Monday, April 11, 2011

How Much can a People Afford - Revisited

A while back I wrote a little bit about how a municipality, as an example of volatile income, must manage it's expenses over time.  I concluded with "either you cut expenses, or you take on debt".   Chatting with a friend today it came to me that I missed one: find alternative income sources.

That should have been obvious - what's the first thing a public body in trouble tries to do?  Raise taxes.  I did list taxation among the various sources of income for a municipality, but neglected to touch on this point.  More on that in a moment.  The other way to increase revenues is to get the economy moving or appeal to the community to do so, or in some way chip in.  Driving up tourism with an advertising campaign or attracting large businesses with huge pools of employees by offering a tax break to the firm for relocating, closing a few streets for a new festival (think permits, taxes, parking tickets and passes that all can generate revenue.)

I seem to remember as a kid there being local, volunteer "friends of the fire department" or "neighbors of mytown PD".  Maybe I'm imagining it, but it seems like there used to be a quasi-grass roots approach to fund raising for public services in lieu of raising taxes or cutting services and jobs.  The Policeman's Ball, the Fire Department Chili Cook-off, bake sales, pancake breakfasts, ice cream socials, benefits, community yard sales, and so on.  Granted, in a city of 750,000 people, with 300 officers on your police force, making up a shortfall that may cost you 1/3rd of your force with bake sales is a bit of a stretch.  But turning over the city park for a music festival where proceeds go to the PD, and having a "support your local police" donation box at every community service event attended by a police officer would be a start. 

So, the point is, sometimes a mayor has to get creative, especially if the turnips are already looking pretty dry.  Which is my way of segueing to tax increases.  As many economists and historians have noted, taxation has the effect of retarding the activity that is taxed.  For one, people have a natural aversion to paying taxes.  This is increased when there are myriad available deductions that have been carved out for special groups of people by their elected representatives.  If you offer loopholes, people will try their best to slip through them.  It's human nature and only makes sense because it has the legitimacy of law.  Of  course I'm referring mainly to income tax here.  Business tax isn't much different.

Taxes on commerce and trade are a suitable thing.  Trade and commerce benefit from things like roads and crime reduction.  More broadly, infrastructure and services.  Really, they benefit everyone, but so goes the rational when politicians cast their gaze upon one constituency or another.  So lets go back to the scenario outlined in the first article where local revenue has taken a sudden dip due to a down turn in the economy.  If I elect to raise taxes, what is the likelihood that it will have a positive affect on this trend? 

Some numbers to consider:

I own a shoe store that grosses $75,000 annually and nets me, the sole employee about $30,000 in profit after all expenses.  I pay my personal income tax on that and probably wind up with about $26,000 at the end of the year.  Part of my expenses is the local 3% commercial tax, or $2,250.  Business takes a bit of a down turn due to a sagging economy and my revenues this year only see me gross $60,000.  My commercial contribution to the city government is going to go down to $1,800.  Lets just pretend this is typical for all businesses in my city.  This means the city has taken a whopping 20% hit to its revenues from the commercial tax alone.  In an attempt to balance the budget, the mayor and city council after much deliberation and impassioned pleas from businesses and the police and fireman's unions decide to raise the local commercial tax by 1%.  This will give them $2,400 on my $60,000, which is a lot better than the $2,250.  It will allow the city to pay some debt, build the rainy day fund and keep services at current levels.  The police, fire and residents are happy.  But business just took a pretty hefty hit.  When my revenues went down to $60,000, my take home went from $30,000 to $15,000.  When the tax rate went up, it further dug in to me for another $150, reducing my total take home to $14,850.   Now, if I've been planning well all along, I can weather the storm for a while, but you can see how the tax increase has just made things a bit tighter for me.  With the increased burden on business, the long term survivability of businesses decreases.  If a down economic cycle is protracted, I may have to close up shop, which means the city will get $0 next time around. 

Now, we can say that it's the down economy and not the tax increase that has put me out of business, but the tax increase certainly hastens that eventuality.  If this kind of balancing goes on for a long time and becomes the new normal, I may likely look afield to friendlier tax terms in other cities.  Then the city loses my commercial income, my personal income, my local economic impact through the buying of my services and goods... and gains an empty hole in the strip mall where my store used to be which sends a disheartening message to everyone who sees it.

So - balancing the books on a large and volatile scale... no easy task.  But I think there's one thing we can conclude - a positive community spirit and attitude can make things a lot better.   Especially a willingness by an administration to be creative and appeal to the population for support rather than legislate it.

A good historical example of this goes back to WWII.  The US ran up the biggest debt in its history to fund war efforts.  To finance this debt, the government SOLD war bonds.  Advertisements encouraging people to do their part to win the war touted the war savings bond as a way to do it.  This is an interesting approach vs borrowing from another country or raising taxes.  A purpose specific bond offers many benefits to the public.  First, the chance to invest money with the promise of a return.  Second, the positive feeling of buying into something voluntarily rather than being coerced into funding it against your principles.  Third, by keeping the debt "in house", the influence the ownership of that debt would command if owned in aggregate by a foreign power is neutered.   As a citizen of spare means, I don't have to buy a bond.  As a citizen of extravagant means, I can buy a bunch and earn a good return.  This is a free, open and positive way to finance a debt.   Bonds typically have more favorable terms for the borrower, vs. loans, as well.

Getting a municipal budget to balance is tricky when so many factors play into the equation, but creative governance and engaged public can pull through tough times, given the chance to collaborate.

Saturday, April 9, 2011

Cash Flow Types

Not everyone can easily live within a budget.  There are a few types of cash flow model I want to present to you with names so you'll recognize which you fall under when you see it.  Being able to recognize your cash flow model will help you determine what kind of budget you'll be able to lay out and how easy or difficult it will be fore you to stick to.

The two driving factors are Income and Expenses.  We have either a Variable Income or a Fixed Income, and we have either Variable Expenses of Fixed Expenses.  This gives us four types, any of which we may move between during the course of our lives.

Four Patterns

Fixed Income, Fixed Expense   (FIFE)
Variable Income, Fixed Expense  (VIFE)
Fixed Income, Variable Expense  (FIVE)
Variable Income, Variable Expense  (VIVE)

The acronyms, FIFE, VIFE, FIVE and VIVE actually have some helpful mental cues to them.  FIFE is like pleasant music - it is the least stressful because you can plan your budget to a penny and not worry about deviating from it.  It is also the least likely to be encountered unless you are a VERY frugal pensioner, have a stable job and simple life, or recipient of a trust.  VIVE on the other hand is like it sounds... vivacious - exciting and a bit dangerous.  When all things are variable, you have a much harder time planning, but it is possible.  This is what small businesses typically encounter.  VIFE is what the self employed typically see - job to job income, regular house payments.  FIVE is typical of pensioners with medical problems, families with children and so on.

Each of these cash flow types can be handled with some degree of budgeting and planning.  We don't have to face these different modes of cash flow on a hand to mouth basis, but it takes a lot of discipline and some good foresight to get in front of and stay on top of.

Let's start with FIFE as that's the easiest and most common for college grads and single or married working folk with no children.  With a fixed cash flow, planning is as simple as setting a budget that keeps you within your means, covers the basics like rainy day savings, giving, debt reduction and having some fun, and then sticking to it.

Later in life, you may find yourself with debt but unemployed - ala VIFE.  Your income has just become variable (with a minimum threshold of ZERO or at least unemployment benefits) but you still have expenses. Planning in this situation is going to be a little tricky.  First thing, start looking for work and take anything that pays.  If it's not "your thing", make sure your clear with the employer that it's short term and you're actively seeking your ideal job of "x".  Then you need to look at what you've got saved, what your monthly expenses are and how long your savings will pay those expenses.  This gives you a timeline for other planning activities outside of finding a job - namely asset and debt reduction.  This typically means getting rid of things that are a source of ongoing expense.  You might have to sell your car, move to a cheaper apartment or in with friends or  family.  Consider renting a room instead of a whole place all your own.  Definitely cancel the cable and if you have a cell phone and can go to the library to check your email, get rid of you phone plan for now as well.  Or ditch the cell phone plan and go to a prepaid phone, which is typically cheaper over the course of a year.  Be resourceful and don't cling to material possessions.  The temporary security they bring you is easily destroyed by the debt you might take on to keep them.  Keep your credit card tucked away for emergencies only.  Don't use it as your own personal bail out, you'll just bury yourself in debt maintenance and, as Ben Franklin said: "he who takes a debt gives another control over his liberty."

Hopefully, you're making your full time job finding the right paying job, but your part time occupation is going to be handling your expenses with dwindling resources.  This is a great time to make some life changes regarding the standard of living you've adopted.  Do you really need all that "stuff"?

Another challenging but equally approachable cash flow model is FIVE.  You have a fixed income but your expenses are variable.  Maybe this is because you have kids and they have random registration fees for sporting clubs or need extra supplies for school projects.  Or perhaps you are on social security or a pension and you are having the usual old age symptoms of random Dr. Visit here, random prescription there.  The important thing here is that you have finite resources.  So you need to plan according to that with a reasonable allowance for expected variables.  Usually we would add up our expenses and subtract from our income.  But to manage the variables, we're going to have to determine a min and max range that is expected.  Add up all the variable costs for the past few years and average them to get this range zeroed in.  Then, in your budget, set aside enough each month to cover the necessary variable expenses.  If this leaves you in the red, look to your fixed expenses for things you can restructure, down-size or eliminate until you have a comfortable monthly budget that will absorb your variable expenses over the course of the year.

Finally, VIVE.  This is more common to small businesses or self employed people who own a business that has a lot of consumables or inventory that experience variable or seasonal demand.  My sister is a bakery coordinator.  Her job is to look at the amount and types of bread being bought month over month at each location she manages and determine how much bread of each type to buy materials to make in the coming month.  This is a complex projection model that is heavily data driven and requires a lot of planning.  The full detail of this is beyond the limited scope of this article and I hope to write something more comprehensive with my sister's aid in the future.  My take on the VIVE cash flow model, though, is that in addition to projecting your expenses, you need to be projecting your income as well based on trends.  This means a LOT of data gathering which in itself can overwhelm a small business, which should give some idea as to the value of a good accountant and solid book keeping practices.

Summing it up, regardless of your cash flow type, you will want to use a budget to keep your expenses inline with your income and to plan for the future.  That's the big thing - the future is what we're all heading for, so let's get there in the best shape possible. Have questions or feedback? Leave a comment!