Forecast shows city revenues climbing after pandemic downturn | January 13, 2023 | Palo Alto Weekly | Palo Alto Online |

Palo Alto Weekly

News - January 13, 2023

Forecast shows city revenues climbing after pandemic downturn

Leaders warn inflation, staff costs and changing work habits may impact local economy

by Gennady Sheyner

Moments after Lydia Kou began her term as Palo Alto mayor, she emphasized that one of the City Council's top priorities for the year would be continuing to revive the local economy after a pandemic downturn that spurred $40 million in budget cuts.

The council will need to retain its focus on "key priorities that benefit residents, small businesses and economic recovery," she said in her first address as mayor. For her and the as newly reconstituted council, that conversation is set to kick off on Jan. 23, when members review Palo Alto's new long-range financial forecast, a document that outlines ongoing revenue challenges and paints a mixed picture of the city's economic future.

In some respects, Palo Alto remains on relatively sound footing, according to the document. After experiencing huge revenue losses during the pandemic shutdown in 2020, the city has seen the trend reverse over the past year with sales tax revenues on the rise and hotels once again welcoming guests, albeit at well below pre-pandemic levels. It also helped that voters threw the council a financial lifeline in November when they approved two revenue measures — a new business tax and an affirmation of the city's historic policy of transferring revenues from the gas utility to the general fund. Combined, these two measures are expected to net about $16.6 million in annual revenues.

But with labor and capital costs going up and with the Federal Reserve raising interest rates, city officials are warning that Palo Alto's economy may be looking at "headwinds" that can stem economic growth. While city officials are projecting a modest surplus over the next two years, the forecast shows a budget gap of $3.4 million in fiscal year 2025, which begins on July 1, 2024.

The budget challenges are due partly to the fact that one-time funding sources that the city had relied on since 2020 are no longer available. This includes major grants from the federal government through the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the American Rescue Plan Act (ARPA).

Remote work poses another challenge. For a city accustomed to seeing its daytime population more than double thanks to commuters, the recent switch by many employees to working from home means fewer patrons for local businesses. While sales tax revenues are expected to increase by $700,000, or 2.2%, between the current year and fiscal year 2024, the forecast projects that the growth will slow and that revenues will not reach pre-pandemic levels until 2026.

When the council's Finance Committee considered the forecast last month, numerous council members pointed to the changing work habits of local workers and suggested that some of the changes that the economy has experienced may be long-lasting.

"We have less office leases and so forth, and less commutes," Kou, who chaired the committee, said at the Dec. 6 meeting. "For the most part, we were told they were the main source of sales tax. With more work from home, we need to kind of focus our economic development more on people who are living here."

Tom DuBois, who concluded his council term this month, also brought up the prospect of a more prolonged downturn and suggested that the city explore a scenario in which offices remain occupied at about 50% for the foreseeable future.

"It strikes me if work-from-home persists and we have a lot less commuters than before, maybe it really looks like an extended recession," DuBois, a former member of the Finance Committee, said at the December meeting. "Rather than a recession being a blip, it's kind of a new normal and we don't really model that."

The forecast also banks on a full recovery of the city's hotel industry, which took the heaviest losses during the pandemic. Revenues from hotel taxes are also expected to slowly creep up but remain below pre-pandemic levels until 2026, according to the forecast.

According to the document, Palo Alto's transient-occupancy tax revenues plummeted by 79%, or $20.5 million, between pre-pandemic levels and fiscal year 2021, when occupancies in many hotels dropped to single digits. The forecast projects strong growth in this sector next year, driven in large part to two new Marriott hotels and the reopening of several others that had closed during the pandemic.

City officials expect hotel-tax revenues to go from $8.4 million in the current fiscal year to $14.4 million in fiscal year 2024 and that they will continue to rise every year after that, ultimately reaching $21.8 million in 2033, the final year in the forecast.

The city's most stable and sizable revenue source remains property taxes, which are expected to continue their long-established pattern of growth. Revenues in this category are projected to go up from $59.8 million in the current year to $63.7 million in 2024 and $67.3 million in 2025, according to the forecast.

While the forecast is intended to set the stage for the forthcoming budget season, it excludes from consideration numerous projects that the city is hoping to pursue but that have not been formally included in the council's capital-plan. Paul Harper, budget manager in the Administrative Services Department, noted that the forecast does not include funding for the renovation of Cubberley Community Center, advancing the city's Sustainability and Climate Action Plan, rebuilding rail crossings or upgrading the animal shelter.

The forecast includes a "moderate scenario" recession that assumes slower revenue growth. In this scenario, the city would face a $7.2 million budget gap in 2025 and smaller gaps in the following three years before revenues overtake expenses. It also includes a scenario that takes into account the new business tax, which the city will gradually implement over a three-year period starting in fiscal year 2024.

Funding from the business tax is restricted to three categories: affordable housing, rail improvements and public safety. The forecast assumes that if about 30% of the tax proceeds (or about $3 million) are to offset known eligible expenses, it will add about $3 million in revenues every year after 2026.

While the document suggests that the city is on the road to recovery, it also warns that expenses will continue to go up, in some cases for reasons beyond the city's control. Staff turnover remains an issue, with the city struggling to recruit and retain employees. The forecast also cites "supply chain issues and inflation that continue to increase costs across all aspects of the city."

"With these variables, ongoing revenues are unable to keep pace with expenses in the short term," the forecast states.

Email Staff Writer Gennady Sheyner at [email protected]


Posted by NeilsonBuchanan
a resident of Downtown North
on Jan 11, 2023 at 10:23 am

NeilsonBuchanan is a registered user.

These projections are a great start for the new Council. I urge the Council to reach their own consensus for major opportunities and risks before the annual setting of new priorties. Thereafter, the Council's Finance Committee can focus on realities as they unfold.

Posted by Eric Filseth
a resident of Downtown North
on Jan 11, 2023 at 3:12 pm

Eric Filseth is a registered user.

I love the LRFF, but you do have to be aware of some the assumptions in it.

One involves the growth of labor expenses, a large element of City costs. Because labor contracts only last a couple of years at a time before renegotiation, labor expense increases aren’t known explicitly more than one or two years in advance. Everything beyond that is an assumption, and City LRFF convention for the out-years is to use 2% per year, basically a theoretical floor. Because City -revenues- normally grow faster than this, the out-years of LRFF’s almost always look great, just like this one does. But in reality only-2% labor expense growth hardly ever happens, let alone in high-inflation periods.

Those of us who were Excel-heads usually took the LRFF as a baseline, and experimented with our own extrapolations using a variety of alternative assumptions. The George Box aphorism, “All models are wrong, but some are useful,” absolutely applies here.

Posted by Annette
a resident of College Terrace
on Jan 14, 2023 at 7:21 am

Annette is a registered user.

About labor costs - here's an exceprt from a 12/16/22 news article about City salaries:

"The new contract, which runs from January 2023 to June 2025, includes three significant changes. First of all, it would approve a pair of 4% increases to all base salaries, the first of which would kick in on July 1, 2023, and the second on July 1, 2024."

Why not require that the LRFF abandon the 2% assumption for labor costs and instead use at least 3%.?? Other than possibly some short-term positive press, nothing good comes from making unsubstantiated rosy forecasts that are relied on for spending decisions only to have to face a harsh reality later in the fiscal year. We sure as heck don't want Palo Alto to follow the State's lead and go from touting a robust surplus to a serious deficit.

Posted by Tom DuBois
a resident of Midtown
on Jan 14, 2023 at 9:34 am

Tom DuBois is a registered user.

Annette - because it’s a floor for negotiation. If we used 3%, then labor groups would never accept less - it’s already budgeted, even in a year of deflation. Council is informed and aware of many of the assumptions as Eric Filseth pointed out.

Posted by Annette
a resident of College Terrace
on Jan 14, 2023 at 10:27 am

Annette is a registered user.

@Tom DuBois - thank you for that explanation.

Posted by Annette
a resident of College Terrace
on Jan 15, 2023 at 11:13 am

Annette is a registered user.

Questions for Tom DuBois.

First, please elaborate on this: "If we used 3%, then labor groups would never accept less . . ."

I ask because that sounds to me like labor groups come to the table with the expectation that the outcome will be at least a 2% pay increase and that expectation would only be higher if the City budgeted more money. That assumes a healthy economy, sufficient revenue streams, and the potential for compensation levels that are out of synch with what often happens in the private sector. In the private sector, sometimes finances are such that bonuses are not paid and salaries are frozen or held at a modest level.

How is it that what the City budgets for labor costs can be viewed by labor groups as a starting point?
Why should labor groups enter negotiations assuming any specific claim to City money?
Why not start at zero?
Where/how does merit enter the equation?
And are negotiated increases across-the-board regardless of pension classification?

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