1 Pursuing Local Tax Policy
But where will we get the money?
—Township mayor in testimony before state legislative committee, 2001
The above quote captures the attitude of many local public officials. Local governments across the United States are struggling to raise revenue to pay for public services. Increased demands by citizens for more, and better, public services; the ever-rising costs of providing services; and a plethora of legal and political restrictions on raising tax revenue have left many American local governments in dire fiscal straits. These revenue problems are not the result of economic downturn. Rather, the problems stem from structural deficiencies that pose a risk to raising revenue and meeting government service responsibilities far into the future.
The ongoing fiscal problems have prompted much discussion in recent years about the future of local government finance. Scholars, government leaders, and representatives of a wide variety of organizations have been debating how local governments will continue to pay for public services (for example, see Sjoquist 2003; Netzer 2003; Fischel 2006; Ladd 1998; Oates 2001b; Peterson 1994; Swartz and Bonello 1993; and Woodwell 1998). The increased discussion, and the prominence of the discussants, illustrates the importance of local governments in the United States and the services they provide.
This book examines how local governments are financed with an eye toward their current and future responsibilities within the American federal system.1 The hypothesis of this book is relatively simple:
The existence of local government that Americans are familiar with will be in jeopardy without a significant change in the way local government is financed.
Without reform to ensure stable tax revenue, local governments could be weakened to the point of irrelevance. That stable tax revenue must be within the political and legal control of local government institutions. Without such a revenue source, local governments will be incapable of efficiently and effectively providing services. More important, local governments will continue to cede financial and political control to the states.
The only revenue source capable of ensuring a strong and vibrant local government is the property tax.2 This assertion is intentionally provocative because a failure to address the problems associated with local government finance will have serious consequences. Essentially, without significant financial reforms, local governments will play a far-diminished role in public life—a consequence that is contrary to the best interests of both the American federal system and the American public.
This book expands on this belief by using basic, widely accepted theories, none of them particularly controversial, or even novel. Essentially, from both an economic and political perspective, local governments are a normative good. But local governments require a certain amount of autonomy over their fiscal affairs to carry out their responsibilities. The property tax is the only source of revenue that provides that autonomy. Unfortunately, public and political pressure have eroded the tax’s vitality for decades, and the tax no longer dominates local government finance. The problem for American cities, towns, and counties is that there are no viable alternatives to taxing property, at least none that can ensure fiscal and political autonomy. Thus, the property tax must be strengthened and revitalized if local governments are to continue to play an important role in American society.
Localism as a Normative Good
The obvious assumption being made is that it is important—indeed, perhaps imperative—that local governments continue to actively participate in the federalist system. Most Americans would say that local governments have played and should continue to play such a role. The American federal system has created the richest, strongest, freest nation the world has ever known. And local governments have, since the beginning of the Republic, been an integral part of that system. The American experience has been shaped in no small degree by its system of local governments.
Americans have many different views on which types of local governments are ideal. Some prefer the metropolis, some the farm community, and others the endless suburbs. As of 2002, 87,849 local government units were spread across the United States. That number includes 3,034 counties, 19,431 municipalities, 16,506 townships, 13,522 school districts, and 35,356 special districts (U.S. Census Bureau 2002). It makes little difference, at least for the purposes of this book, whether one believes that large cities, rural towns, or suburban counties are the ideal vehicle for local governance. What is important is that the American people favor local governance, a fact confirmed by years of public opinion research.
Chapter 2 begins by describing how local governments have served American society. It also sheds light on why local government is so important to American citizens. The logic of localism is grounded in two interrelated virtues that resonate with citizens. Local governments are efficient providers of the most visible, and many of the most important, public services. In addition, local governments enhance and foster democratic values and civic participation.
That local governments are efficient—that is, they can most closely match public services with citizen demands—is almost beyond dispute. Americans have come to expect certain services—such as police protection, emergency ambulance services, elementary and secondary education, and local roads—that can be provided more effectively and efficiently by local governments than by the federal or state governments. The efficiencies of local government have led to the belief that public services should be provided by the jurisdiction covering the smallest area over which benefits are distributed (for example, see Oates 1972). Americans do not look to their state capitals or federal government to provide fire and police protection, trash removal, or animal control. Rather, Americans look to their mayors, city councils, and county supervisors to perform such services.
In addition to effectively providing fundamental services, local governments serve another important role. They promote democratic ideals and practices, a view held by American political philosophers since the time of Thomas Jefferson. Citizens are much more capable of influencing public policy within their locality than they are at either the state or federal levels of government. Citizens know the policies that they would like to see pursued and can monitor whether these services are being performed satisfactorily.
Local political leaders recognize the visibility of local services and are thus attuned to the wishes of their constituents. This, in turn, reinforces confidence in the public’s ability to influence local government. For this reason, scholars have found that local governments are more responsive than states or the federal government to citizens’ demands. This responsiveness is one reason to protect and strengthen the American system of local government.
Localism requires a certain degree of fiscal autonomy; local governments must have some political and legal control over the amount of revenue they can raise and spend. This control must be exercised without undue influence by higher levels of government, particularly at the state level. Without such autonomy, local governments cannot effectively provide the services their residents demand. Without fiscal autonomy, local governments are almost irrelevant in the American federal system of government.
The need for fiscal autonomy is easy to understand. The three levels of government—federal, state, and local—have worked because each level is governed democratically. The elected leaders are accountable to the public. One way that accountability is accomplished is through elected officials providing the public services—be they spaceships or kindergarten teachers—that the citizens demand. To do that, officials raise and lower taxes to pay for those services. If the citizens are not getting the services they want, they will express their displeasure at the ballot box or they will relocate to another city or town. The effectiveness of the system depends on the ability to raise (or lower) taxes in order to provide the necessary level of services at prices citizens are willing to pay.
The threat many localities face is that the fiscal autonomy of local governments has been declining for several decades. Today, local governments have less control over their fiscal affairs than at any time in American history. Local fiscal autonomy is being superseded by state centralization of local finance. State governments are increasingly taking over public services traditionally provided by and paid for by localities. By ceding financial control to the states, however, localities cede political control over local affairs. And that is the danger this book seeks to address.
Political and Economic Constraints on Localism
Local governments’ ability to raise revenue in a federal system is inherently limited. Chapter 3 describes those limitations in terms of three interrelated political and economic imperatives that generally govern the actions and affect the tax policies of local governments in the United States. The imperatives profoundly affect local tax policy.
First, local governments must provide the fundamental services that their residents demand. The streets must be policed, the trash collected, and children educated. There is little room for debate as to whether local governments must provide these services; they do so a priori.
Second, local governments must promote and protect the wealth of their citizens. Local governments do so by competing with other areas to attract firms and individuals who will contribute more in taxes than they will consume in services, protective zoning practices, and the provision of high-level public services at modest tax costs. Local governments also direct much of their energy toward increasing and maintaining housing values, since the home is the most valuable asset of most citizens.
Third, except in the largest cities, local governments cannot engage in redistributive policies, and they cannot impose progressive taxes. Redistributive policies run counter to the imperative to foster economic wealth. Attempts to redistribute wealth inevitably lead to an out-migration of wealthier residents and an in-migration of poorer residents. This limitation has long been recognized by academics, and more important, by political leaders (Peterson 1981).
Still, it is possible to construct a tax system that comports with the imperatives discussed above—while ensuring a meaningful level of local autonomy over fiscal affairs. Chapter 3 also describes the principles of sound tax policy and their application to local public finance. Those principles include fairness, efficiency, accountability, and neutrality. But they are applicable to all governments. Because of local governments’ place in the federal system, they must operate under additional guidelines.
Sound local tax policy must be guided by the benefits principle of taxation rather than by one’s ability to pay. Benefit taxes are designed to tax only those receiving local public services. Ability-to-pay principles imply progressive or redistributive taxes that cannot function effectively for local governments. In addition, local fiscal policy must be grounded in the taxation of immobile tax bases to the greatest extent possible. Local government efforts to tax mobile bases, such as intangibles or corporate profits, inevitably fail.
The Logic of the Property Tax
Within the framework of sound local tax policy, the property tax is the only viable source of own-source tax revenue for local governments. Since the beginning of the nation, the property tax has dominated local public finance. Chapter 4 explains why the property tax has served the needs of local governments so well for so long.
The property tax has long provided a stable and reliable source of revenue for local governments. Property tax revenue grows as property values increase. Because over time property values have always increased, local government officials can rely on a steady source of increasing revenue without the political costs of raising rates. Because the tax base is immobile, local governments can easily predict revenue yields from year to year. No other source of revenue offers such reliability.
Further, administration and compliance with the property tax is relatively easy and thus inexpensive. Once again, this virtue arises because the underlying tax base—the land or improvements thereto—is immobile. For government, the tax base is easily identifiable. While land values change, most local government administrators can easily ascertain the number of acres, parcels, and buildings within the area. Another advantage of the property tax from a governmental perspective is that taxpayers cannot easily hide or move property. Thus, evading the property tax is virtually impossible. The tax presents equally attractive compliance benefits for the taxpayer. Most residential property owners face minimal compliance costs. Unlike for federal and state income taxes, taxpayers do not have to file forms to comply with property tax laws. The government calculates the property tax value and the amount of tax due. The taxpayer’s compliance begins and ends with the payment of the tax.
Most important, the property tax has endured because it is conceptually attractive. As opposed to state sales and income taxes, property tax revenue is raised locally to support local public services. Thus, the connection between the source of the revenue, the property, and the services being provided is strong. In this respect, the property tax functions as a benefits tax, precisely the way most public finance experts believe local government should be funded.
A Good Tax under Siege
Although the property tax has dominated local government finance, it has come under intense political pressure. The percentage of total government revenue raised from real property taxes has continuously declined for decades. Local governments once raised more than 80 percent of their own-source tax revenue and 65 percent of total revenue from real property taxes. While collections vary widely by state, the property tax now accounts for less than 40 percent of local government tax revenue and just 25 percent of total revenue.
The reasons for this precipitous decline are explained in chapter 5. The overriding cause of the decline of the property tax has been the public’s deep-seated dislike of the tax. For decades, public opinion polls have identified the property tax as the “worst” tax. The public’s dislike of the tax arises from the fact that the tax is highly visible; the tax traditionally must be paid in a single lump sum once a year. Citizens also dislike the tax because of past administrative problems; local governments have had difficulties fairly valuing property for tax purposes. Part of the problem of accurately valuing property stems from the fact that property tax burdens continue to increase. In any event, that view has created a strong bias against the tax. Political leaders and the press routinely characterize the property tax as unfair and as the “most hated” tax. These negative sentiments affect people’s perception of the tax.
The public’s unhappiness with the property tax spurred a series of property tax revolts in the late 1970s and early 1980s. The revolts led to significant limitations on local governments’ ability to raise property tax revenue. Today, 44 states restrict property taxation in some way. Limitations apply to rates, assessment increases, and the total amount of revenue that can be collected from the tax. These restrictions have seriously curtailed both revenue collection and the ability to rely more heavily on the tax in the future.
The property tax also has a continuously shrinking tax base. As explained in chapter 5, local governments lose billions of dollars each year from exemptions for charitable organizations and economic development. Nonprofit organizations, including churches, schools, and hospitals, have received property-tax exemptions throughout American history. Local governments, in competing for business investment, also grant property tax exemptions to firms willing to relocate to their jurisdiction. Property tax exemptions and targeted tax exemptions have serious consequences for local governments.
Finally, the ongoing debate over school finance has further reduced popular and political support for the property tax. Traditionally, citizens were willing to pay property taxes to support public education (Fischel 2001b). However, local governments’ reliance on property taxes to fund public education has created fiscal inequities between property-rich localities and property-poor localities. One remedy to this problem has been the replacement, often under court mandate, of local school property taxes with state funds. Once property taxes no longer primarily fund local education—that is, once the connection between the local public service and the local tax is lost—public support for the tax evaporates.
There Are No Alternatives to Taxing Property
With the property tax under siege, local governments have increasingly turned to other sources of tax revenue to pay for public services. Chapter 6 describes local-option sales and excise taxes. These consumption taxes are the second-largest source of tax revenue for local governments after the property tax.
Local governments impose these taxes in much the same way as states do. In many cases, these taxes are usually collected as part of the state tax. That is, the vendor collects the tax and remits it to the state. The state then returns the local portion of the tax revenue to the jurisdiction in which the purchase was made. The tax offers administrative and compliance conveniences to both the government and the taxpayer. Local governments have minimal administrative responsibilities. Individual taxpayers incur virtually no costs in complying with the tax. Despite lingering concerns over fairness, consumption taxes enjoy widespread support among the public.
Nonetheless, local-option sales and excise taxes are unlikely to play an important role in the future of local government finance for several reasons. First, the overall sales tax base has been steadily falling as more goods and services consumed by Americans are exempt from tax. The continuing shift from an economy based on manufacturing and tangible personal property to one dominated by services and intangible personal property has greatly reduced the tax base. Second, political leaders, recognizing the inherent regressivity of the sales tax, have exempted virtually all goods and services deemed necessities. Thus, in most states, food, medicine, and utilities are exempt from tax. Third, the debacle over electronic commerce has lessened interest in local-option sales taxes. Today, most of what Americans consume is not subject to sales tax. For these reasons, most public finance experts do not believe local-option sales and excise taxes are an adequate or viable source of revenue for local governments. They certainly will not be able to replace the property tax as a source of local revenue.
Local governments also impose local-option income and business taxes to raise revenue. These taxes are discussed in chapter 7. Local governments do not rely on income or business taxes as much as they rely on local-option sales taxes. Only a handful of states allow local governments to tax personal or business income. Local governments have not taxed income more extensively for several reasons. Local-option income taxes can have a detrimental effect on the local economy. Both the public and the political leadership perceive that local governments are better off without such taxes. This perception feeds the existing bias among state political leaders against income taxes. The local-option income tax is not a viable alternative for local governments and will not move beyond its current status.
Local-option business taxes are even less likely to assume a more important role in financing local government. Because of the mobility of capital, local governments cannot effectively tax business activity, especially in the modern economy, where business is less dependent on land and immobile equipment. Few states now allow local governments to tax businesses, and political leaders have little motive for expanding the reach of local business taxation.
With property taxes under siege and other tax sources limited, local governments have been forced to rely more heavily on nontax revenue. Chapter 8 presents the two most important sources of nontax revenue, intergovernmental aid and user fees and charges. Intergovernmental aid is the largest single source of revenue for local governments. State governments fund local government services, especially elementary and secondary education, more than ever. They are doing so, in part, because local governments’ ability to raise adequate amounts of revenue continues to be limited. They are also doing so because of the court-ordered centralization of public education finance. In either event, such aid is damaging to the concept of localism.
State financing of local government gives rise to several problems. First, such financing is inefficient. Relying on political leaders in the state capitals to fund local police, fire, ambulance, and schools virtually guarantees that those and other essential local public services will not be adequately funded. State political and policy leaders are too far removed to ascertain local government service needs. This distance erodes the political accountability that helps ensure local government efficiency.
Second, state financing inevitably results in less local political control. All state aid carries rules and regulations as to how local governments must spend the money. Governors and legislators have a greater say in how money sent to cities, towns, and counties will be spent. The historical record suggests that all forms of financial centralization are accompanied by such “strings.” State control over spending can affect everything from the kinds of books in the local library, to the number of police officers on the street, to the curriculum in the schools, to the artwork adorning local public buildings. Equally important, increased state funding also creates long-term uncertainties for local government finance. When states face budget crises, the first expenditure they often cut is aid to local governments. During the state budget problems of 2001–02, for example, virtually every state slashed intergovernmental aid.
Further, state political leaders are forced to decide among competing interests for government aid. For example, when states run budget surpluses, as they have in recent years, politicians are always under pressure to cut taxes. But the excess revenue may be better spent on local public services. When states run budget deficits, state lawmakers are reluctant to increase taxes to support local public services. The problem is, it is impossible to determine the effects of state financial control of local government. That uncertainty alone should give all Americans pause about the wisdom of ceding financial control over important local public services to the states.
User fees and charges are widely used by local governments—in large part because of the limitations placed on other sources of revenue. Over the past quarter-century—essentially since the onset of the tax revolts—state and local governments have increasingly relied on user fees and charges to fund public services. User fees and charges are among the most, if not the most, efficient methods of financing public services. For that reason, public finance experts regard user fees as an effective means of financing local government (Oates 1993). When the public pays for services directly, the government is less likely to over- or underproduce the service. Local governments can thus better gauge demand for the service, making user fees the ultimate benefit tax.
User fees and charges, however, are incapable of raising enough revenue to meet public service demands, because they have a limited base. For administrative reasons, local governments cannot impose user fees on services widely available to the public. In addition, they cannot, for political reasons, impose fees on many services deemed necessities. Market forces limit the size of fees: Local governments cannot charge more for the underlying service than the public would be willing to pay. And at this point, local governments have imposed user fees and charges on just about everything they can. For these reasons, user fees and charges will continue to play an important, but limited, role in financing local government.
Raising Revenue in the Modern Economy
Local governments face serious limitations on their ability to raise revenue, and the financial constraints are likely to worsen. The rapidly changing economy and the demographic makeup of society will have profound effects on the tax systems of all levels of government, but the effects may be the greatest on American localities. Chapter 9 discusses some of the many challenges that local governments will continue to face.
The continuous shift from manufacturing to a service-based economy will have the greatest impact on local taxation. Business no longer comprises mostly factories with extensive plants and equipment. Manufacturers that sell tangible personal property no longer dominate the economy. Rather, modern American businesses are more likely to use high technology and intangibles to create and sell services. Many modern businesses no longer need extensive real property holdings (which local governments were able to tax), and many no longer exclusively sell tangible personal property (the sales of which are also subject to tax).
International trade has also changed local government finance. Interlocal competition has traditionally placed limits on local government taxation. Cities and towns, once competing with other jurisdictions within a metropolitan area or within a state, are now competing with jurisdictions worldwide. Intergovernmental competition has long placed pressure on local governments vying for business investment, particularly with respect to taxes on mobile bases. Local governments cannot effectively tax mobile capital, as many owners will move the capital out of the jurisdiction. That problem is magnified in a global economy.
Deregulation of key industries, such as electricity, gas, telecommunications, and financial services, has also changed state and local business tax systems (Bonnet 1998). Compared with unregulated businesses, regulated industries have traditionally been subject to higher property and other tax burdens. Further, many local governments own and operate utilities that provide services, usually electricity, to their residents. Cities own a majority of electric utilities operating in the United States, and the profits of the operations typically fund general government services. Overall, deregulation will likely reduce utility revenue and curb property tax revenue.
Finally, demographic changes will challenge local government tax policy. A rapidly aging population will put particular pressure on the property tax. Traditionally, senior citizens have opposed property taxation more vigorously than the rest of the population. Part of that opposition stems from the fact that senior citizens, many living on fixed incomes, face rapidly rising tax burdens as a result of property value inflation. The aging population will likely further pressure the already-beleaguered property tax.
Possible Solutions
The underlying assumption of this book is that local governments are a normative good, and that they must have a dependable source of revenue to ensure that they operate efficiently and effectively. If that assumption is correct, then only the property tax can provide that revenue. The property tax in its current state, however, cannot provide the revenue necessary to fund local government. Thus, the tax must be strengthened and revitalized if local governments are to retain some measure of political autonomy.
Chapter 10 sets forth several policy proposals that could lead to a more viable property tax and help ensure that American citizens have the option of governing their affairs locally. The property tax will never be strengthened unless public attitudes change. Citizens need more information about the positive attributes of the property tax. Leaders must show the public the connection between the services paid for by the property tax and the value of their property. More important, political leaders must illustrate to the public that property tax is the only source of revenue that will ensure that they have some control over the public services they demand.
To complement this education effort, the excesses of the property tax revolts must be reversed. Essentially, tax experts must encourage a property tax “counterrevolt.” Neither economic nor tax policy justifies the most draconian property tax limitations—those on rates and assessments. Attempting to reverse the excesses of the property tax revolts may appear daunting.
After all, the limitations remain politically popular, and the property tax remains politically unpopular. In addition, the tax remains unpopular despite that fact that most problems that originally gave rise to the public’s unhappiness with the tax have been addressed. Strengthening the property tax is possible if reforms retain safeguards for those on fixed income, such as senior citizens. But those safeguards must be better explained to citizens, who are woefully unaware of many of the policies designed to alleviate property tax burdens. Strengthening the property tax will also likely require governments to reduce other local-option taxes as well as state tax burdens.
State and local governments must also address the significant problem of exempt properties. Exemptions for economic development and charitable organizations cost local governments billions of dollars and shift the burden of paying for public services to other taxpayers. State and local governments must limit the amounts of property eligible for exemption.
Of course, state governments must also address the problem of fiscal inequities in education finance. In many states, the remedy for such inequities has been to shift fiscal responsibility to the states, while at the same time limiting local government taxing powers. Methods of equalizing school spending that do not include reducing local taxing authority must be found.
Finally, policymakers and political leaders should consider fundamental local tax reform with an emphasis on split-rate taxation. Split-rate taxation, a version of Henry George’s concept of land value taxation, simply involves taxing the value of land at a higher rate than improvements to that land (buildings and other manmade structures). Virtually every public finance expert has lauded split-rate taxation, because taxing land has no effect on economic decisionmaking. At the same time, reducing the tax on improvements provides an incentive for individuals and companies to develop underused or vacant land.
A split-rate tax system would allow local governments to raise revenue according to the three political imperatives under which they operate and to raise the steady source of revenue necessary to provide basic services. Such a system will allow local governments to provide incentives to create and enhance the wealth of the community. Because the tax on land is neutral—that is, it does not distort market decisions—such a system will not involve redistributing wealth. Further, because the land is immobile, such a system provides an ideal base for raising revenue in the 21st century. Chapter 10 explains why split-rate taxation has been called the “magic bullet” that can solve many problems of local government finance.
Without significant reforms to the property tax system, local governments will continue to cede financial and political control to the states. As this concession occurs, a fundamental aspect of American government will cease to play an important role in the federal system. Americans should be wary of such an outcome.
Notes
1. The premise of the book is based on an article written for State Tax Notes entitled “To Preserve Local Government, It’s Time to Save the Property Tax” (Brunori 2001d).
2. For the purposes of this book, property taxes refer to ad valorem taxes on real property (i.e., land and improvements thereto). Taxes on intangibles and personal property are discussed separately.
