Summary

I use to carry out their economic responsibilities in an equitable and efficient manner? From the general overview in this introductory section, the book proceeds to specific analysis of separate pieces of state and local finance

and then returns, at the end, to more general analysis of broad policy

issues. WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

. . . It has become evident in recent years that the serious business of governing the United States is

largely being done in the States.' —THE WALL STREET JOURNAL

HEADLINES

IN A 1999 SURVEY OF PUBLIC ATTITUDES TOWARDS GOVERNMENTS THAT CONTINUED A LONG

SERIES BEGUN BY THE US ADVISORY COMMISSION ON INTERGOVERNMENTAL RELATIONS,

RESPONDENTS WERE ASKED... "FROM WHICH LEVEL OF GOVERNMENT DO YOU FEEL YOU GET THE

MOST FOR YOUR MONEY?"

LOCAL AND STATE GOVERNMENTS DREW THE HIGHEST NUMBER OF RESPONSES, CONSIS-

TENTLY OUTDRAWING THE FEDERAL GOVERNMENT BEGINNING IN THE 1980S.

A SECOND QUESTION ASKED ABOUT "TRUST AND CONFIDENCE" IN GOVERNMENT TO "DO A

OOD JOB." MUCH HIGHER PERCENTAGES TRUSTED THE LOCAL AND STATE GOVERNMENTS THAN

FEDERAL GOVERNMENT TO DO A GOOD JOB "A GREAT DEAL OF THE TIME" OR "A FAIR

UNT OF THE TIME." 2

PUBLIC'S 1999 RATINGS OF FEDERAL, STATE, AND LOCAL GOVERNMENTS

Most for Money (percentage) Do a Good Job (percentage)

23 56

29 67

3 1 69

raverse City Whacks Washington.' Wall Start Journal, 28 July 1987.

L. and John Kincaid. "Public Opinion and American Federalism: Perspectives on Taxes, Spending, rust." SpectruM: The Journal of State Government, Summer 2001.

3

Figure

Overlapping local government boundaries-Ingham County

PART 1 ■ INTRODUCTION CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

4 5

The economic issues involved in the financing of state-local governments deserve and demand separate attention for four primary reasons: (1) the state-local government sector is a substantial part of the U.S. economy, with its spending rep- resenting nearly 14 percent of Gross Domestic Product (GDP) and comprising more than half of total government domestic expenditure; (2) the major services pro- vided by state-local governments—education, transportation, social services, and public safety—are those that most affect residents on a day-to-day basis; (3) state-local government experiences, experiments, and policies often form the basis for subsequent programs or policy changes by the federal government or even by gov- ernments in other countries; and (4) because of the diversity of state-local governments and the ease of mobility among them, the analysis of many economic issues is sub- stantially different in the state and local arenas than for the federal government.

The importance of diversity and mobility for state-local government finance cannot be overemphasized. As you will learn in this book, tremendous diversity exists both in the structure of subnational government in different states and in the magnitude and mix of revenues and expenditures. In 2002, there were about 87,275 different state-local governments in the United States, each with independent functional responsibilities and revenue sources. Besides the 50 states, these includ- ed about 39,000 general-purpose local governments (counties, municipalities, and townships) and about 48,600 special-purpose local governments (school and other special districts). Because the boundaries of many of these jurisdictions overlap, any individual is a member or resident of at least two subnational governments (a state and a locality) and more likely a resident of four or more (state, county, municipality, or township, and at least one special district), each with separate elected officials and separate taxes and services.

The complicated relationship among local jurisdictions is illustrated in Figure 1.1, which depicts the cities, townships, and school districts for one county (of 83) in Michigan. Residents of the area covered by the map obviously are part of (that is, elect officials, pay taxes to, and receive services from) the State of Michigan and Ingham County (shown in gray). Within the county, the fine solid lines identify cities (Dansville, East Lansing, Lansing, Leslie, Mason, Stockbridge, Webberville, Williamston, and so on). Townships are shown as the regular square-shaped areas outlined in dotted lines that cover the entire county, with township names printed in italics. School districts (shown by the thicker, jagged lines) cross city, township, and even county boundaries. As an illustration, residents of the Williamston School District also could reside in Williamston City or Williamston, Locke, Leroy, Wheatfield, Alaiedon, or Meridian Townships. Thus, residents in this area are members of at least four state and local jurisdictions.

The division of responsibility among these different types or levels of subna- tional government varies substantially by state or region, however. In some states, such as Alaska, Arkansas, Delaware, Hawaii, New Mexico, and Vermont, local governments play a relatively limited role with the state government being domi- nant. In others, such as Colorado, Florida, New York, and Texas, local governments account for the majority of state-local expenditures. The division of responsi - bility within the local sector also varies by state. In Maryland, for example ,

counties are the dominant form of local government, collecting about 70 percent of

local own-source revenue and making about 74 percent of all local government

East Lansing

Haslett Okemos

Williamston

I Stockbridge

Stockbridge

Stockbridge

a a a 200

PART I ■ INTRODUCTION

6

expenditures. At the opposite end of the spectrum, counties have no fiscal role at all in Connecticut where local government services are provided primarily by 179 separate and nonoverlapping "towns." Michigan represents a more common or typical structure where counties account for about 21 percent of local expenditures, municipalities and townships about 32 percent, and the rest by special districts, especially independent school districts.

In short, it can be very misleading to talk about "the services" provided by states, counties, cities, or local governments in general because there is no single structure. Similarly, even among governments that have responsibility for the same services, the quantity and quality of service provided can vary substantially. There is also great variety in the way in which subnational governments finance those services—that is, on which sources of revenue to rely. Indeed, this diversity is the essence of a federal, as opposed to a unitary, system of government.

The ease of mobility among these diverse subnational governments, however, causes the diversity to have economic implications. Diversity is largely uninteresting without mobility, and mobility is unimportant without the choice diversity creates. The notion of mobility here is not only physical mobility (the location of residences or businesses among different jurisdictions) but also economic mobility (the choice of where to consume or invest). In many cases, individuals can independently select the location of residence, work, investment, and consumption. Many individuals live in one city, work in another, and do most of their shopping at stores or a shopping mall in still another locality. In some cases, these activities cross state as well as local boundaries. And, when individuals save through bank accounts or mutual funds, their money is invested in all kinds of projects located in many different states, local- ities, and even different countries. This economic mobility coupled with the choice provided by the diversity of subnational governments is largely the topic of this book.

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

7

Table 1.;

The Relative Size ofj Federal and State—Local Government, 2003

Federal Government

Amount Percentage

State and Local Government

Amount Percentage

Type of Expenditure (billions) of GDP (billions) of GDP

Expenditures from own sources $2,263.9 20.6% $1,162.5 10.6%

Expenditures after grants 1,924.9 17.5 1,501.5 13.7

Domestic expenditures, own sources 1,581.8 14.4 1,069.2 9.7

Domestic expenditures, after grants 1,243 11.3 1,408.1 12.8

NOTE: Domestic expenditures include nondefense purchases, transfer payments to persons and governments, and net subsidies of government

enterprises

SOURCE: Department of Commerce, Bureau of Economic Analysis

Figure 1.2

600

Federal civilian IIII Federal military State ■ Local

g 500•

8- 400 0 0

300

Government

employment

relative to

population

FISCAL CHARACTERISTICS OF THE SUBNATIONAL PUBLIC SECTOR

O a

Size and Growth

In 2003, state-local governments spent more than $1,160 billion of resources collect- ed from their own sources (that is, excluding spending financed by federal aid), which represented almost 11 percent of GDP (see Table 1.1). When spending financed by federal grants is included, state-local expenditures represent nearly 14 percent of GDP. It is also interesting to compare the state-local sector to the federal government alone: For every dollar collected from its own sources and spent by the federal government in 2003, state-local governments collected and spent about $0.51. In per-capita terms, state-local governments collected and spent about $4,040 per person in 2002, whereas the federal government collected and spent (including grants to state-local governments) about $7,860. If comparison is limited to spending for domestic programs by all levels of government, state-local governments collected more than 40 percent of those funds and were responsible for spending about 53 percent. Finally, as depicted in Figure 1.2, state and local gov ernments account for more than 80 percent of all government employees, a share

1965 1970 1975 1980 1985 1990 1995 2000 2002

Year

that has been increasing over time. By any of these measures, state-loc overnments are both an important component of the U.S. economy and yeg

e fractiorcr5Fthe entire government sector. Another interesting way to evaluate the magnitude of state-local c

ctivity is to think of the states as business firms—taking in revenue and roduc- Lrig services—and compare the states based on genera revenue to the largest cor-

o,rauons based on sales revenue. All the state governments are large enough to be e Fortune 500 list of largest firms, 9 states are among the 50 largest (by

f these entities, and California is fifth largest, exceeded only by Wal- es, Exxon-Mobil, General Motors, and Ford.

25

20 -

Figure 1.3

State-local

expenditures (as a

percentage of

personal income)

PART I ■ INTRODUCTION

-o- State-local total -s- State-local own source State total -o- State own source

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

$8000 State-local total State-local own source -a- State total -o- State own source

$7000

$6000

$5000

$4000

$3000

$2000

$1000

9

Figure 1.4

State-local expen-

diture (per capita

in 2000 dollars)

0 I I I . ; .[ t .1, . • ,1 41' ';‘ cfg A4 41) `bb ce ofP 44' 4;1'e ce 44" 413 0 44b cfP cP1'

Year

The current substantial relative size of the subnational government sector arose initially from a roughly 25-year period of sustained rapid growth between 1950 and 1975. Using National Income Accounts data, state-local expenditures grew from about 6 percent of GDP in 1950 to about 12 percent in 1975, implying that state-local spending increased at roughly twice the rate of the national economy. Using Census data, the growth of total state-local government expenditures (either including or excluding spending financed by grants), both relative to per- sonal income and in real per-capita dollars, is depicted in Figure 1.3. In 1952, total state-local spending from all sources represented slightly more than 11 percent of personal income, but, by 1975, state-local spending had grown to about 20 percent of income. Even excluding federal grants, state-local spending from own sources increased from about 10 percent of income in 1952 to about 17 percent in 1975. A similar pattern of growth is shown by per-capita, 2000 dollars, indicating that state-local spending also increased faster than population growth and prices during this period. Not surprisingly, the pattern of growth in spending by state governments alone parallels the pattern for the entire state-local sector rather closely.

The relative growth of the state-local sector in this period is usually attributed to three factors. First, income in the United States increased rather substantially in these years; this caused an increase in demand for many different types of goods and services, some of which were provided largely by subnational govern- ments. Second, growth in population and change in the composition of the pop- ulation (especially the postwar baby boom) also lead to an increase in demand for state-local services (especially education). Third, substantial increases;

0: . ,

y1 aS°ti cfg' AQ' 14) ti5 4) 0, 4, 00 .;\ 6, 6\ 61, ayti 4:/ 1 .$1 4F4 4F$ 1 N 1 N N

Year

manufacturing-labor productivity and thus manufacturing wages during this period created pressures to increase wages of state and local employees as well. This caused an increase in the relative cost of providing those services. In essence, spending rose faster than the economy grew because the population to be served (especially children) was rising relatively fast, because the costs of providing state-local services were rising faster than average, and because consumers were demanding new or improved services from subnational governments.

The relative size of the state-local government sector has not changed nearly as substantially since the middle 1970s, however. State-local spending has continued to grow relative to personal income since 1975, but at a much more modest pace than previously. Over this period, state-local spending has increased from a little more than 20 percent of income to slightly above 23 percent, hardly dramatic

ge over a 25-year period. A similar slowdown in the growth of state-local ovemment spending beginning in the latter 1970s is reflected by the graph of real

-capita spending in Figure 1.4. Whereas state-local government spending has tied to increase faster than the combination of population growth and infla- e growth rate in the last 25 years of the century (168 percent) was substan- ess than in the earlier 25 year period (230 percent). Similarly, the change

pending by state governments alone parallels the pattern for the entire ,,t,Viocal sector rather closely. Thus, the past 25 years have seen little substantial

,gein the relative fiscal magnitude of state and local government, at least at the cro

eneral, the reduction in the relative growth of the fiscal size of state and local t during the last quarter of the past century simply reflected a reversal

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

II

Figure 1.5

•

• •,,•■• • • •

•

1962 1967 1972 1977 1982 1987 i 1992 1997 1999

Year

2000 I 2001 I 2002

PART I ■ INTRODUCTION

10

of all those factors that had been operating since 1950. Income did not grow as fast in those years as previously, partly because the economy experienced four nation- al recessions between 1974 and 2002. Demand for educational services lessened as the baby boomers completed school and delayed starting their own families. State-local government costs, especially wages, did not increase relatively as fast in this period as previously, in part due to slower growth of private productivity nationally. Federal grants to state-local governments did not grow in this period anywhere near as fast as in the previous period, although state-local spending from own sources also follows the same pattern of slowing growth. Finally, it has been suggested that the slowdown reflects a change in the tastes or preferences of consumers for government services, as reflected by the coordinated opposition to state-local taxes in the late 1970s and 1980s, which has come to be called the "tax revolt." This change in the political environment seems to have persisted. What- ever the combination of factors, it is clear that the past 25 years have represented a very different environment for state-local finance than in the preceding 25-year period of substantial growth.

The growth in state-local spending that has occurred has been influenced by several factors, including increasing health care costs, increasing corrections expenditures by states, slower growth of federal grants, and services that state-local governments are mandated to provide by the national government. Research by Gramlich (1991) suggested that the increased state-local spending in real or relative terms in the 1980s was explained mainly by three factors: (1) rising costs of producing services (especially for health care), (2) increased demand for services (particularly due to more prisons, a growing prison population, as well as an increase in the number of school children), and (3) a small effect from new fed- eral government requirements for state-local spending. Most recently, since 2000 state-local spending has increased relatively substantially again, measured both relative to personal income and in real, per-capita terms. This recent growth seems driven by continuing increases in health care costs, growth in the number of elder- ly people and school-age children, and public safety issues, including corrections and efforts to prevent terrorism. At the time this is being written, therefore, it is an open question whether this recent growth is a temporary phenomenon or the start of another long period of relative fiscal expansion for the state-local sector.

Although not apparent in Figure 1.4, an important distinction exists between the roles of state and local governments. In 2002, state governments collected 59 per- cent of state-local taxes and 55 percent of own-source state-local revenue; ho- wever, state governments only were responsible for about 45 percent of direct spending. The difference represents the importance of state aid to local govern- ments. To put it another way, local governments are responsible for about 55 per- cent of state-local spending, but collect only about 41 percent of taxes, a differen - tial that has been growing.

Expenditure Categories More than half of the money spent by state and local governments in aggregate provides education or income maintenance services, as shown in Figure 1.5

a,

0-x 30 a) 5)

c

al 20 0 a, ,,,cr) 15

10

45

40

35

25

5

0

Distribution of

state-local general

expenditure

-o- Education -a- Public welfare t Health and hospitals -o- Highways

-o- Governmental administration t Police protection Corrections

2002, these categories accounted for nearly 52 percent of total state-local general spending, with education accounting for about 36 percent and public welfare about 16 percent. Expenditures for highways and health and hospitals, the other main direct consumer services, represent about 7 to 9 percent of state-local spend-

, . mg, whereas expenditures on police services and corrections represent only about 3 to 4 percent. After a 25-year decline, the share of spending for education has increased in the past 10 years. Expenditure for public welfare and health and hos- pitals has continued to increase, while the highways have become a smaller frac- tion of state-local spending in aggregate.

The distribution of spending by category for state-local governments together asks important differences between states and local governments, on average. e distribution of general expenditure for states and localities are shown sepa-

ately in Figure 1.6. (According to the Census definition, general expenditure lodes all expenditures except those for government utilities, liquor stores, and

mployee retirement funds.) Education is by the far the largest category of spend- g for both states and localities (31 percent for states, including higher education

spending and state grants for schools, and 44 percent for localities). States also 44. relatively large fraction of their expenditures on welfare, transportation,

and hospital services, whereas the other major expenditure categories ovemmbenc safety tsre and d housing, transportation, health and

d public

1 2

Higher education 12%

Figure 1.6

General expendi-

ture, state govern-

ments, 2002 (total:

$1.109 trillion);

Interest on debt 3%

Administration 4%

Corrections 3%

Health and hospitals 6%

Transportation 7%

Other 11%

Grants for K-12 education 19%

Other grants 14%

Public welfare 21%

Environment and housing 11%

Other 9%

Education 44%

Figure 1.7

Distribution of

state-local general

-o- Individual income -o- Current charges -a- Miscellaneous revenue — revenue Federal government -a- Property tax -o- Sales and gross receipts

35

30

25

20

15

10

5

P er

ce n ta

g e

o f g

e n

e ra

l r e ve

n u

e

0 (;)-1, ,o gsl, 4,N 41' c;\ 61,

„ „ „ , ,o, c,/ (3/

41/4) 4° 4\ 4\ 4b c)cb c?) c)c) \ \

Year

Figure 1.8

General revenue,

state govern-

ments, 2002 (total:

$1.062 trillion);

PART 1 ■ INTRODUCTION CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

13

General expendi-

ture, local govern-

ments, 2002 (total:

$997.6 billion)

Interest on debt 5%

Administration 5%

Public welfare 4%

Health and hospitals 8%

Police and fire 8%

Transportation 6%

Revenue Source&

State—local governments receive revenues from a variety of different sources, including a number of types of taxes, as shown in Figure 1.7. When all revenues to all state—local governments are added together, the five major sources, all of rough ly equal importance, are charges and miscellaneous revenue (24.9 percent of th total), sales taxes (19.2 percent), property taxes (16.6 percent), federal gran (21.4 percent), and income taxes (12.0 percent). In contrast, the predominant sour of revenue for the federal government is income taxes, including the personal an corporate income taxes and the social security payroll tax. There have been no su tained trends in revenue shares over the past 10 years, although the share from f eral aid has started to increase again in the past several years and the share from charges has continued to increase modestly.

The composition of revenues differs between states and local governments even

more than the difference in expenditure patterns, as shown by Figure 1.8. Restrict -

ing the comparison to general revenue (excluding utility, liquor store, and emplo ee retirement revenue), states get nearly 75 percent of their revenue from sales t (about 25 percent), income taxes (about 20 percent from individual and corpo

Charges 9%

Other taxes 6%

Corporate income taxes

Individual income taxes 18%

2%

Other 10%

Federal aid 30%

Sales and excise taxes 25%

Charges 15%

Other taxes 4%

Income taxes 2%

Sales taxes 4%

Other 8%

Federal aid 4%

State aid 36%

Property taxes 27%

General revenue,

local governments,

2002 (total:

$995.9 billion)

PART I ■ INTRODUCTION

1 4

taxes), and federal grants (30 percent). The two dominant sources of general rev- enue for local governments accounting for about 63 percent of the total are state grants (about 36 percent) and property taxes (27 percent). From another perspective, grants from both the federal and state government provide about 40 percent of local government general revenue. It is worth noting that these are averages for all local governments; substantial variation exists both by type of local government and state.

DIVERSITY OF SUBNATIONAL GOVERNMENTS

Although the statistics presented earlier for both the level and mix of expenditures and revenues characterize the overall state-local sector, they do not necessarily represent the fiscal picture in any individual state and local jurisdiction. As noted, diversity is the norm in subnational finance. Accordingly, the data in Tables 1.2-1.4 show some comparison of the fiscal environment in different states. Comparing the level of expenditures or revenues among states is not enough; instead, it is nec- essary to standardize the data because of the different sizes and characteristics of the states. The two most common ways of standardizing are to compare the data in per-capita terms (per person) or as a percentage of income. However, suppose that one state has higher per-capita expenditures than another or that expenditures take a larger fraction of income in one state than another. Do these mean that ser- vices are greater in one state than the other? Not necessarily.

The rationale for per-capita comparisons is that it may require more expenditure and revenue to provide equal services to a larger population than to a smaller one. The degree to which that is true for different state-local services is not clear, how- ever. If the production of state-local services exhibits constant returns to scale, that is, if the average cost of providing a unit of service to one consumer is constant, then total cost will increase proportionately to population. Equal per-capita amounts are then consistent with equal services, if all other factors are the same between the jurisdictions being compared. On the other hand, the production of some services may exhibit increasing returns to scale, which means that cost per person falls as the number of people served rises. In that case, equal services are consistent with lower per-capita expenditures in the larger jurisdictions, if all else is the same.

A similar analysis applies to interjurisdictional comparisons based on the frac- tion of income taken by state-local expenditures and revenues. One might expect that two states, one rich and one poor, would have the same percentage of their income going to government services. This is true only if the income elasticity 0 demand for those government services is one; that is, if demand for service incre es proportionately with income. If not (that is, if demand for state-local servic increases slower or faster than income), then equal percentages of income going state-local expenditures are not expected. In addition, this analysis requires th factors other than income be the same between the jurisdictions being compared •

In general, differences in state-local expenditures or revenues among states arise because of (1) different decisions about what services to provide through public sector as opposed to the private sector in different states; (2) differenc input prices (especially labor) among the states; (3) differences in environt0

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

'5

such as area, population density, or weather, which affect the cost of producing ser- vices; and (4) differences in demand for services from either population differ- ences, income differences, or differences in tastes. Standardization in per-capita terms may offset only the population effects, and standardization by state-income level offsets only the income effect on demand. With either standardization, dif- ferences in spending or taxes can remain, which do not reflect service differences. As a result, extreme caution is necessary in making interstate fiscal comparisons. A higher level of revenues and expenditures in one state may mean there are more services in that state, may reflect higher production costs in that state, or may mean that residents of that state have decided to provide some service (hospitals, for instance) through the government rather than privately.

Expenditures With the preceding cautions in mind, the differences in state-local expenditure among the states are shown in Table 1.2. In 2002, stale-local governments spent an average of $6,166 per person or about 19.9 percent of individuals' personal incomes. Seven states spent more than $7,000 per person—Alaska ($13,466), Delaware ($10,808), New York ($8,523), Wyoming ($7,801), Connecticut ($7,105), Minnesota ($7,102), and California ($7,041)—and eight states spent less than $5,300 per person—Arkansas ($4,889), Arizona ($4922), Tennessee ($5,089), New Hampshire ($5,132), South Dako- ta ($5,145), Missouri ($5,192), Idaho ($5,258), and Oklahoma ($5,273). A similar range exists in the fraction of income taken by state-local expenditures, from 41.9 percent in Alaska and 25.9 percent in New Mexico to 14.9 percent in New Hampshire and 16.4 percent in Connecticut and New Jersey. There is also very little of a regional pattern in the level of expenditures. Although per-capita spending is consistently below average in the Southeast and above average in the Far West, substantial variation occurs within regions in the other cases.

Although a general correspondence exists between the rankings of states by per- capita spending and spending as a percentage of income, some important differ- ences stand out. In California, for example, per-capita spending is 14 percent greater than the national average, but spending relative to income is only slightly above the average. California's apparently high per-capita spending might be attributed to its above-average income. On the other hand, Arkansas is the lowest state in per-capita spending, but its spending relative to income is above average.

ere the relatively low income in the state may be holding per-capita spending n. And per-capita spending in both Maryland and Maine is very dose to the nal average, but spending relative to income is about 16 percent below the nal average in Maryland and 14 percent above average in Oregon. either measure, spending is way above average in Alaska. The explanation

ily lies in two factors: high costs for producing services and the collection of tial amounts of oil-extraction revenue, which is distributed as royalties

to residents.

e last two columns of Table 1.2 show the fraction of state-local expenditures, ore and after transfers, made by the state government in each state. The ous regional pattern is the relatively strong role played by state govern-

in New England (with the exception of New Hampshire). Otherwise, there

PART I ■ INTRODUCTION

16

Table t.2 State and Local Government General Expenditure by State, 2002 a

Per Capita State-Local

State-Local Expenditure as a

Percentage of

State Government Share of State-Local Direct Expenditure,

State and Region Expenditure Personal Income Before Transfersb

United States $6,166 19.9% 56%

New England Connecticut 7,105 16.4 66 Maine 6,262 22.7 64 Massachusetts 6,698 17.1 69 New Hampshire 5,132 14.9 56 Rhode Island 6,474 21.1 64 Vermont 6,264 21.4 78

Mideast Delaware 6,834 20.9 77 District of Columbia 10,804 24.3 na Maryland 6,004 16.6 58 New Jersey 6,473 16.4 55 New York 8,523 23.8 45 Pennsylvania 5,999 19.8 59

Great Lakes Illinois 5,944 18.1 51 Indiana 5,394 19.5 53 Michigan 6,116 20.3 62 Ohio 5,906 20.6 55 Wisconsin 6,339 21.4 55

Plains Iowa 5,888 21.6 58 Kansas 5,534 19.2 56 Minnesota 7,102 21.5 63 Missouri 5,192 18.5 53 Nebraska 5,704 19.8 53 North Dakota 6,053 23.6 63 South Dakota 5,145 19.1 54

Southeast Alabama 5,533 22.2 55 Arkansas 4,889 -21.0 75 Florida 5,449 18.2 49 Georgia 5,491 18.6 52 Kentucky 5,342 21.3 68 Louisiana 5,442 22.0 57 Mississippi 5,407 24.5 60 North Carolina 5,534 19.7 57 South Carolina 5,937 23.4 60 Tennessee 5,089 18.7 51 Virginia 5,547 16.8 58 West Virginia 5,447 23.5 71

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

17

Table 1.2

(continued)

Per Capita State-Local Expenditure

State-Local Expenditure as a

Percentage of Personal Income

State Government Share of State-Local Direct Expenditure,

Before Transfers b

State Government Share of State-Local Direct Expenditure,

After Transfers

4,922 18.2 53 36 6,287 25.9 75 58 5,273 20.2 62 55 5,352 18.0 46 41

6,301 17.7 46 39 5,258 20.6 62 51 5,601 22.7 65 60 5,760 22.8 67 51 7,801 25.6 50 46

13,466 41.9 75 68 7,041 21.0 59 38 6,851 23.7 79 78 5,893 18.2 51 35 6,720 23.3 58 50 6,559 19.9 62 47

'General expenditure includes all expenditures other than utility, liquor store, and employee retirement expenditures.

'State direct general expenditure less intergovernmental revenue plus state aid to local government as a fraction of state-local direct general expenditure less federal aid

SOURCE: US Bureau of the Census, Census of Governments, State and Local Government Finances, 2002

much variation within regions. State governments take a dominant role in awaii (79 percent of own-source expenditure), Vermont (78 percent), Delaware

,,,77 percent), Alaska (75 percent), Arkansas (75 percent), New Mexico (75 percent), .West Virginia (71 percent), Massachusetts (69 percent), Kentucky (68 percent),

Utah (67 percent). Local governments provide the majority of own-source s in New York (45 percent of own-source expenditures by the state), Colorado

percent), Texas (46 percent), and Florida (49 percent).

evels of state-local revenues and taxes, both per capita and relative to are shown in Table 1.3. The relative state rankings in revenues are, not

mgly, generally similar to the relative state positions in expenditures. Thus, onal pattern shows relatively low revenues and taxes in the Southeast and . .

variation within most other regions. Besides taxes, state-local general

State Government Share of State-Local Direct Expenditure,

After Transfers

45%

59 61 52 52 63 62

64 na 51 51 41 49

41 43 43 47 44

49 46 46 48 38 58 53

49 58 38 41 60 51 54 46 56 42 45 67

State and Region

Southwest Arizona New Mexico Oklahoma Texas

Rocky Mountain Colorado Idaho Montana Utah Wyoming

Far West Alaska California Hawaii Nevada Oregon Washington

SOURCE: Bureau of the Census, State and Local Government Finances, 2002

revenue includes grants from the federal government as well as charges and fees. Generally, the level of taxes and level of general revenue is correlated, but not nec- essarily. A state with an unusually large amount of federal aid or charges may have average or above-average revenue, but below-average taxes. For instance, Delaware, which receives substantial revenue from corporate license fees, has a relatively high level of general revenue but about average taxes.

It is important to note that these data refer to revenue and tax collections, not burdens. To the extent that states collect revenue from nonresidents (severance taxes, some sales taxes, some business taxes, property taxes on nonresident prop- erty owners), the taxes or fees do not represent a burden on residents. In those cases, standardizing by the resident population or income does not provide an accurate or useful picture.

Substantial diversity also exists in the mix of revenue sources used in different states, as shown in Table 1.4. The five major state-local revenue sources identified- property taxes, sales taxes, income taxes, federal grants, and user charges-account for more than three-quarters of state-local government general revenue on average, with each accounting for between 12 and 21 percent of revenue. The aggregate pic- ture thus shows a diversified and balanced state-local revenue structure; however, the picture is very different in some individual states. Most obviously, the general ales and individual income tax shares are zero in some cases. In a few states, these

e revenue sources in aggregate represent a substantially smaller share of revenue the average, indicating that there are some other substantial sources of funds

those special cases. For instance, these five sources account for only about 48 per- of revenue in Alaska (which receives substantial revenue from oil leases and ranee taxes), for 54 percent in Delaware (which generates substantial corporate

3,347 2,794 3,084 3,186 3,469

2,847 2,967 3,752 2,703 3,107 2,693 2,439

2,185 2,417 2,806 2,939 2,667 2,726 2,293 2,805 2,431 2,28 3,12 2,56

2,8, 2,68

PART I ■ INTRODUCTION

18

Table t.3 State and Local Government Per Capita Revenue, by State, 2002

State & Region General Revenue Federal Aid United States $5,987 $1,281

New England Connecticut 6,696 1,186 Maine 6,335 1,491 Massachusetts 6,143 973 New Hampshire 5,183 1,048 Rhode Island 6,332 1,685 Vermont 6,334 1,785

Middle Atlantic Delaware 7,143 1,223 District of Columbia 12,102 4,965 Maryland 6,103 1,119 New Jersey 6,567 1,064 New York 8,197 1,907 Pennsylvania 5,860 1,305

Great Lakes Illinois 5,564 1,024 Indiana 5,323 1,033 Michigan 5,830 1,262 Ohio 5,775 1,221 Wisconsin 6,069 1,204

Plains Iowa 5,766 1,239 Kansas 5,445 1,153 Minnesota 6,748 1,238 Missouri 5,194 1,310 Nebraska 5,740 1,153 North Dakota 6,221 1,801 South Dakota 5,168 1,524

Southeast Alabama 5,339 1,408 Arkansas 4,961 1,364 Florida 5,423 936 Georgia 5,419 1,143 Kentucky 5,253 1,339 Louisiana 5,828 1,451 Mississippi 5,375 1,626 North Carolina 5,487 1,272 South Carolina 5,294 1,329 Tennessee 4,831 1,337 Virginia 5,513 881 West Virginia 5,592 1,659

Southwest Arizona 4,974 1,115 New Mexico 5,975 1,717

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

1 9

Table 1.3

(continued)

State & Region General Revenue Federal Aid Taxes

Oklahoma 5,234 1,279 2,545

Texas 5,233 1,099 2,829

Rocky Mountain Colorado 6,055 992 3,232

Idaho 5,116 1,094 2,543

Montana 5,679 1,763 2,367

Utah 5,598 1,170 2,699

Wyoming 8,577 2,403 3,681

Far West Alaska 11,497 2,854 3,301

California 6,691 1,424 3,555

Hawaii 6,129 1,277 3,498

Nevada 5,714 817 3,220

Oregon 6,321 1,882 2,632

Washington 6,166 1,195 3,311

Taxes

$3,216

4,441 3,562 3,764 2,912 3,456 3,227

3,427 5,643 3,753 4,116 4,684 3,064

PART 1 ■ INTRODUCTION

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

20

21

Table 1.4

Table r.

State-Local Revenue Sources by State, 2002

Percentage of State-Local General Revenue from

State & Region Federal Aid Property Tax General Sales Tax Individual Income Tax User Charges

United States 21.4% 16.6% 13.2% 12.0% 15.0%

New England Connecticut 17.7 26.3 13.3 16.2 7.7 Maine 23.5 23.7 10.4 133 9.9 Massachusetts 15.8 22.4 9.5 20.3 9.8 New Hampshire 20.2 33.9 nt 1.1 12.6 Rhode Island 26.6 20.0 11.0 12.4 8.4 Vermont 28.2 21.4 5.6 10.6 11.3

Middle Atlantic Delaware 17.1 7.1 nt 13.6 16.2 District of Columbia 41.0 11.6 8.1 13.7 4.4 Maryland 18.3 16.7 8.3 23.7 12.1 New Jersey 16.2 29.0 10.9 12.4 12.3 New York 23.3 17.2 10.7 19.4 11.7 Pennsylvania 22.3 15.2 10.4 13.2 15.4

Great Lakes Illinois 18.4 23.0 10.9 10.8 11.4 Indiana 19.4 18.5 11.7 12.7 17.8 Michigan 21.6 16.9 13.4 11.4 16.1 Ohio 21.1 16.2 11.7 18.0 13.9 Wisconsin 19.8 19.9 12.0 15.3 14.9

Plains Iowa 21.5 17.1 12.0 10.8 19.5 Kansas 21.2 17.3 15.7 12.7 14.2 Minnesota 18.3 15.7 11.4 16.4 14.7 Missouri 25.2 13.4 14.6 13.5 13.4 Nebraska 20.1 17.8 13.1 11.7 14.6 North Dakota 28.9 13.3 9.9 5.0 17.7 South Dakota 29.5 17.1 17.2 nt 10.9

Southeast Alabama 26.4 6.2 12.5 9.0 25.2 Arkansas 27.5 7.6 19.2 11.8 14.8 Florida 173 18.2 17.3 nt 17.3 Georgia 21.1 15.0 16.9 14.6 15.7 Kentucky 25.5 9.3 10.9 16.5 13.3 Louisiana 24.9 7.4 18.6 6.9 17.0 Mississippi 30.2 10.8 15.3 6.4 20.1 North Carolina 23.2 12.3 11.1 16.5 19.3 South Carolina 25.1 14.6 11.5 11.1 21.6 Tennessee 27.7 12.6 21.3 0.5 18.7 Virginia 16.0 17.2 9.2 17.2 16.7 West Virginia 29.7 8.9 9.5 10.2 13.0

I (continued) Percentage of State-Local General Revenue from

State & Region Federal Aid Property Tax General Sales Tax Individual Income Tax User Charges

Southwest Arizona 22.4 16.7 22.7 82 11.3

New Mexicp 28.7 7.0 16.2 9.0 11.3

Oklahoma 24.4 8.2 14.4 12.7 18.1

Texas 21.0 22.5 16.8 nt 14.8

Rocky Mountain Colorado 16.4 16.0 15.9 133 17.7

Idaho 21.4 14.5 12.0 12.7 19.6

Montana 31.0 16.6 nt 10.1 14.6

Utah 20.9 11.4 15.8 12.8 20.0

Wyoming 28.0 16.3 13.7 nt 16.4

Far West Alaska 24.8 11.5 1.7 nt 9.7

California 21.3 13.3 13.8 14.6 15.9

Hawaii 20.8 8.3 21.7 15.0 14.0

Nevada 14.3 14.9 19.4 nt 19.2

Oregon 29.8 14.5 nt 17.0 18.0

Washington 19.4 15.9 25.4 nt 18.2

SOURCE: US Bureau of the Census, Census of Governments, State and Local Government Finances, 2002

license fees as the official legal "home" state for many of the largest corporations), and for about 68 percent in Nevada (which receives substantial gambling revenue).

More of a regional pattern exists in the reliance on different revenue sources than in the level of taxes and expenditures. For instance, most of the New England states rely on property taxes more than average and the Southeastern states (except Florida and Virginia) rely on property taxes less than average. General sales taxes tend to be relied on more than average in the Southeast and Southwest, individual income taxes tend to be used to a relatively small degree in the Southwestern states, and the use of user charges is relatively low in New England and the Middle Atlantic states but relatively high in the Rocky Mountain, Southeastern, and Far West states. In some cases, these regional patterns result (1) from the relative fiscal importance of state as opposed to local governments, (2) from the nature of the economies m these states and regions, or (3) from historical factors coupled with inertia.

Geographic or regional competitive factors influencing revenue structures are often not decisive, however, as reflected by a number of regional anomalies- similar states located together with different revenue structures. For instance, Ore- gon has no general sales tax and accordingly relatively high reliance on individual income taxes, whereas neighboring Washington has no individual income tax and high reliance on the sales tax. Among other similar cases, New Jersey relies heavi- ly on property taxes and little on sales taxes, whereas Delaware has little reliance on property taxes, but heavy reliance on income taxes. New Hampshire has very

50

Figure 1.9

Public sector size, selected nations, 2003

PART I ■ INTRODUCTION

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

22 23

high reliance on property taxes, no sales tax, and a very limited income tax; Maine and Vermont's tax structures are more similar to the national average with more balanced use of income taxes, sales taxes, and user charges. Finally, in two states dominated by the oil industry, property tax reliance is low in Oklahoma and income tax use about average, whereas there is no individual income tax and high proper- ty tax reliance in Texas.

Although reflecting the great diversity in the world of state—local finance, these differences in revenue structure also raise the issue of whether there are any eco- nomic, as opposed to historical or institutional, explanations for these different fiscal decisions by various states. The economic argument consistently offered to explain the choice of revenue structures is the opportunity to "export" tax and other revenue burdens to nonresidents. For instance, an analysis by Mary Gade and Lee Adkins (1990) of state government (only) revenue structures supports the idea that differences in the opportunity to export taxes go a long way toward explain- ing states' choices of tax structure. For instance, Gade and Adkins' analysis shows that severance taxes are relied on heavily by states with an immobile resource base, and that taxes deductible against the federal income tax are used more intensively by states where a substantial number of taxpayers itemize deductions and face rel- atively high federal tax rates. (Through the deduction, state taxpayers lower their federal taxes forcing other federal taxpayers to pay a greater share.) On the other hand, they report that states tend not to try to export tax burden by taxing manu- facturing goods heavily, even if they are to be exported, apparently because of a fear of inducing a relocation of those manufacturing activities.

Interstate Variation During the past 20 years, fiscal differences have narrowed substantially among the states. The changes in the distribution of state—local per-capita direct general expenditure are shown in Table 1.5. If all states and the District of Columbia are considered, the coefficient of variation for per-capita spending fell by half between

Table 1.5

Variation in Per Capita State—Local General Expenditure

Coefficient Max to Min Mean of Variation Maximum Minimum Ratio

1982 All states $1,992 0.47 $7,958 $1,345 5.9 1992 All states 3,900 0.30 9,893 2,751 3.6 1998 All states 5,224 0.23 11,502 4,037 2.9 2002 All states 6,221 0.23 13,466 4,889 2.8

1982 Excl. AK & DC 1,841 0.19 3,157 1,345 2.3 1992 Excl. AK & DC 3,708 0.17 7,788 2,751 2.1 1998 Excl. AK & DC 5,025 0.12 7,351 4,037 1.8 2002 Excl. AK & DC 5,797 0.12 8,491 4,889 1.7

SOURCE: Department of Commerce, Bureau of the Census

1982 and 2002, from .47 to .23. Similarly, the ratio of the highest to lowest spending state fell from 5.9 to 2.8. Even if the two outlying jurisdictions of Alaska and the District of Columbia are excluded from the analysis, an important decline in inter- state variation in spending is still apparent. Not surprisingly, there has also been a similar decrease in interstate variation in per-capita revenue. Interstate variation in per-capita revenue is slightly greater than the variation in per-capita spending, which reflects the equalizing role played by federal aid. Some of the narrowing of fiscal differences over this period is the result of growth and changes in the struc- ture of intergovernmental grants. The other major factor is the narrowing of regional economic differences (that is, convergence of state personal income), which has translated into a corresponding narrowing of fiscal differences as well.

INTERNATIONAL COMPARISON

Government Spending in Selected Industrialized Nations Government spending relative to the size of the nation's economy is smaller in the United States than for most other major industrialized nations, as shown in Figure 1.9. Total (federal, state, and local) government spending in the United States is about 35 percent of GDP, about the same as in Australia, slightly less than in Japan, and substantially less than in Canada, France, Germany, the United Kingdom, or the average of all industrialized nations (the nations in the Organiza- tion for Economic Cooperation and Development). Total government receipts as a

60

United Australia Canada France Germany Japan United All OECD States Kingdom

Receipts as a percentage of GDP ■ Outlays as a percentage of GDP

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

r 2 4 PART I ■ INTRODUCTION 25 FISCAL ROLE OF SUBNATIONAL GOVERNMENTS

Federal govern- ment role, federal nations, 2002

Figure 1.1 o

What is the appropriate economic role for subnational governments in a federal system? Which responsibilities are better handled by the federal government, by the subnational governments, and can be shared among them? In what ways do the main characteristics of that sector—mobility and diversity—influence that role? Richard Musgrave (1959) has identified three traditional economic functions for government: (1) maintaining economic stabilization, (2) altering the distribu- tion of resources, and (3) obtaining an efficient allocation of society's resources. The conventional wisdom has been that state-local governments are limited in achieving the first two principally by the ease of mobility among them. Despite the fact that this notion suggests that stabilization and distribution are more appropriately federal government functions, it is apparent that many state-local services have substantial distributional implications and that the sheer size of the subnational government sector means that it may have macroeconomic effects. Thus, the conventional wisdom and some recent challenges to that wisdom are considered next.

United States

El Federal share of total revenue III Federal share of total taxes CM Federal share of expenditure net of grants

percentage of GDP are lowest in the U.S. among these seven nations (except for Japan). It is interesting to note, as well, that at least in 2003, the total public sector was operating a budget deficit in these nations—outlays are greater than receipts—except for Australia and Canada.

Three of these other nations—Australia, Canada, and Germany—have federal systems of government similar to that in the United States. Each of these nations has separate federal, state, and local governments. Although the structure is simi- lar, the relative role for subnational government compared to the federal govern- ment is quite different among these nations, as shown in Figure 1.10. In terms of total government revenue, Australia has the most centralized system and Canada the least, with the federal government's role falling between those two extremes in Germany and the United States.

Central government expenditure, excluding grants paid from the federal gov- ernment to states and localities, tells a different story. In Australia, for instance, the federal government accounts for only about 55 percent of direct spending, although it generates 75 percent of revenue. The difference represents federal grants to states and localities, which are substantial in the Australian system. Th federal government is most dominant in Germany, where it accounts for mo than 60 percent of direct public spending. In contrast, the central government accounts for only 40 percent of direct public expenditure in Canada. By this mea- sure, then, states and localities are most important in Canada, where they account for about 60 percent of direct- government expenditure (purchases of goods and services).

Stabilization Policy Stabilization policy refers to the role of the government in maintaining employ- ment, price stability, and economic growth through fiscal and monetary policy. The conventional position is that state and local governments are inherently limited in influencing the economic conditions in each specific subnational jurisdiction; that is, a single state or municipality has little control over prices, employment, and the general level of economic activity in that jurisdiction. One reason is that state-local governments do not have any monetary authority (which rests with the Federal Reserve Board). Moreover, it is usually argued that states should not have mone- tary authority because separate state monetary decisions would increase the costs of transactions over boundaries and because each state would have an incentive to pay for trade by expanding its own "money supply," a large portion of which would be held by nonresidents.

A second factor is that the general openness of state-local jurisdiction economies restricts the opportunity for fiscal policy to be effective. Imagine a state or city attempting to expand economic activity by the traditional expansive fiscal policies- lowering local taxes, providing cash grants to residents, or expanding government

urchases. As a result, residents are likely to increase consumption spending, but e ultimate effect of a substantial part of that consumption increase will occur in

ther jurisdictions where the goods and services are sold or produced. If your city orrowed $100 per resident and then gave each resident $100 "free" to spend in

y way, it is no different than if each resident borrowed $100. If the residents use the money to buy shirts, for example, the economic gain goes to the producers of Shirts (and suppliers of their inputs), which may not be in your city. In addition, of course, the borrowed funds used to finance the expansive fiscal policy eventually

ust be repaid with a substantial portion of the funds (perhaps even all) having sorrowed from nonresidents.

PART I ■ INTRODUCTION

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

z6

2 7

Edward Gramlich (1987) challenges this conventional wisdom about the impor- tance of state-local stabilization policy by arguing that changes in the economy as well as past misperceptions may make subnational fiscal policies more potent than believed, and even necessary. Gramlich first notes evidence that individuals may not move between states in many cases for economic reasons and that a growing share of expenditures is for services purchased locally. If these types of mobility are less than previously believed, then subnational fiscal policies can have greater effects within the jurisdiction. In addition, Gramlich argues that, increasingly, macroeconomic problems are regional rather than national, resulting from eco- nomic factors affecting specific industries. In that case, regional or state fiscal pol- icy might be necessary, with some regions conducting expansionary policy while others are pursuing contractionary policies.

There is a totally different stabilization issue as well, whether the aggregate fis- cal position (taxes and spending) of the subnational sector influences the overall national economy. With subnational government spending accounting for 11 to 14 percent of the national economy, the expectation is that this sector does have an impact on national macroeconomic conditions. This factor has been noted most in two contexts. First, the state-local sector has had an aggregate budget surplus in many years that partly offsets the federal government budget deficits that have been common since 1970. In effect, the investment of surplus funds by state and local governments is a source of finance for both the federal government deficit and private-sector borrowing.

Second, some are concerned that state-local fiscal changes during national eco- nomic recessions or expansions might contribute to the national economic cycle. For instance, subnational government policy would be procyclical if states and localities reduce expenditures because a recession causes state-local revenues to decline (or increase less than was anticipated), thereby further reducing aggregate demand and slowing the economy more. A number of studies of this issue gener- ally show that this does not occur, and that state-local government fiscal policies tend to be countercyclical—states and localities respond to the revenue decrease caused by a recession by spending from reserves or by raising tax rates (Bahl, 1984). The maintenance of state-local spending during a national economic con- traction has a moderate countercyclical effect. Similarly, during economic expan- sions, state-local governments often build up reserves, thereby moderating the increase in aggregate demand. It is important to note that this conclusion applies to the aggregate state-local sector and not necessarily to every subnational juris- diction, and that the magnitude of this state-local countercyclical effect will vary for different recessions and expansions, depending on their length and other characteristics. -

The conclusions seem to be that while individual states and localities have been considered limited in their capability to influence aggregate demand in their own jurisdictions, that case may be overstated. In fact, regional macroeconomic prob- lems may demand and even require regional policies. The collective fiscal deci- sions of states and localities do have an impact on national economic conditions, however. It is incorrect, therefore, to focus only on the federal government's fiscal behavior when evaluating the macroeconomic implications of the public sector.

Distribution Policy Distribution policy refers to the role of the government in obtaining and maintain- ing the socially preferred distribution of resources or income, in most cases by redistributing resources from rich to poor (there have been no serious claims that the economy, absent government intervention, generates too much income equality). The conventional wisdom has been very similar to the issue of stabiliza- tion. State-local governments are limited in their capability to redistribute resources because different jurisdictions select different amounts of redistribution and individuals and firms can easily move among the jurisdictions to frustrate any intended redistribution. If that is the case, then redistribution is also more appro- priately carried out by the federal government (at least if international mobility is less than interjurisdictional mobility within the United States).

The conventional thought can be easily illustrated. Suppose your city proposed to tax all families or individuals with income above $50,000 and to use the revenue to provide cash grants to individuals and families with income below $50,000. Such a pure redistributive policy would create an incentive both for higher-income taxpayers (those above $50,000) to move to a different city where such a redistrib- utive tax did not exist and for lower-income individuals and families (those below $50,000) to move to your city to receive the grants. Paradoxically, if such moves occur, the program does result in a more equal income distribution in your city, but little redistribution from rich to poor. The existence of the incentive does not mean that all individuals will actually respond in this way—moving is costly and other locational factors may offset these redistributional incentivcs but if some respond in this way, part of the program's intent is mitigated. The incentive will be greatest for very high- and very low-income individuals and when mobility is easiest. Moving among localities within the same area to avoid or take advantage of a local government redistribution program is expected in most cases to be easier or less costly than moving among states, and similarly moving among nations is more costly than moving among states. For these reasons, it has been argued that redis- tribution is best handled at the national level, and if not, at the states.

This conventional position flies in the face of several important facts, however. State governments administer the major health and welfare programs (especially Medicaid), which are inherently redistributive. Other services provided by state-local governments, especially education, have important distributional implications. Finally, distributional concerns affect many state-local fiscal deci- sions, including the choice of tax structure. In the cases of explicit redistribution, substantial diversity exists in the levels of support selected in different states even though the federal government typically pays about half the cost through a system of matching grants with higher matching rates for lower-income states. Similar dif- ferences occur in education services offered in different states and localities. Thus, despite the conventional notion that redistribution is best handled by the federal government, the actual fiscal structure leaves a substantial amount of redistribu- tion to the subnational sector.

What accounts for the continuing distributional responsibility of subnational government and what are its effects? One possibility is that society has decided

yip

ii

PART I ■ INTRODUCTION

CHAPTER ONE ■ WHY STUDY STATE AND LOCAL GOVERNMENT FINANCE?

29

that redistribution should be a subnational government responsibility. This is rea- sonable if individuals only care about the welfare of other individuals who reside in their jurisdiction and if there is little mobility in response to redistributional policies. In that case, redistribution would be similar to, say, waste collection, and would be best handled at the local level where individual preferences could be sat- isfied. On the other hand, if individuals care about the welfare of lower-income individuals in the society regardless of what state or city they live in or if mobility frustrates local decisions, then some federal government involvement in redistrib- ution policy is called for.

The federal government is involved in the redistribution decisions of states through the federal grants for those programs. In theory, those grants could correct for the difficulties created by migration by reducing the cost of engaging in redis- tribution to residents who do not move. In effect, having federal grants pay for part of subnational government redistribution prevents higher-income individuals from avoiding some contribution. The available evidence seems to show, however, that few transfer recipients—on the order of 1 to 2 percent—actually do move to other states to receive higher welfare benefits annually (Gramlich, 1985b). Howev- er, the cumulative effect of a small number of moves in each year can be a sub- stantial change in the geographic distribution of welfare recipients over time if the interstate pattern of benefits does not change. Even so, Gramlich's analysis shows that the degree of mobility of recipients alone is not sufficient to justify the rela- tively large federal government share in welfare-program grants.

The conclusions, then, are that mobility of taxpayers among jurisdictions is not so severe as to preclude subnational redistributive policies, but that even with gen- erous federal grants, many states (representing about half of welfare recipients) choose very low welfare-benefit levels. In Gramlich's (1985b, p. 43) words, "voters in these low-benefit states appear to have little taste for redistribution...." The issue about the appropriate level of government to carry out redistribution policy depends on our attitudes about this variation in benefit levels. If the variation is tolerable, then the current structure (with perhaps less generous federal grants) is acceptable; if a more uniform standard for benefit levels is desired, then a direct federal income-redistribution program or at least a minimum benefit standard imposed by the federal government is called for. These issues are considered in more detail in Chapter 21.

Allocation Policy Government intervention in the market also may be necessary to ensure that soci- ety achieves its desired allocation of resources—that is, for specific goods and ser vices to be produced in the desired quantities. Here the objective of government, at

all levels, is to maintain market competition and to provide those goods and ser- vices directly that the private market fails to provide efficiently. The practical issues focus on what specific responsibilities fall into the category of private-market fail-

ure, how large government should be to meet those responsibilities, how the gov-

errunent's resources should be generated, and on what mix of services shoul those resources be spent. Because the government is providing these services a result of the market's failure to do so in an efficient or equitable way, it

important to consider how government can most efficiently provide those services and whether government can do a better job than the market. If a good or service is best provided through government, then the subsequent issue is which level or type of government—federal, state, or local—can best carry out that responsibility.

Given the conventional wisdom that state-local governments are inherently lim- ited in carrying out stabilization and distribution policy, it is not surprising that the focus of economic analysis and research has been on the allocative role of subna- tional governments—their role, methods, and effectiveness in directly providing goods and services. That, too, is the primary focus of the rest of this book. Because of the importance traditionally assigned to the allocative role of subnational gov- ernments, the economic principles about market efficiency and market failure are first reviewed in Chapter 2 to provide a theoretical framework within which the institutions and practice of state-local government finance can be analyzed and evaluated.

Economic mobility coupled with the choice provided by the diversity of subna- tional governments makes analysis of state-local government finance interesting and different from that of the federal government.

The current substantial relative size of the subnational government sector- 40 percent of the total public sector in the United States—arose from a roughly 25-year period of sustained rapid growth between the early 1950s and mid-1970s. Since the mid-1970s, however, the relative size of the state-local government sec- tor has not increased substantially until the past few years, when relative growth has increased again.

More than half the money spent by state-local governments in aggregate pro- vides education or income maintenance services, with transportation and health and hospitals being the next two largest categories of spending on direct consumer services. To finance these services, state-local governments receive revenue from

major sources, all of roughly equal importance: charges and fees (24.9 percent e total), federal grants (21.4 percent), sales taxes (19.2 percent), property taxes percent), and income taxes (12.0 percent). e conventional wisdom has been that state-local governments are inher- limited in carrying out stabilization and distribution policy. Therefore, the

s of economic analysis and research has been on the allocative role of sub- ahonal governments—their role, methods, and effectiveness in directly pro-

g goods and services. Although individual states and localities may be ed in their capability to influence aggregate demand in their own jurisclic- , regional policies may be preferred to national stabilization policies in some

The collective fiscal decisions of states and localities have an effect on o_ nal macroeconomic conditions as well. The mobility of taxpayers among dictions is not so severe as to completely offset subnational redistribu-

- ies, but even with generous federal grants, many states (representing If of welfare recipients) choose to provide a small amount of income

ution.

SUMMARY

PART I ■ INTRODUCTION

3 0

DISCUSSION QUESTIONS

CHAPTER 2

1. "The state-local government sector stopped growing relative to the size of the economy in the late 1970s because of a decline in the amount of federal aid to states and localities." Do you think this is correct and why?

2. The recent growth (since 1999) in state and local spending relative to income, population, and prices is still not as fast as growth that occurred in the 1952 to 1975 period. Discuss the reasons why state-local spending increased so fast in the earlier period and consider what might be different in the recent period of growth.

3. Although the diversity of subnational governments means that the notion of "typical" behavior is often not meaningful, it is still common in presentations of data, news reports, and political debate to compare a state or locality to the "national average." How does the state-local sector in your state compare to that average in terms of (1) the structure of localities, (2) the level of expenditure, (3) the pattern of services provided, and (4) the mix of revenue sources? Do you know of any reasons why your case might differ from the national average?

4. Some surveys show that citizens usually are aware of services provided by local governments, but often not certain of the services provided by state governments. Make a list of five services provided by your city/township and five provided by your state that directly benefit you. After thinking about how you directly pay for those services, do you believe you get your money's worth?

SELECTED READING

Bahl, Roy. "The Growing Fiscal and Economic Importance of State and Local Governments." In Financing State and Local Governments in the 1980s, 7-32. New York: Oxford University Press, 1984.

Giertz, J. Fred and Seth Giertz. "The 2002 Downturn in State Revenues: A Comparative Review and Analysis." National Tax Journal 57,1 (March 2004): 111-132.

Oates, Wallace. "An Economic Approach to Federalism." In Fiscal Federalism, 3-30. New York: Harcourt Brace Jovanovich, 1972.

Rivlin, Alice. Reviving the American Dream: The Economy, the States, and the Federal Government. Washington, DC: Brookings Institution, 1992.

Sjoquist, David L., ed. State and Local Finances Under Pressure. Northampton, MA: Edward Elgar, 2003.

MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

The economic function left to state and local govern- ments in the United States system is the allocation function, i.e., the determination of the amount and

mix of local public services to be offered. 1 —ROY BAHL

HEADLINES

"FROM THE DAYS OF ADAM SMITH, ECONOMISTS HAVE RECOGNIZED THAT A SYSTEM OF PER-

FECTLY COMPETITIVE MARKETS ENHANCES ECONOMIC WELL-BEING IN SEVERAL WAYS: BY PER-

MITTING RESOURCES, PRODUCTS, AND SERVICES TO GO TO THOSE WHO VALUE THEM MOST; BY

PROVIDING INCENTIVES FOR COST SAVINGS AND INNOVATION IN THE PRODUCTION AND DISTRI-

BUTION OF GOODS AND SERVICES; AND BY FOSTERING LOW PRICES. YET, LIKE ADAM SMITH,

TODAY'S ECONOMISTS ALSO RECOGNIZE THAT UNDER SOME LIMITED BUT IMPORTANT CIRCUM-

STANCES, MARKETS DO NOT ALWAYS ACHIEVE THESE DESIRABLE ENDS. WHEN THEY DO NOT,

APPROPRIATE GOVERNMENT ACTION CAN IMPROVE MARKETS' FUNCTIONING AND SO INCREASE

ECONOMIC WELL-BEING... .

ADAM SMITH PUBLISHED THE WEALTH OF NA I IONS IN 1776, THE SAME YEAR THOMAS

FFERSON WROTE THE DECLARATION OF INDEPENDENCE. SINCE THAT TIME .. GOVERNMENT

WORKED IN PARTNERSHIP WITH THE PRIVATE SECTOR TO PROMOTE COMPETITION,

GE , EXTERNALITIES, AND PROVIDE PUBLIC GOODS. 2 "

financing State and Local Governments in the 1980s. Oxford, England: Oxford University Press, 1984, 25.

the President. Washington, DC: February 1995, p. 129.

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