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CITY OF SAN MATEO
Agenda Report
City Hall
330 W. 20th Avenue
San Mateo CA 94403
www.cityofsanmateo.org
Agenda Number: 13 Section Name: {{section.name}} File ID: {{item.tracking_number}} TO: City Council
FROM: Alex Khojikian, City Manager
PREPARED BY: Finance Department
MEETING DATE: April 15, 2024
SUBJECT:
General Fund 2024-25 Operating Budget – Preview and General Fund Ten-Year Forecast RECOMMENDATION:
Receive the General Fund 2024-25 operating budget preview and General Fund ten-year forecast BACKGROUND:
Development of the fiscal year 2024-25 budget has been underway since January, and the proposed budget document is beginning to take shape. Before finalizing the proposed budget for City Council approval at a public hearing in June, staff wishes to provide a preview of the General Fund’s 2024-25 budget estimates for Council comment and direction.
Additionally, this report includes a ten-year forecast of the General Fund to support budget planning discussions.
General Economic Conditions
This year’s budget development encountered notable challenges due to economic uncertainties, particularly concerning interest rates, inflation, and labor market conditions. Recent developments indicate that the U.S. and local economies remain strong. However, local government agencies continue to grapple with sustained inflation, a competitive labor market, and high interest rates. These factors collectively have placed downward pressure on real estate-related tax revenues and increased costs of providing municipal services. •Economic Growth: Real GDP increased at an annual rate of 3.4% in the fourth quarter of 2023 (chart 1) and is projected to maintain a trend growth of 2.4% for both 2024 and 2025. •Labor Market: The labor market remains robust with the U.S. unemployment rate stable at 3.8% as of March 2024 (chart 2), and nonfarm payroll employment adding 303,000 jobs, significantly more than the 200,000 jobs economists expected. San Mateo County’s unemployment rate, at 3.7%, is below the national average. •Inflation: Inflation, measured by the Core Personal Consumption Expenditure Price Index (PCE), decreased to 2.9% in February 2024 (chart 3). Reduction in core PCE index signifies easing inflation, yet it is still higher than the Fed’s long- term 2% target. As such, inflation remains a concern to the economy. •Interest Rates - From March 2022 through July 2023, the Federal Open Market Committee (FOMC) increased the federal funds rate eleven times in response to elevated inflation. Since July 2023, the federal funds rate has remained between 5.25% and 5.5%. In the Federal Reserve’s March 2024 policy meeting, the Fed decided to keep the interest rates unchanged, marking the fourth consecutive meeting the Fed kept interest rates on hold. With a strong labor market, the markets now anticipate the Fed will take a gradual and cautious approach on interest-rate adjustments (chart 4) and will likely wait until the latter half of 2024 before considering any rate cuts.
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Chart 1: U.S. Real GDP Growth Chart 2: U.S. Unemployment Rate Source: U.S. Bureau of Economic Analysis
Chart 3: Inflation - Personal Consumption
Expenditure (PCE) Index Year-Over-Year Change
Chart 4: Market Projections for Federal Fund Rate
General Fund 2024-25 Budget Preview
The 2024-25 budget preview offers a rough estimate of the General Fund’s revenues and expenditures at the baseline budget levels. While not providing exact figures, this provides an early review of the City’s financial standing.
Total General Fund revenues are projected to be $166.8 million, a $5.3 million (3.3%) increase compared to the 2023-24 mid-year projections. The assumptions for major tax revenues are noted below:
•Property Tax: Expected to reach $83.7 million, an increase of $5.3 million (or 6.8%) from the 2023-24 mid-year estimates, primarily due to secured property tax growth and assumed receipt of the 2022-23 VLF shortfall. •Sales Tax: Projected at $30.6 million, comprising $23.1 million of the local 1% (Bradley Burns) sales tax and $7.5 million of local 1/4% (Measure S) transaction tax. Sales tax annual growth is expected to be moderate at 1%-2%. •Real Property Transfer Tax (RPTT): Assumed to average $8 million, aligning with long-term baseline projections. •Transient Occupancy Tax (TOT): Anticipated to be at $4 million, reflecting a significant decrease from the previous projection of $7 million, due to the San Mateo Marriott closure.
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Total General Fund expenditures are expected to reach $177.3 million, up $5.6 million (or 3.3%) compared to the 2023-24 adopted budget.
Personnel costs, including salaries, wages, overtime, healthcare, and pension, are projected to be $88.2 million. As a full- service city, to provide core services, approximately half of the total General Fund expenditure is for employee compensation. It’s worth noting that the City’s annual contribution to SMC Fire for fire services is currently included under other operating costs. When factoring in the city’s share of SMC Fire’s personnel and legacy costs, the total personnel expenses will represent a higher percentage of the General Fund expenditures, approximately 68% rather than 50%.
The projected personnel cost reflects negotiated increases in employee compensation, rising healthcare expenses, and increases in pension contributions. The latter of which will begin increasing significantly in fiscal year 2024-25 as a result of the California Public Employees’ Retirement System (CalPERS) investment loss of negative 7.5% in fiscal year 2021-22. It is anticipated that the unfunded pension liability payment will continue to increase until it reaches its peak in 2030-31 before gradually decreasing.
Other General Fund expenditures include:
•Non-personnel operating expenditures, projected to be $76.1 million, which reflects preliminary baseline budget projections and inflation adjustments.
•Transfers out, anticipated to be $13.0 million, comprising of $8.0 million contributions to Capital Improvement Plan (CIP), of which $3.7 million from Measure S, $2.7 million from Measure S for debt service related to the 2020A Revenue Bonds issued for flood control and street rehabilitation projects, $2.0 million to replenish the General Liability Insurance Internal Service Fund’s fund balance, and $0.4 million annual contribution to the Equipment and Vehicle Replacement Fund for major building component replacement.
In summary, the General Fund total expenditures are projected to exceed total revenues in 2024-25, resulting in a budget deficit of approximately $10.5 million. It will require drawing on the General Fund’s Rainy Day Reserve to maintain core services and investments in CIP.
General Fund Ten-Year Forecast Scenarios
This year’s General Fund ten-year forecast has been challenging due to two major uncertainties: (1) VLF shortfalls and (2) the impacts of interest rates on real property-related tax revenues.
VLF Shortfalls
Property tax in-lieu of Vehicle License Fee (VLF) is a key component of the City’s property tax revenues, accounting for approximately 18% of total property tax revenues or approximately 10% of total General Fund revenues. As explained by the County of San Mateo in Attachment 2, currently there is no reliable funding source for VLF shortfalls. With more school districts shifting from non-basic-aid to basic-aid status, the County of San Mateo’s VLF shortfall continues to grow.
The county-wide VLF shortfalls are expected to be $70 million for fiscal year 2022-23 and $114 million for fiscal year 2023-
24. The City’s share of the countywide VLF shortfall is roughly 6%, translating to $4.2 million and $6.6 million for 2022-23 and 2023-24, respectively. Currently, there are only five non-basic-aid school districts remaining in the San Mateo County.
The County forecasts that all school districts will become basic-aid schools within the next 7-8 years. As such, the City’s VLF shortfall is projected to reach $24 million by 2034-35.
Historically, the State has reimbursed counties and cities for any in-lieu VLF shortfalls through a special appropriation in the State budget. However, as the county-wide VLF shortfalls continue to widen, the State’s willingness to fund this obligation may diminish, particularly during fiscal years when the State experiences significant deficits. As of this report, the State has not included the county-wide 2022-23 VLF shortfall of $70 million into its 2024-25 proposed budget.
Therefore, it is imperative for the county and cities in San Mateo County to continue advocating for the VLF revenue, as losing State funding on VLF shortfalls would severely impact to the City’s financial health. This funding should remain local as it is tax revenue remitted from property owners within the City and County.
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Interest Rates and Real Estate Market
Interest rates play an important role in the real estate market. High-interest rates are expected to restrain economic activity and serve the Fed’s goal to gradually bring inflation down to the target 2%. High-interest rates also dampen the real estate market, both residential and commercial. Over the last 13 years, the City’s real property assessed value has grown annually by an average of 6.9%. Due to high interest rates, the real estate market has shown signs of slowing down.
Property tax annual growth dropped to 5.5% in 2023-24 and is forecasted to further decline to 3.0% in 2024-25. If interest rates persist at elevated levels, the cooling effect on the real estate market will continue to impact the City’s tax revenues.
Staff remains optimistic about regional real estate demand, believing that once interest rates decrease, the real estate market will rebound. However, the timing and pace of interest rate cuts remain uncertain, posing a significant challenge to the long-range forecast.
SCENARIO ANALYSIS:
The General Fund ten-year forecast (Attachment 1) illustrates the fiscal challenges and uncertainties facing the City, particularly VLF shortfalls and the impact of high interest rates on tax revenues. To address these uncertainties, staff developed three scenarios - optimistic, pessimistic, and middle-ground - to outline potential fiscal outcomes, highlighting the needs for strategic planning and preparedness for various economic conditions to maintain the City’s long-term financial health.
Optimistic Scenario: This scenario projects the highest growth in revenue sources, assuming favorable budget conditions.
In this scenario, staff assumes that the State will backfill 100% of the City’s VLF shortfalls with a two-year gap and interest rates will start to decline within the next 12-24 months. Property tax, as the primary revenue source, is projected to experience significant annual growth (averaging 6% annually), alongside modest increases in other tax revenues. As shown in Attachment 1 – Scenario B, this scenario reflects robust economic growth and optimistic fiscal health. Although rising labor costs and unfunded pension liability continue to put pressure on the City’s operations, under this scenario, the General Fund maintains a healthy balance. It projects that after a few years of operating deficits, the General Fund will start having surplus in the second half of the 10-year forecast, with its fund balance returning to the $100 million level by 2034-35.
Pessimistic Scenario: As shown in Attachment 1 – Scenario C, the State refuses to backfill the VLF shortfalls, resulting in significant revenue loss for the county and cities in San Mateo County. In addition, this scenario assumes that interest rates remain high and property tax experiences 3% annual growth for the next two fiscal years before aligning with the 4% long-term growth rate again. With slower growth in secured property tax and the possibility of losing VLF revenue, this scenario presents the most conservative projections. If realized, the results would be devastating for the City. And the City would need to make drastic cuts to service levels to balance the budget. It highlights the importance of continuing to advocate for the VLF revenue and exercising cautious fiscal management.
Middle-Ground Scenario: Reflected in Attachment 1 – Scenario A is the middle ground scenario, which represents a balanced forecast, assuming a 4% year-over-year growth for property tax, reduced VLF revenues, RPTT at $8 million baseline, TOT at $4 million baseline, and moderate growth in all other major revenues. In this scenario, the General Fund faces a structural deficit. The General Fund total fund balance decreases to $31 million in 2034-35, which is just enough to cover 15% of the General Fund’s operating expenses.
OTHER CHALLENGES
City Facilities and Infrastructure Needs
In the April 15 meeting, Public Works staff will present a five-year CIP Budget Preview to the City Council, detailing the funding needs for City facilities and infrastructure improvements. As outlined in Attachment 1, the three scenarios for the General Fund ten-year forecast were developed based on an assumption of $7.25 million baseline annual contribution to CIP from the General Fund. The baseline CIP contributions include $4.25 million from the main General Fund and $3.0 million from Measure S (a General Fund sub-fund). The City’s funding needs for CIP far exceed these baseline annual
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contributions, not to mention the City still has over $300 million in unfunded CIP projects. This underscores the substantial gap between current funding levels and the actual needs for capital improvements.
Pension Costs
Due to the high degree of market volatility, CalPERS reported an investment loss of negative 7.5% in FY 2021-22, missing its long-term investment goal of 6.8%. As a result, the City’s unfunded pension liabilities went up $101 million, driving the City’s total unfunded pension liabilities to nearly $300 million. This investment loss will be amortized over a 20-year period, beginning in FY 2024-25.
As shown in Chart 5, the City’s pension costs consist of two components: (1) normal cost and (2) unfunded accrued liability (UAL) payment. While normal costs are projected to be steady and growing at a moderate pace, UAL payments are projected to increase significantly. Due to the 2021-22 investment loss, the City will pay an additional $2 million to $8 million annually for UAL during the five-year ramp-up period (2024-25 through 2028-29). Once the five-year ramping has been completed, the increase in pension contributions is projected to be an additional $10 million per year for four years (2029-30 through 2032-33), as compared to that for 2023-24, before gradually decreasing. The General Fund’s share of the UAL payments is roughly 86% of the citywide UAL, translating to an additional $2.1 million and $2.9 million for 2024-25 and 2025-26, respectively, and then an additional $4 to $8 million per year until it peaks in 2030-31 before the UAL requirements start to ramp down.
Chart 5: Citywide All Funds - Pension Outlook
Source of information: CalPERS pension outlook. * UAL payment includes Fire UAL legacy costs and is projected under the annual prepayment option.
RECOMMENDATIONS AND STRATEGIES
In light of the uncertainties surrounding VLF and real estate market recovery, staff recommends taking the middle ground approach for the City's long-term planning. More information, particularly regarding VLF funding, may become available in June. Staff will continue to provide the City Council with updates and refined forecasting.
Under the optimistic scenario, if the City continues to receive 100% VLF shortfalls from the State and the real estate market rebounds and remains strong, the General Fund’s deficits will be temporary. While the City may not have sufficient resources to fully fund all CIP needs, it will be able to maintain core services and support baseline annual contributions to fund essential CIP projects. Under the middle ground scenario, however, the City is projecting to face a structural deficit issue and will be required to take actions to balance the budget.
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Currently, the City’s General Fund is in a strong fiscal position with an estimated $109.9 million in reserves at the end of the current fiscal year 2023-24. The estimated reserves include $39.4 million allocated to the Operating Reserve, $5.9 million assigned to the Housing Set Aside, $8.3 million committed to CIP Projects, and $56.4 million for the Rainy Day Reserve.
In contrast to the City’s limited fiscal position during the Great Recession, the City Council’s prudent fiscal discipline during the period of recovery and growth post-Great Recession placed the City’s General Fund in a solid position. This enabled the City to draw on its Rainy Day Reserve in times of economic uncertainties. As such, the City has the resources to navigate these uncertainties in the next 12-24 months. It also gives the City time to plan for measurable actions to address the budget deficit issue and meet CIP funding needs.
NEXT STEP:
Any feedback and/or direction received from the Council as a result of this report and supporting presentation will be incorporated into the recommended FY 2024-25 budget and corresponding long-term financial plan. Staff anticipates delivering the budget to the City Council with a public hearing and budget adoption in June.
BUDGET IMPACT:
There is no direct budgetary impact resulting from this report. The financial status of the General Fund will continue to be monitored. Updated final estimates will be incorporated into the recommended 2024-26 Business Plan.
ENVIRONMENTAL DETERMINATION:
This report is not a project subject to CEQA, because it is a government fiscal activity which does not involve any commitment to any specific project which may result in a potentially significant physical impact on the environment. (CEQA Guidelines Section 15378(b)(4).)
NOTICE PROVIDED
All meeting noticing requirements were met.
ATTACHMENTS
Att 1 - General Fund Ten-Year Forecast
Scenario A – Middle Ground
Scenario B – Optimistic
Scenario C – Pessimistic
Att 2 - Conceptual Overview of the VLF shortfall in San Mateo County
STAFF CONTACT
Karen Huang, Finance Director
[email protected]
(650) 522-7110