believe it is possible to develop a long-term plan that is less dependent on the willingness of the public to finance a business model that by its very nature requires increased resources each year. In order for local governments to achieve fiscally sustainable business models, they will have to: 1. Stimulate revenue growth by pro-actively encouraging revenue-generating activities and monetizing public assets; 2. Adopt a return-on-investment approach to ensure that spending is directed in a way that optimizes future revenue generation; 3. Improve the operating productivity of labor and capital by adopting new technologies and services delivery models. 4. Recalibrate service levels as targeted outcomes are achieved, 5. Use operating savings to eliminate infrastructure deficits and invest in capital and economic development that encourages growth in the residential population and in private investment. In essence, by aggressively implementing Recommendations 1 through 4, cities can generate the resources they need to fund Recommendation 5. This strategic reorientation places a high priority on infrastructure and economic development in securing a sustainable city business model. By being smarter about how we operate government, we can find the cash needed to fund investments that lead to future prosperity. The successful deployment of this strategy will insulate local governments from the vagaries of the business cycle and help them to focus on their resources on those things that truly drive fiscal sustainability. Best of all, local governments will deliver their desired outcomes more reliably. Local government revenues may be flatlined, but that doesn’t mean that local governments have to take it lying down.


IBM and smarter government

About the authors

Government plays an increasingly central role in our economic lives. In the United States, government is now responsible for more than 4 out of every 10 dollars spent within our economy. Perhaps even more importantly, large sections of the private economy – health care, financial services, communications, and energy to name just a few – are more closely integrated with government than ever before. Traditional lines between the private and public sectors are becoming less distinct, and the overall performance of our economy is now dependent on improved cooperation and alignment between private companies and government. Getting government right – that is, making sure that it operates in a highly efficient and effective manner – has never been more important. In recognition of the fact that the performance of government is the public’s collective responsibility, IBM has launched its Smarter Government program. Our goal is to help governments inject intelligence into their decision support processes, business operations, and public infrastructure to improve performance and deliver better public outcomes. Governments need to maximize the public value they generate through every dollar they spend. We think we can help.

For more information To learn more about how we can help your city improve performance and deliver better public outcomes, contact your IBM sales representative to request any of the following white papers or visit us online. IBM Smarter Planet: ibm.com/smarterplanet IBM Smarter Government: ibm.com/smarterplanet/us/en/ government/ideas

Daniel B. Prieto

Vice President and Practice Lead, Public Sector Strategy & Innovation, IBM U.S. Global Business Services 202-551-9411 [email protected]

David Edwards

Smarter Government Campaign Lead, IBM U.S. Global Business Services 404-502-6842 [email protected]

Acknowledgments Many colleagues contributed to the analysis, findings and recommendations in this paper. We are grateful for their contributions. They include: Alan Howze David Post

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Footnotes 1 National Commission on Fiscal Responsibility and Reform The moment of truth: Report of the National Commission on Fiscal Responsibility and Reform, pg 11 December 1, 2010 2 American Society of Civil Engineers estimate, 2009 3 Public Spending on Transportation and Water Infrastruc- ture, Congressional Budget Office Report, 2010, pg 11 State and Local Infrastructure Financing, George Washington Institute of Public Policy (GWIPP), 2005, pg 4 4 We assume for the purposes of this analysis that Federal, State and Local governments are equally complicit in underfunding infrastructure; as a practical matter that may not be true in all states. 5 For further explanation, see http://en.wikipedia.org/wiki/ Baumol%27s_cost_disease 6 “The Crisis in Local Government Pensions in the United States,” Joshua Rauh of the Kellogg School of Business and Robert Novy-Marx of the University of Rochester, 2010. 7 Cashing The Public Safety Dividend: Recalibrating Spending on Police Services in a Era of Declining Crime Rates, IBM white paper 2011. 8 See The Neighborhood-Centric City: Achieving Fiscal Sustainability by Maximizing Returns on Investment in Neighborhood Health.

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