A DOZEN garbage bags lie at the gate of Garden Cemetery in Chelsea, only a few steps away from graves adorned with American flags. The bags have lain there for a long time: Chelsea is a troubled little city, much more concerned with its whopping deficit than with trash pickup.Financial problems are not news for the 1.8 square-mile community, founded in 1624, six years before Boston, in whose physical and historical shadow it languishes in 1991. While Boston is known for its key role in the birth of the American nation, Chelsea is perhaps best known for its fires - several major ones over the years. A huge one in 1973 wiped out most of the textiles and shoe factories that once were the basis for its prosperity. Other businesses in Chelsea simply closed or migrated, forcing this small community, like many other factory towns in Massachusetts to rely increasingly on property taxes to pay its bills. But in 1980, voters passed Proposition 2 1/2, an initiative that limited taxation on property. That, in turn, caused Chelsea and many other cities and towns to rely increasingly on state aid. State aid ballooned, then began to shrink. "In 1981, Chelsea received $6 million in state aid," says Mayor John J. Brennan Jr. "When I took office here four years ago, Chelsea was hovering around $21 million in receipts from the state." State aid has been cut by $4 million for fiscal year 1992, which began July 1. With tightening of the state money pipeline, municipal governments are scrambling for revenue sources. Having survived its fires, Chelsea faces a more pervasive danger: bankruptcy. With the state experiencing its own revenue shortfalls, Massachusetts voters earlier this year elected Republican Gov. William Weld, who promised to balance the state budget and avoid tax increases. Chelsea officials say their city will be broke by October. "We're going to lose at least 100 [public school] teachers out of 300," says Sidney Brown, the city treasurer. "So far, we've kept the police and fire department's personnel up. How long we can do that, I don't know." The Chelsea situation is not a local aberration. Across much of the United States the impact of recession and migration of traditional industries has left both large and small communities in serious financial straits. "There are, unfortunately, a number of distressed smaller communities that are experiencing this kind of difficulty," says William Barnes, director of research for the National League of Cities. Some longtime residents of ethnically diverse Chelsea, say that the economic problems, the slow but sure decline in the quality of services, and the reputation of what some call a "dirty, violent, drug dealers' city," is strongly connected with Hispanics, whose presence here was began to be significant in early 1970s. The leaders of the Hispanic community, now representing 50 percent of the city's 28,000 population, say the problems were always here and absorption of new people with different traditions has always been a traumatic experience. Marta Rosa, president of the commission, points out that not all the old residents share this opinion. "I have found that the Jewish community is much more aware of the 'not-so-much-the-golden-era.' I have found Jewish people who say they couldn't enter a certain part of the Irish Catholic area. So it's history repeating itself." Ms. Rosa, whose successful campaign for a position on the local school committee enabled her to officially represent the Hispanic community's interests as a delegate to the Board of Aldermen, blames the stereotypes the old-timers have about Hispanics. "We are either on welfare and not working, or we are drug dealers and we're standing on the streets selling drugs. We don't care about education; that's the stereotype," she says. For Rosa, who came to Chelsea 22 years ago, at the age of 9, the real problems lie in the local power structure. "The community has changed so drastically in composition of folks, and yet the leaders are the same people." she says. "I tell you, no one gives the community power. Every group has to find their way, to break the barriers that keep the community oppressed and marginalized. The only way we've been able to do it is through community awareness and education of people". Persistent lack of communication among Chelsea's various ethnic groups has created a vicious circle, says Mayor Brennan. Economic problems generate ethnic tensions, which aggravate economic troubles because people seem more likely to blame each other rather than searching for new solutions, he says: "People love to play the blame game." Brennan will be in office only until January 1992. He says he is determined not to seek another term because Chelsea's problems are structural and the mayor's hands are tied. One structural problem is that Chelsea is land poor, Brennan says, and therefore tax poor. People are being undertaxed he adds. Brennan says he was forced to consider a solution other than the typical "hat-in-hand" visit to the governor's office to get more state aid. "I tried to broaden the tax base by way of a Proposition 2 1/2 override. I spent six months on that and failed 3,900 to 1,100. The people killed it," he says. Chelsea resident Elaine Uminski says, "We were afraid that the wrong people would get the money. The feeling in the city is that if you've got a city job, you're set for life." Others criticize the financial practices of Mayor Brennan. "We need a manager in the city, someone who knows how to control a budget," says Fire Chief Louis T. Addonizio, who has had some disputes with the mayor over the budget. Handcuffed to a $6 million deficit for the next six to 10 months, with very little hope for economic recovery, Brennan has decided to step out in 1992.