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New Jersey’s Laws and Fiscal Safeguards Make Municipal Bankruptcy Unlikely

keevey
Richard F. Keevey

This is the first article in a two-part series

Recent developments in Detroit have renewed interest in municipal bankruptcy proceedings and the reasons that brought that city to its present financial situation.

In a court hearing Wednesday, an attorney for the city – which filed for Chapter 9 status in July --- contended that without the protection of bankruptcy to enable it to restructure its $18 billion in debt, nearly two-thirds of every dollar of taxpayer money would go to cover debt and other expenses. But the bankruptcy status would also enable the city to cut pensions for thousands of people, prompting protests by crowds gathered outside the courthouse.

Chapter 9 of the Bankruptcy Code concerns the reorganization of municipalities, including counties, school districts, authorities, etc. This code is unique when compared to bankruptcy law for private corporations. Corporations can declare bankruptcy -- usually Chapter 11 of the code -- but municipalities cannot be liquidated and judges cannot force municipalities to take specific actions, principally because the U.S. Constitution sets limits on the judiciary’s power over municipalities.

Although Detroit is the country’s largest Chapter 9 bankruptcy case, there have been other recent examples of local governments filing for Chapter 9. In California, principally as a result of the long recession and foreclosures caused by the subprime mortgage crisis, a number of high-profile municipalities, including Stockton, Vallejo and San Bernardino, have gone through or are going through the process. Although different in charter, another recent classic case is Jefferson County, Alabama, which defaulted on sewer construction bonds -- and previously in 1994, the Orange County, CA, situation where the county sustained investment losses triggered by interest rate speculation that plunged the affluent county into bankruptcy. (1)

The principal role of judges in municipal bankruptcy is to decide if a municipality is eligible, approve its plan to adjust its debts, and verify that the plan was properly implemented. The judge, for example, cannot interfere with the operation of the debtor. Municipalities have less leverage in restructuring their organization than corporations. Municipalities, for example cannot typically sell assets, but they can negotiate how debt is restructured, including how its bonded debt, pension obligation, and other contractual commitments can be adjusted. (2)

It is not the intent of this paper to analyze bankruptcy actions but rather to suggest that more careful oversight by state governments could have negated these drastic actions. Many states, including very large ones, such as California and Texas, have no laws or processes that provide adequate oversight and intervention to limit fiscal distress that could lead municipalities into declaring bankruptcy. (3)

Most students of municipal finance would acknowledge that New Jersey has some of the country’s most distressed municipalities, including Camden, Trenton and Newark. Yet none of these municipalities or any of the other 1,500 jurisdictions (including municipalities, school districts, counties and authorities) in the state approaches the need to declare bankruptcy. Why is that?

One answer is that New Jersey has one of the most significant set of laws, budgetary tools and overall state oversight programs, including aid funds from the state, to monitor local government finance –and, when necessary, actually ‘take over’ a municipality experiencing severe financial stress.

This paper will review the overall structure and nature of the state government in New Jersey and its local governments; analyze the laws and processes that provide the state with extensive oversight authority; and finally discuss some specific measures and recent actions that have further limited fiscal stress at the local level of government.

Structure and functions of local government

To understand local government finance in New Jersey and the oversight role played by the state, it is helpful to consider the overall state and local government structure. New Jersey has a very strong central state operation with a governor who has significant appointment and budgetary powers. New Jersey local governments tout their home-rule powers – while that is true in certain circumstances, when it comes to local and school finance the state’s powers and oversight responsibilities are quite extensive.

State Structure: The state’s Office of the Governor is often viewed as the strongest in the country. Unlike any other state, the governor is the only officer elected statewide, and all cabinet officers and principal state officials are appointed by the governor. (The office of lieutenant governor was created in 2006 and runs with the governor in elections.). The governor has both constitutional veto power to propose changes in enacted bills and an absolute line-item veto to eliminate specific provisions in appropriations acts – including dollar amounts and language. The Legislature is composed of 40 senators elected for four-year terms and 80 Assembly members elected for two-year terms.

There is a unified court system headed by a Supreme Court which makes rules governing all the courts in the state and has jurisdiction over admissions to the bar and discipline of attorneys. All state court judges, including the Supreme Court judges, are appointed by the governor with the advice and consent of the Senate, and they are precluded from political activity and outside employment. If re-appointed after an initial seven-year term, judges receive tenure, with a mandatory retirement age of 70. The governor appoints each of the 21 county prosecutors. (4)

Home rule: While explicit grants of home rule are avoided in the state’s constitution, a relevant section reads as follows: \The provisions of this Constitution and any law concerning municipal corporations … shall be liberally construed in their favor. The powers of counties and such municipal corporations shall include not only those granted in express terms but also those necessary or fair implication, or incident to the powers expressly conferred… (5)

While many scholars emphasize the sweeping nature of this provision, judicial decisions have been mixed. Although some courts have taken a strict constructionist approach to local powers, and in general courts have honored the spirit of the constitutional provision, they have also supported the state’s right to preempt activity in any given field.

The Supreme Court has generally been deferential to local government when individual rights have been involved. Alternatively, a series of landmark decisions in 1975, 1983 and 1986 ruled that all municipalities have a constitutional obligation through their land-use decisions to provide a realistic opportunity for meeting the region’s need for housing for moderate and low-income families (a.k.a. the “Mount Laurel” cases). The Legislature has provided a number of ways in which municipalities may meet this obligation -- ways that have evolved over time. (6)

Structural Features of Home Rule: The state’s 566 municipalities range from Tavistock Town, with just five residents, to large cities like Newark (277,000) and Jersey City (247,000). Despite the state’s population of almost 9 million, only six municipalities in the state have populations of 100,000 or more.

The Home Rule Act of 1917 formally granted townships authority as full-fledged municipalities and granted a long list of specific powers to all municipalities.

Where municipalities do vary, however, is in the organization of their government. Each type of municipality has a different structure as set forth in state law – city, town, borough, township or village. Voters have the option of changing the structure to one of several optional forms of government based on laws passed over the years, including council-manager, and strong mayor-council.

The 21 counties in New Jersey have been historically governed under a committee system with the governing body known as the “Board of Chosen Freeholders.” Traditionally, freeholders take responsibility for supervising specific county departments –either individually or through a committee structure. In 1972 the Legislature enacted an optional charter law for counties. This provided the option of having an elected county executive.

Annexation of territory and consolidation of municipalities is authorized by law, but since the entire area of the state is part of an incorporated municipality, the agreement of both jurisdictions is required for consolidation.

The Legislature’s constitutional responsibility “to provide for the maintenance of a thorough and efficient system of free public schools for the instruction of all children of the state between the ages of five and eighteen” has been delegated to what are now approximately 600 local school districts. Historically, the schools were coterminous with municipalities, but there are approximately 70 regional districts that cover more than one municipality. (7)

Functions of Local Government: A wide range of activities is authorized by law for municipalities, but the details are rarely mandated. The largest single function is police protection, followed by public works.

County government frequently serves as the jurisdictional unit within which a state function is carried out. Historically, the court system and welfare systems were county functions overseen by the state; however, constitutional changes in the early 1990s transferred the financing of courts and family support systems to state government. Counties play a role in financing and staffing the prosecutor’s office and running certain correctional institutions. County public health activities have increased, and many counties support a library system. Many counties also provide centralized solid waste and recycling collection and disposal systems.

While municipalities were historically permitted to establish special districts, they are limited to fire districts. There are several residual districts from earlier times, 11 solid-waste collection districts and two water districts.

Municipalities and counties are also permitted to create authorities for such functions as utility (water and wastewater), redevelopment, housing, parking and other specialized purposes. Many counties have “improvement” authorities encompassing a wide range of services and also serving as a financing agency, with authority to issue revenue bonds for a variety of purposes. Today, there are over 300 individual municipal, regional and county authorities.

Legislation has existed for many years to encourage municipalities to share services. Since the 1970s, the state has engaged in a variety of grant-based and support programs to encourage these efforts. Today, because of rising property taxes and the rising costs of government in general, many municipalities and counties have entered into shared-service agreements.

Land-use planning is one area where there is a constitutional basis for municipal home rule. Virtually every municipality in the state has adopted a zoning ordinance and has both a planning board and a zoning board of adjustment, while some small municipalities have taken advantage of state law that permits a single “Land Use Board.” (8)

Fiscal oversight of local governments

Overview: New Jersey has one of the strongest set of laws in the nation – dating back to the 1930s – giving state government extensive powers and oversight over local finances. The Division of Local Government Services in the Department of Community Affairs and its Local Finance Board enforces laws and procedures that allow the state to oversee the key financial operations of all municipalities, counties, authorities and special districts. The Department of Education, similarly, oversees financial operations of school districts.

The separate state statutes that give the division its responsibilities include:

  • Local Bond Law (N.J.S.A.: 40A:2.)

  • Local Budget Law (N.J.S.A.: 40A:4-1 et seq.)

  • Local Fiscal Affairs Law (N.J.S.A. 40A:5-1 and the Local Authority Fiscal Affairs Law (N.J.S.A. 40A:5a)

  • Local Public Contracts Law (N.J.S.A.40A:11)

  • Local Government Ethics Law (N.J.S.A. 40A: 9-22)

For example, state law limits how much debt local government may issue. For municipalities, the limit is 3½ percent of the three-year average equalized (market) valuation; for counties, it is 2 percent; for school districts, it is 4 percent of the same base. Exemptions and procedures allow borrowing above the limits, but only with the review and approval by the Local Finance Board (see discussion below concerning the board). Annual debt statements must also be filed with the Division of Local Government Services 30 days after the close of the fiscal year.

In addition, the Division of Local Government Services regulates local government budgets and financial affairs in considerable detail. For example, according to statute, balanced county and municipal budgets must be submitted, approved and certified each year by the division. (9)

The division prescribes the procedures and forms, and oversight of the Local Budget Law, including a calendar of public hearings that must be followed in submitting the budget and receiving approval from the division.

The division does not judge the amount or purpose of appropriations, but it does insure that the budget is balanced, that required procedures have been followed, and that all necessary items (i.e. debt service, pension payments, etc.) have been fully included in the budget -- and, equally important, that revenues are not overstated.

A statutory provision requires all municipalities to budget for a “reserve for uncollected taxes.” The tax levy must be increased to allow for less than full tax collections, based on prior year tax collections.

The division requires filing of unaudited annual financial statement 40 days after the close of the fiscal year. This document is critical for review of the annual budget as it includes realized revenue, tax collection rates, and surplus from prior year operations.

The division also requires an annual audit of each county and municipality, with a copy filed with the state. In addition, recent procedures issued by the division require the local government body to meet with the external auditor and review the opinion and the management letter. The procedures also require the chief financial officer to describe how the local unit will correct the problems identified in the audit and submit a corrective action plan to the government body and the division.

The Local Finance Board (an arm of the Division of Local Government Services) has five members appointed by the governor with advice and consent of the Senate. It has extensive statutory powers and responsibilities, including the power to issue rules and regulations which are binding on all local units under the board’s jurisdiction. The board must also approve the creation of all local authorities. Local authority budgets and financial reporting are subject to budget review, similar to counties and municipalities.

Furthermore, the Local Finance Board has the authority to assume supervision of the financial affairs of local units that fall into fiscal difficulty. This authority requires specific conditions, such as defaulting on bond payments or otherwise showing a need for extraordinary assistance and oversight. (10)

Going into 2013, there were no municipalities subject to full control of the Local Finance Board, but in the past various municipalities have been under control of the board. Within the past two years as many as six municipalities have been under control of the board, including Atlantic City, Union City and Asbury Park.

The release of these municipalities from Local Finance Board oversight is due in part to the “Transitional Aid” program (see discussion below)

In addition, the Division of Local Government Services provides technical assistance, oversight and extraordinary financial assistance to any municipality in need of extra assistance to maintain financial viability.

The division also oversees a professional certification process to insure that key financial managers in the municipality and county are properly qualified. It issues certifications for the Chief Municipal Finance Officer, the Chief County Financial Officer, the Certified Tax Collector, the Qualified Procurement Officer, and other professional positions. (11)

Local Government Revenue: The property tax is the dominant source of revenue for all local governments -- municipal, county and school districts. In FY 2012, for example, $26 billion in revenue was raised by the property tax -- which was more than the combined income, sales and corporation taxes collected by state government.

The total property tax is allocated as follows: (12)

  • Schools -- 13.6 billion

  • Municipalities -- $7.7 billion

  • Counties -- $4.7 billion

The property tax is a residual tax, meaning that it becomes the balancing revenue source for municipalities, counties and school districts after all other revenues have been considered to support expenditures.

According to the New Jersey Constitution: Property shall be assessed under general and uniform rules. All real property shall be assessed and taxed locally… for allotment and payment to taxing districts, and shall be assessed according to the same standard of value, and all real property shall be taxed at the same general tax rate...(13)

Municipalities serve as the property tax collection agency for the taxing entities that impose the property tax. The municipal collector bills each property owner through a consolidated, then allocates the revenue to each jurisdiction –municipality, county and school district.

Generally, municipalities, counties and school districts have no power to levy an income or sales tax. There are exceptions approved by the Legislature – Atlantic City has been authorized to collect a luxury tax (a form of sales tax), Newark has been authorized to levy a very limited wage tax, and the communities composing “Wildwood” in Cape May County have a sales tax override to fund tourism improvements.

In addition to the property tax, municipalities and counties receive revenues from state aid, and from a wide variety of licenses, fines, permits, parking meter revenue, interest on cash reserves, construction permits, and a sales tax override on hotels. State and federal grant programs supplement some locally funded programs. Counties are limited to the property tax, certain specific fees, and grants and transfer payments from the state and federal governments.

School district revenues come principally from the property tax and state aid – as well as a small percentage from a variety of federal grants. (14)

It is important to note that all state income taxes and .5 percent of the sales tax collected by the state must be used for property tax relief, under provisions of the Constitution. Most of the income tax is disbursed to school districts, with the remainder distributed as direct property credits to eligible residential taxpayers, and as municipal and county aid.

A report of the Property Tax Reform Task Force of the New Jersey League of Municipalities, released in June 2013, argued that the property tax should be reduced significantly to improve the state’s competitive position, and to make it affordable for families and seniors to stay in the state and for young couples and graduates to buy homes in New Jersey. The principal component of the plan calls for reducing property taxes by 30 percent and have a corresponding increase in the income tax. The governor has called the plan ’ridiculous’ and ‘gimmicky’ and various opinion pieces have presented arguments that range suggesting that the proposal ‘was just a starting point for discussion’ to one that argues that the income tax s much too volatile to be a dependable substitute for the property tax, especially in recessionary environment. To date no action has been taken by the Legislature. (15)

FOOTNOTES

1.Maciag, Mike. “How Rare Are Municipal Bankruptcies?” Governing Magazine. January 24, 2013.

2.Norton, William L. Jr., and Norton, William L. III. Bankruptcy and Practice 90:1. See also Know, John, and Levinson, March 2009. Municipal Bankruptcy: Avoiding and Using Chapter 9 in Times of Stress. Orrick, Herrington and Sutcliff.

3.“The State Role in Local Government Financial Distress.” The Pew Center of the States. July 23, 2013.

4.For a more detailed discussion of the New Jersey state government see, the web site of the NJ Office of Legislative Services, New Jersey Legislature. www.njleg.state.nj.us

5.See New Jersey Constitution, Article IV, Section VII (11)

6.For a history of the historic Mount Laurel Decision (Southern Burlington County N.A.A.C.P. v. Township of Mount Laurel, 67. 151 (1075) and its subsequent cases see New Jersey Digital Library. http://njlegallib.rutgers/mtlaurel/aboutmtlaurel.php

7.For an excellent discussion of the features and functions of NJ local government, including home rule see: Reock, Ernest, Jr., Joseph, Alma, and Collins, Michelle, “Home Rule,” in Home Rule in America. Congressional Quarterly Press, Washington, DC, 2001.

8.Ibid, see “Home Rule” above.

9.The budget review and certification process requires significant staff time and so since 1995, local governments have been allowed to self-certify that their budgets meet all of the state requirements. The state only reviews in detail each local budget every three years. However, local units that have ever been put on a watch list or has received state aid as a distressed municipality, or exhibit other fiscal problems must continue to submit its budget every year for formal review and approval. On average the state reviews approximately 50% of all local budgets each year

10.For a complete listing of powers of the Local Finance Board, see N.J.S.A. 40A:9-22.7

11.For a detailed discussion of the powers and responsibilities of the NJ Division of Local Government Services, see www.nj.gov/dca/divisions/dlg

12.See ”Abstract of Ratables for CY 2012,” New Jersey Division of Taxation, Department of Treasury at www.state.nj.us/treasury/taxation/lpt/abstractrate.html

13.See New Jersey Constitution. Article VIII, Section I (1)

14.For a good discussion of local government revenues and taxation see Origins of the Property Tax in New Jersey, published by the New jersey State League of Municipalities at www.NjSLOM.org

15.See the above website of the New Jersey League of Municipalities for additional details of the Property Tax Proposal. See also opinion pieces by Paul Mulshine, “ Property Tax Policy is Out of Their League,” Star Ledger, June 16, 2013; and an opinion piece by Richard F. Keevey, “One Way Not To Cut the Property Tax,” Star Ledger, June 16, 2013. For additional comments on the need for property tax reform see various opinion pieces and research papers, including the opinion piece, “Property Tax reform: Difficult but Not Impossible,” by Bill Schluter, The Times of Trenton, July 12, 2013.

Richard Keevey is a visiting professor at the Woodrow Wilson School, Princeton University. He was the state budget director and comptroller for two New Jersey governors, from both major political parties. He also held presidential appointments as deputy undersecretary of defense for finance and as the assistant secretary and chief financial officer for the Department of Housing and Urban Development.

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