Over the next few weeks, many municipalities and states will be trying to hash out their budgets. It is clear that this is not going to be an easy task.

Already, the controller of Harrisburg, Pa., the state capital perched on the Susquehanna River, is talking about declaring Chapter 9 bankruptcy, which gives communities protection from creditors while trying to work out a debt payment plan. If the city goes ahead, it would be the first time since at least World War II that a state capital declared bankruptcy.

But for the most part, municipalities are likely to try to avoid this route. It involves lawsuits, the loss of access to the bond markets to fund their capital projects, and allowing a bankruptcy judge to make decisions normally the province of elected officials. Also, just the mention of the word “bankruptcy” by a public official sets off alarm bells for the bond-rating services.

“It will trigger a call and questions from us,” says Richard Raphael, group managing director for public finance at Fitch Ratings in New York. “The consideration of it is a serious concern.”

Mr. Raphael does not expect defaults on bonds to be widespread, but he adds, “There will be situations of severely distressed communities.”

Most cities and states obtain their revenue from either property taxes or income taxes. During good times, there is a lag in the downturn in revenues. But during bad times, it works the other way.

For example, unemployment in some states is as high as 14 percent. This reduces state income tax collections. At the same time, an unemployed consumer is not spending as much money, reducing sales tax receipts.

And the federal funds from the stimulus package, which were helpful to states in balancing last year's budgets, will be phasing out as well. In New York, Mayor Michael Bloomberg complains regularly about the cut in state funds.

In addition, many states will continue to see income tax revenue fall this spring, as investors continue to write down losses in the stock market. Analysts expect the market’s downturn to hang over state finances for some time, because investors can carry the capital gains losses forward for years.

And, many communities are still experiencing a downturn in property values. This either reduces revenues after an assessment or results in fewer home sales, which may effect transfer taxes.

“We think many municipalities will have budget pressures that will require cutting or raising revenues,” says Mr. Raphael.

States and communities also have a lot of assets that can potentially be sold, points out Mark McMullen, a director at Moody's Economy.com, who follows state and local governments.

“These are not underwater homeowners or financial service companies,” he says. “They have a lot of infrastructure and land and valuable assets to cash in.”

In Harrisburg, for example, there are news reports that Mayor Linda Thompson is trying to work out a way to sell some assets. The controller, Daniel Miller, did not return several phone calls.

There are ramifications for the future of a community that declares bankruptcy. “It does adversely affect your credit rating going forward,” says Mr. McMullen. States need a good credit rating, because they need to borrow to finance capital projects, such as water treatment facilities, and to smooth out their income stream.

The largest example of a community declaring bankruptcy is Orange County, Calif., which filed for Chapter 9 in 1994. The last community to declare bankruptcy appears to be Prichard, Ala., which filed for Chapter 9 in October 2009. This was the second bankruptcy for the town, which also had sought protection from its creditors in 1999. The main reason it entered bankruptcy was to address debt from fighting lawsuits and to work out a way to pay retired municipal workers.

A year earlier, Vallejo, Calif., went bust. That city was hurt by declining real estate values after the housing bubble burst in 2007. Rafael says the city has used the bankruptcy to try to renegotiate some labor contracts. “They presented a plan in December, but it’s not approved yet,” he says.

In fact, even if a community felt as if it had no choice but to declare bankruptcy, it might not be able to do so. Half of the states require a municipality to seek state permission to file. That may not be easy to obtain. Instead, a state may set up a control board to monitor the finances of the community. Pennsylvania is one of the states that requires a municipality to seek permission to go bankrupt.

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