For decades, Palo Alto has viewed its municipal utilities as both critical community operations and a prudent investment — one that helps to subsidize police, fire and popular services such as parks, libraries and art exhibits.

In recent years, the city has been transferring about $21 million from its gas and electric utilities to its general fund, which pays for most city services not related to utilities. The logic behind the transfers is simple: just as investor-owned utilities like PG&E profit from their operations, the city should be able to make money from the investment it made in municipal utilities over a century ago.

Now, that practice is facing a legal challenge, with significant budget implications. Resident Miriam Green has led a class-action lawsuit against the city, challenging the transfer policy. While the Santa Clara Superior Court had affirmed the city's right to transfer funds from utilities to the general fund, it had concluded that the city had illegally taxed its gas customers when it raised rates in 2012, 2014 and 2016. The city was ordered to issue $12 million in refunds to gas customers — a decision that both sides are expected to appeal.

But while the class-action suit continues to wind its way through the legal system, the city is significantly reducing its transfers from the gas utility to address the court order. According to City Manager Ed Shikada's proposed budget, the reductions in transfers will add $8.4 million to the city's budget hole in each of the next four years and $4 million annually thereafter.

"It really is an ongoing revenue reduction, while the first four years is a higher revenue reduction (than is) expected further out," Shikada said Thursday, during a virtual town hall meeting on his proposed budget.

For the City Council, which is now planning for a second straight year of budget cuts, the timing of the litigation could hardly be worse. The city's general fund relies heavily on revenues from sales and hotel taxes. Both revenue sources have plummeted during the COVID-19 pandemic, with hotel revenues dropping by 67% from pre-pandemic levels and sales tax revenues dropping by 23%, according to Chief Financial Officer Kiely Nose.

In fiscal year 2019, the city had received $25.3 million in revenues from hotel taxes. In the current fiscal year, that number is projected at $4.8 million. Nose attributed the precipitous drop to the fact that about 60% of the hotel taxes are collected from business and visitor travel.

"Over the last year, with both of those basically dropping to zero except for in critical areas, we have seen significant decline in our third largest revenue source," Nose said Thursday, alluding to the fact that only property and sales taxes bring in more revenue.

The city's dire budget outlook makes the utility lawsuit particularly problematic. Mayor Tom DuBois noted during the council's Monday discussion that utilities transfers have historically helped to pay for the many services that residents love.

"We need residents to support that continued transfer to utilities, or we'll have to find alternative sources, or we'll have to cut some things permanently," DuBois said. "We should be clear with people: If this transfer ends, it's going to have some real impacts."

In the coming weeks, the council's Finance Committee and the full council will determine what exactly those impacts would be. On Thursday, Shikada and Nose both went over some of the proposals in the budget for fiscal year 2022, which begins on July 1. These include keeping the Downtown, Children's and College Terrace libraries closed, while stationing vending machines at each branch to allow residents to pick up books. They also propose cutting popular programs at the Palo Alto Art Center, reducing city support for Children's Theatre, adopting a "brownout" model at Fire Station 2, which would keep the College Terrace station closed any time the department isn't fully staffed.

"This is a really difficult conversation," Shikada told the roughly 30 participants at the Thursday town hall. "We recognize community members are all coming through more than a year of really difficult conditions and are hopefully and in many ways anxious to be returning to civic life. We would like to do that as much as we can and certainly support the services provided to the community."

On Thursday, some residents questioned the planned budget cuts, including a proposal to cut the number of school crossing guards in two. Eileen Kim noted that the city is reducing crossing guards just as children throughout the city are preparing to resume biking to schools — and often crossing dangerous thoroughfares such as Embarcadero and Middlefield roads and El Camino Real.

"I just don't understand how it's possible to reduce crossing guards and be safe," Kim said. "What are the liabilities that the city has if there's an accident when there's no crossing guard?"

Police Chief Robert Jonsen assured attendees that his department and contractors will continue to enforce traffic near schools, though he said the city will have to reduce the number of intersections where crossing guards are stationed.

"We're still going to make sure high-traffic intersections have crossing guards available," Jonsen said. "It's just we're not going to be able to provide services for every intersection currently on the contract."

Shikada underscored Thursday, as he had in prior discussions, that the resource allocations in his proposed budget are not sustainable but "reflect the necessity for the city to live within our means … and ensure that our expenses do not exceed expected revenues." He also indicated that the city will soon resume exploration of a major new revenue source that the council has been discussing for years: a business tax. The council was preparing to place a business tax on the November 2020 ballot but scrapped that plan once the pandemic upended the local business climate.

Shikada said that barring declaration of a fiscal emergency, which would require a unanimous council vote, the earliest time that the city can bring a tax measure to the voters is during the next council election, which will take place in November 2022. He said the council is scheduled to discuss the business tax next month.