After languishing relatively disused for nearly eighty years, municipal bankruptcy is part of the new normal. The eyes of the nation were riveted on Detroit, and smaller filings across the country have proliferated in recent years. As Warren Buffett has argued, bankruptcy is becoming more legitimate as a way of dealing with municipal financial distress, and we should expect to see more of it.

At the same time that municipal bankruptcy is becoming more common, the image of the typical municipal creditor is changing; the typical creditor may be a retired worker instead of a distant bondholder. In the wake of recent decisions signaling that public pensions may be cut in bankruptcy, we may expect to see more and more cities deploying bankruptcy as a way of cutting pensions when the residents don’t want to raise taxes. In my recent article, Taxes and Ability to Pay in Municipal Bankruptcy, I argue that bankruptcy was not intended to be used this way. The legislative history of six major municipal bankruptcy statutes passed from the 1930s through the 1980s shows that bankruptcy is for municipalities that can’t pay, not those that just don’t want to pay.

Moreover, congressional intent was for tax increases, not just spending cuts, to be on the table when a municipality seeks federal bankruptcy protection. Indeed, the legislative history suggests more congressional interest in tax increases than in spending cuts in the debates over the prerequisites for relief in municipal bankruptcy. In short, municipal bankruptcy was never intended as a way to ensure that budgets are balanced by spending cuts instead of tax increases.

The still-developing caselaw on municipal bankruptcy is consistent with the legislative history on this point. Cities that received bankruptcy relief, cities such as Detroit in Michigan and Stockton, Vallejo, and San Bernardino in California, have been found to have made credible showings that they were in deep, bona fide financial distress, so that tax increases would not actually raise revenues. By contrast, courts have denied relief to municipalities that could have raised taxes to meet their obligations. And in the bellwether California case of Stockton’s municipal bankruptcy, the court found taxes and bankruptcy deeply intertwined: it found the city eligible for bankruptcy in part because bankruptcy made it feasible to pass a tax increase.

At least four different statutory provisions reflect the overarching policy against the use of bankruptcy to avoid payable debts. These are the requirement that a municipality be insolvent to commence a bankruptcy case, the requirement that cases and plans be filed in good faith, and the requirements that bankruptcy plans be “in the best interests of creditors” and be “fair and equitable” to dissenting classes of creditors.

It might be argued that it violates the Tenth Amendment for a federal bankruptcy court to evaluate whether a municipality could raise taxes to meet its obligations instead of filing a bankruptcy plan that cuts pensions. The legislative history suggests that Congress thought this objection was met by the fact that the court would simply be applying conditions to relief that the bankrupt municipality is affirmatively seeking. The recent expansion of the unconstitutional conditions doctrine in Sebelius v. National Federation of Independent Business might call that view into question, but even so, considering tax levels in evaluating bankruptcy relief is easily distinguishable from conditioning Medicaid funding on eligibility expansion.   For one thing, Sebelius stressed the argument that Medicaid is too big a part of states’ budgets to turn down, but nearly half of states have turned down municipal bankruptcy; only about half of states have authorized their municipalities to file for federal bankruptcy protection. Nor is considering taxes a change to an ensconced federal program, as the principle that taxes are relevant suffuses the (sparse) caselaw on municipal bankruptcy as well as the relevant legislative history.

Just how are bankruptcy courts supposed to take ability to tax into account? A strict requirement that the municipality tax to the level where tax increases do not produce revenue – taxing to the top of the Laffer curve – could be supported based on the statute’s text and legislative history, but the paper suggests courts consider a less extreme test, one that has support in judicial precedents that consider where a city’s taxes are relative to its peers’.   The paper suggests that if a city taxes below the top of a range of its peers, it would have to explain why not when defending its eligibility for bankruptcy. An acceptable explanation would be that the bankruptcy itself would make a tax increase to the top of the peer range feasible. Cities would also to reach or maintain taxes at the top of the range as part of the bankruptcy plan of adjustment or offer an explanation for not doing so.

The preceding post comes to us from John P. Hunt, Professor of Law at UC Davis School of Law.  The post is based on his recent article, which is entitled “Taxes and Ability to Pay in Municipal Bankruptcy” and available here.