How a gap in city's budget became a $1 billion canyon

In June, Mayor Nutter presented a budget that had something for just about everyone - tax cuts, better parks, more police - but it came with a caveat.

"It is worth remembering that any contraction in national economic activity in 2008 or later will place many of the revenue estimates . . . at risk," he said in his five-year plan.

Well, that contraction has come, and with it a gaping $1 billion hole in Nutter's five-year spending plan.

How did the gap grow to such monstrous proportions? Just about every major area of city revenue - including business, wage, and real estate transfer taxes - has fallen precipitously. Some critics say Nutter should have braced for slow economic times, though no one suggests he could have foreseen such a breathtaking economic collapse.

Trouble arrived in August when the city's second-largest source of income, the business-privilege tax, was found to have been $399 million in the fiscal year that ended June 30 - $39 million below the $438 million predicted by Mayor John F. Street.

Nutter had counted on annual 4 percent growth in the business tax starting with Street's higher number - so the drop meant an immediate $300 million gap in the city's five-year plan.

At the same time, the sagging stock market eroded the municipal pension fund, leaving the city to make up the loss with $150 million total over the next five years.

On Sept. 11, Nutter announced that those two factors had opened a $450 million hole in the five-year plan. He warned that it could easily get worse.

"Even when we announced it at $450 million, it was a much bigger problem," Clay Armbrister, Nutter's chief of staff, said in an interview.

That became evident in the next three weeks. Lehman Bros. filed for bankruptcy on Sept. 15. Washington Mutual failed on Sept. 25, and the stock market plummeted. Finally, on Oct. 3, Congress passed its $700 bailout package, but global stocks continued to fall.

On Oct. 8, Nutter put the five-year shortfall at between $650 million and $850 million because tax receipts for the first quarter of fiscal 2009 had come in - specifically real estate transfer taxes and wage taxes - and the picture was bleak.

Real estate transfer taxes, which come from property sales, had been been sagging for two years, but Nutter predicted they would go up slightly in 2009 and throughout the five-year plan.

By late October, with credit markets frozen and the economy in free fall, it was clear those taxes would not meet Nutter's $187 million projection for fiscal 2009.

The drop in real estate transfer taxes alone added $182 million to the five-year shortfall, according to the city. The revised projection for this year, $155 million, is nearly $80 million less than the fiscal year that ended June 30, 2006.

In addition, wage taxes for 2008 were down $16 million - that's essentially $100 million out of the five-year plan right there.

On Oct. 21, finance director Rob Dubow estimated the budget gap then at $841 million, though City Councilman Bill Green predicted that it would exceed $1 billion.

Green was right. At the end of October, an actuaries' report on the pension fund, requested by Controller Alan Butkovitz, revealed an additional $174 million that the city would have to contribute between now and 2013.

On Nov. 6, Nutter announced a deficit of just more than $1 billion and a plan to close it through layoffs, service cutbacks, and a freeze in tax cuts.

At that point, the projection for wage taxes had fallen dramatically, with a staggering national economy that had shed 159,000 jobs in September.

Today, projections for the shortfall due to lower wage-tax expectations over five years have grown to $279 million because even the 1 percent dip in 2008 had forced the city to reduce all of its forecasts going forward.

Business-privilege taxes now are forecast to fall $388 million short over the five years.

The city's contribution to the pension fund now makes up $283 million of the gap.

The real estate transfer tax shortfall of $183 billion rounds out the chief four ingredients in the recipe for an economic crisis.

Those four alone account for more than $1.1 billion; the actual budget deficit comes out as less because of expected savings in other areas and expected increases in property and parking taxes.

Some say the deficit could be higher, given that Nutter is still counting on selling $3.5 billion in bonds in fiscal 2011 to shore up the pension fund and ease the city's yearly payments by $35 million annually - or $105 million over three years of the plan.

In the current market, that pension bond is not realistic. And Butkovitz said he would not count on that savings in the future.

"I'm very skeptical about it," he said. "Right now, I don't think it's a reasonable assumption for the bond to be included in those years."

Green, too, said the pension bond was "speculative," and described the administration's projections for real estate transfer, business-privilege, and wage taxes as overly aggressive.

He pointed out, for instance, that the administration assumed wage-tax growth would exceed inflation and that real estate transfer taxes would flatten out and show small growth after two years of strong decline.

"It was clear that the economy was slowing down, and I thought it was unreasonable to expect we were going to have all kinds of tax growth in all kinds of categories," said Green, who nevertheless voted with all 16 fellow Council members to approve Nutter's budget.

Green acknowledged that different forecasts would not have changed the city's predicament, but argued that making tougher choices in the spring would have alleviated some of the pain now.

Others, including Butkovitz and the Pennsylvania Intergovernmental Cooperation Authority, which must approve the city's five-year plan as required by the state, signed off on Nutter's revenue projections and are not changing their tune now.

"I don't think Green or anyone else foresaw a $250 million annual problem," said Tony DiMartino, assistant city controller.

"To be perfectly frank," said Uri Monson, executive director of PICA, "if I went to my board and said they can't approve the plan because business-privilege taxes are going to be $40 million under and Lehman Bros. is going to file for bankruptcy, they would fire me."

City budget director Stephen Agostini built the econometric model predicting growth in the city's economy. It includes information from the Congressional Budget Office, the Federal Reserve, and the Blue Chip Economic Indicators.

Agostini said the city's projections had been circulated among experts and compared with national numbers, but "everybody's going to be wrong" in the kind of dynamics that have shaken the economy since the summer.

"Many of us have not seen this in our lifetime," he said.

Going forward, Agostini said, the city's fortunes will rise and fall with the economy.

"If the economy goes in the tank in the next three to six months - which is conceivable - all bets are off," he said.