How Cities Fail: Service Delivery Insolvency and Municipal Bankruptcy

By Clayton Gillette (New York University School of Law)

Clayton Gillette

Courts in municipal bankruptcy cases have confronted the inherent vagueness in the statutory tests for municipal “insolvency” by embracing a test of “service delivery insolvency.” That test is typically evaluated in terms of a significant reduction in the availability of city services. Focus on a municipality’s failure to deliver services certainly serves as a plausible proxy for fiscal health, since provision of services is a primary function of local governments and thus a function that a financially healthy municipality would satisfy. Initially, such a test appears to be viable, since it invites both temporal and interlocal comparison service levels as a measure of fiscal health. Nevertheless, this article indicates severe limitations of a service delivery insolvency test. Reductions in service may indicate efforts to recover fiscal health rather than indicating fiscal distress, because that distress was generated by overspending on services. In addition, focus on particular service reductions as a measure of insolvency creates perverse incentives for local officials who desire to obtain debt relief to diminish those services most susceptible to measurement. When determining eligibility for Chapter 9, two potential measures other than service delivery insolvency may serve as alternative or complementary proxies for the need to adjust municipal debt: population outflows and loss of agglomeration benefits.

Population outflows may serve as an alternative indicator of fiscal distress. A city that fails to provide services at a level commensurate with its tax prices may lose mobile residents, and population declines imply that the per capita debt of the municipality is increasing. But that measure does not necessarily distinguish among emigrants. If those who exit consumed more services than they paid for, then exit will not necessarily betoken fiscal distress.

Local fiscal health is often dependent on the capacity of the locality to obtain the benefits of agglomeration. As a result, and notwithstanding measurement difficulties, one promising proxy for fiscal distress entails identifying whether those who have exited would otherwise have contributed agglomeration benefits to the locality. Agglomeration effects are related to the benefits that individuals or firms receive from being located within a network of other individuals or firms, such as sharing of knowledge and information, reducing spatial mismatches between jobs and places of residence, and neighborhood effects which are necessary for the development of social capital. Agglomeration may affect decision making by prompting residents to remain when they might otherwise emigrate because they would lose network benefits in excess of the gains they would obtain from exit. Demonstrable declines in agglomeration benefits could, more than population declines or rough measures of service delivery insolvency alone, inform judgments about the potential sources of fiscal distress and the likelihood that debt adjustment would be appropriate. If population decline is largely attributable to exit by firms that tend to generate local agglomeration benefits, then continued and declining fiscal distress is more likely to occur without intervention than if population decline results from exit that creates less of a reduction of those benefits.

The full article is available here.