Chapter 12Taxing and Spending

The Principles of FinanceRevenuesThe Political Economy of TaxationManaging MoneyState and Local SpendingCurrent Issues in State and Local Finance

The Principles of Finance

Two basic principles describe state and local financial systems – interdependence and diversity.

Interdependence – state governments raise money through own-source revenue which is monies derived by a government from its own taxable resources, and also through intergovernmental transfers, which is the transfer of money from one level of government to another.

Diversity of revenue sources - is the second principle of state and local finance systems.

Diversity

Each level of government is dependent on one type of revenue device more than others.

The national government focuses on income tax, the state governments focus on sales tax, and the local governments focus on property tax.

There is an important difference between tax capacity, which is the potential to raise revenues from taxes, and tax effort, which is the degree to which a state exploits its fiscal potential.

State and Local Tax Burdens, 2007, in Descending Order

Revenues

Certain trends can be found in all state and local finance systems.

For example, property tax is unpopular and is no longer a significant source of state revenue, although its contribution to total own-source local revenues is still strong.

States continue to depend heavily on sales tax, but alternatives are being used more widely.

Distribution of Total State and Local Tax Revenue by Source

Types of Tax

Regressive tax – a tax in which the rate falls as the base or taxable income rises. This tax places a greater burden on low-income citizens than on high-income citizens.

Progressive tax – a tax in which the rate rises as the base or taxable income rises. Thus, the more you make, the greater proportion of your income is extracted by the progressive tax.

Proportional (flat) tax – a tax in which people pay an identical rate regardless of income or economic transaction.

Criteria for Evaluating Taxes

Among the most important criteria for evaluating taxes are equity, yield, elasticity, ease of administration, political accountability, and acceptability.

Yield – taxes can be evaluated on the basis of efficiency, or how much money they contribute to government coffers versus the effort expended to collect them.

Political accountability holds that tax increases should not be hidden, and that local legislative bodies should have to approve them publicly.

Major State and Local Taxes

The principal types of taxes are those on property, sales, and income.

Local governments depend on property taxes for three-quarters of all their own-source revenues. Property tax has lost acceptability recently because it lacks political accountability, is hard to administer, and regressive.

States currently collect most of their revenue from general sales and gross receipts tax. The sales tax has remained in favor because voters perceive it to be fairer than other forms of taxation.

Rating State and Local Taxes According to Six Criteria

Severance Tax

Thirty-nine states place a severance tax on some form of natural resources.

Severance taxes are popular in states rich in natural resources because they help keep income, property and sales taxes relatively low.

Severance revenues also help pay for environmental damage resulting from resource extraction operations.

Gambling: Lotteries and Casinos

Forty-one states have lotteries.Lotteries can bring in large sums of money, are

popular and entertaining, and are voluntary. In addition, lotteries relieve pressure on major taxes.

On the downside, they are costly to administer and have low yields.

Lotteries are considered inelastic because earnings are cyclical and generally unstable.

The Political Economy of Taxation

Spending – taxes lead to spending. A tax-service paradox develops when people demand more government services but do not want to pay for them through higher taxes.

The political economy – the set of political choices that frames economic policy has become perplexing for state and local officials.

Tax revolt – twenty-seven states have constitutional limitations on taxing and spending. The stirrings of new tax revolts are constantly in evidence.

Total State and Local Government Spending by Service Delivered

The Political Economy of Taxation

Fiscal stress – financial pressure on a government from such factors as revenue shortfalls and taxing and spending limitations. Factors contributing to fiscal stress are adverse social and economic conditions, mostly beyond state and local government control.

Limited Discretion – the discretion of non-national governments is limited with ceilings on rates and amounts of taxation and spending.

Pensions – state and local governments are required to publicly report the funding status of employee pensions and health care benefits.

Managing Money

Every state except Vermont is constitutionally or statutorily mandated to balance its budget each fiscal year. States then require local governments to balance their budgets.

Until recently, state and local governments estimated their annual revenues by extrapolating from past trends.

The quality of data and the validity of the economic assumptions determine the accuracy of revenue estimates.

Long-term Borrowing

General obligation bond- a debt instrument supported by the full financial resources of the issuing jurisdiction.

Revenue bond – a bond that is paid off from income derived from the facility built with the bond proceeds.

Industrial development bond (IDB) – a bond issued to fund the construction of a facility to be used by a private firm.

State and Local Spending

The three major policy areas where state and local governments spend their revenues are:

Economic Development – this is a high priority for all the states, but many questions need to be asked regarding the payoffs.

Education Policy – around $500 billion is spent annually on elementary and secondary education by states and localities

Social Welfare and Health Care Policy – numerous healthcare and public assistance programs have been established to ease the problems of the poor, elderly, and disadvantaged.

Current Issues in State and Local Finance

State and local governments are experiencing significant long-term problems in political economy.

Primitive tax systems are out of step with today’s service- and information-based global economy.

The need for increasing state and local capability and responsiveness by reinventing and reinvigorating government has never been greater.

State and local financial relationships are characterized by sharing and cooperation, but also by conflict over mandates and limited local discretion.