Estimating Local Revenues and Expenditures

Since the end of World War II, local government expenditures for various have been increasing at phenomenal rates, often outstripping the overall growth of the national economy. The combined total for all local public functions has grown regularly at a faster rate than the Gross Domestic Product (GDP). Between 1960 and 1971, local government expenditures financed from all sources increased at a compound rate of 9.7% per year, while the GDP rose at an annual average rate of only 6.9%. These differential rates of increase were further exacerbated during the seventies by the downturn in the economy, coupled with the continued spiraling inflation. In the 1980s, the annual growth rate for local governmental expenditures continued to out pace the GDP, averaging 8.55% per year.

The Elasticity of Local Revenues and Expenditures

The relationship between changes in local government expenditures and the Gross Domestic Product (GDP) can be examined by a useful measure suggested by James Heilbrun. [7] This index, which Heilbrun calls the "elasticity of local spending," is derived by dividing the percentage change in local government expenditures by the percentage change in GDP.

When local government expenditures are increasing at a faster rate than the GDP, the value of ELS will be greater than one. Between 1960 and 1969, the ELS for all local governments had a value of 1.406 (i.e., 9.7% divided by 6.9%), whereas during the preceding decade, 1950-59, the value was 1.525 (9.0% divided by 5.9%). The decade of the 1980s recorded an ELS for local governments of only 1.0892 (8.55% divided by 7.85%).

Heilbrun also suggests that it is possible to define the elasticity of local revenue sources in a similar fashion, i.e., by dividing the percentage change in local tax revenues by the percentage change in GDP. If the value of the elasticity of local revenue sources is equal to the value of the elasticity of local spending, and if all expenditures are paid out of local sources, then local government could finance the growth of expenditures year-by-year with no increase in tax rates. The growth of the GDP would induce just enough expansion in the local tax base to provide the revenues needed to pay for growing expenditures. However, since the end of World War II, the elasticity of local revenues has been far below that of local spending, thus contributing to the persistent financial problems encountered by most local governments.

Estimates of the elasticity of property taxes throughout the United States vary from a low of 0.8 to a high of 1.3, with the majority of such estimates placing the value in the range between 0.8 and 1.0. On a national basis, the general sales tax collected by local governments is estimated to have an elasticity of between 1.0 and 1.27, with the majority of estimates falling at 1.0. In other words, the growth of revenues from the general sales taxes closely parallels the growth of the GDP. Other sources of general revenue (excluding intergovernmental aid), such as taxes on particular commodities and miscellaneous fees and charges, tend to have elasticities well below 1.0. When these parts are added together, it appears that the elasticity for the aggregate of local taxes and charges, at best, is about 1.0 and perhaps somewhat lower. With an expenditure elasticity of about 1.09 and a tax or revenue elasticity of 1.0 or less, it should be clear why local governments are under continual pressure to raise tax rates or to adopt new taxes if they are to finance increases in local expenditures from local revenue sources.

Efforts of local governments during the past thirty years to develop other tax sources have been successful in only a limited number of larger cities. The dependence of local governments on the property tax stems from one inescapable fact--the lack of viable options. No other form of taxation is readily available for productive use at the local level. Unilateral taxation of income, sales, or business receipts by local governments may prove dysfunctional to the financial well-being of such municipalities. That is, if one municipality in a region introduces such taxes, new economic activities tend to locate beyond its taxing jurisdiction.

Real property, however, is quite immobile. Differential taxes seldom induce migration out of a local geographic area. Workers must reside close to their work; retail outlets tend to locate close to consumers; manufacturing establishments, once committed, tend to stay put, since property taxes are a modest part of their total cost (although such taxes may play an important role in initial location decisions). In short, real property offers a reliable base upon which local governments can safely levy taxes.

The yield from local property taxes in the years following World War II responded fairly well in the aggregate to increases in the Gross Domestic Product, as well as to increases in population. These conditions led Burkhead to conclude in 1963 that: ". . . the property tax is a far better fiscal instrument than most of its critics have allowed. There is every reason to believe that it will continue to hold its relative fiscal importance in state-local public finance structures." [8] Four years later, Benjamin Bridges reached somewhat less optimistic conclusions, reflecting the general inability of local revenue sources to keep pace with the rapid growth of the economy and the parallel increases in public sector costs. [9]

These fiscal discrepancies have an important bearing on the capacity of local governments to finance capital facilities. A community's ability to accumulate capital reserves or to borrow to finance long-term capital investments is conditioned, in large measure, by its overall "financial solvency." Any capital improvements program must be formulated within the financial capacity of government to pay for its needs and desires. A community that cannot meet its short-term public expenditure demands from existing (and projected) sources of revenue will have great difficulty in securing willing investors for its long-term bonds. Under such circumstances, investors are likely to demand a high rate of interest to offset the risk. To propose improvements that the government cannot afford or without a clear notion of how they will be paid for is to invite unrealistic programs that, from the beginning, are destined to prove unsuccessful.

Current Projection Practices

Techniques for making revenue and expenditures projections, with few exceptions, have remained virtually unchanged over the past fifty years. Some public officials and administrators simply make "best guesses" about future levels of revenues and expenditures The common tendency is to allow prior patterns to influence projections. Revenue and expenditure expectations for the coming year are determined by applying the observed percentage changes between the previous and current fiscal years. Alternatively, a trend line may be developed by fitting a series of historical data and then extrapolating these "trends" to obtain the projection.

The current "state of the art" may be illustrated by a publication of the Management Information Service of the International City Manage-ment Association. The projection process advocated in this report consists of dividing revenue and expenditures into "readily definable major categories" and then projecting these categories for five or six years "on the basis of past trends." These projections are then compared to provide some notion of "future free fiscal capacity," that is, the uncommitted moneys which can be used to assume new program initiatives, for capital expenditures, to establish capital reserves, or for debt service.

While this approach has the advantage of simplicity, it leaves many problems unresolved. Advocates of this approach may stress that such things as the tax base and tax rates are likely to change and that local governmental officials should be consulted to determine possible deviations from historical trends. Allowance is seldom made, however, for such contingencies in the projections. On the contrary, the population and the economy often are treated as if they will remain stable regardless of recent rates of growth. And the rate of salary increases of public employees and changes in other major cost factors are treated as if they will remain constant.

Even when the goal of local government is to provide the same level of service over a period of years, disruptions in service delivery may result unless likely changes in the demand for such services are anticipated with sufficient lead time to make necessary adjustments. Increases in population receiving a particular service may necessitate added personnel and often additional capital equipment and facilities. A new school, for example, should be available when the need exists. A five to six-year lead time is required to ensure the availability of such public facilities at the time the demand becomes critical. Therefore, forecasting is required simply to prevent current services from rapidly becoming inadequate. Furthermore, uncertainties surrounding intergovernmental assistance programs give rise to the need for long-range forecasting both to justify requests for such funds and to map out contingency plans in the event that these funds are not forthcoming.

Financial Analysis: Estimating Local Revenues

The fundamental purpose of a financial analysis was stated some years ago in a report of the National Resources Planning Board.

. . . (to) determine approximately the present and future ability . . .to pay for the construction and maintenance of public improvements, by estimating the present availability of funds, by research into the probable future trends of municipal revenues and expenditures, by appraisal of all factors related to the administration and operation of the program, and by determining what limitations are imposed, by statutes or prior commitments, upon the freedom of the municipality to act. [10]

The analysis of revenues is a three-step process which involves:

(1) An estimate of available revenues under existing fiscal policies;

(2) An exploration of alternative fiscal policies; and

(3) Selection of a general fiscal policy which will best fit the future public service and capital expenditure needs in light of the limitations placed on the jurisdiction's financial capacity.

The first step in revenue analysis is to determine whether any modifications in existing policies will be required to finance the desired service programs and related capital expenditures. An analysis of available revenues under existing fiscal policies will provide a basis for determining the most advantageous and realistic means by which revenues and expenditures can be brought into equilibrium, i.e., by increasing the former or reducing the latter.

The probable amounts to be received from present rates of taxes and miscellaneous charges must be estimated after thorough analysis of collection trends and conditions affecting the yield from each source. The rates of all service charges (user fees) must be compared to changes anticipated in the cost of rendering the services at the same level and/or increasing the level of service. Consideration must be given to possible adjustments in the rate schedule. In order to accomplish these objectives, it may be desirable to have unit cost data available through the application of cost accounting procedures.

Each source of revenue may require a different formula in order to forecast a reliable budget figure. Each source should be tabulated over a sufficiently long period to establish valid trend lines that take into account both boom and recession periods. It is also necessary to develop and project appropriate indices against which various sources of revenue can be matched in order to make future estimations. Some revenue sources may produce essentially the same yield from year to year, while other revenues may fluctuate significantly and cannot be relied upon to produce the same amount from one year to the next. Some sources are dependent upon the fiscal policies of other levels of government (e.g., federal and state aid programs), while other sources are directly or indirectly related to the level of service and capital expenditures provided by government.

For each revenue source, there is a rate or charge and an item subject to the levy of a tax, license, or charge. The yield must be estimated by determining how frequently the item subject to tax (or charge) will occur. No source of revenue should be estimated solely on collections of the previous year. Some revenue sources are more stable than others; however, a high level of stability should not lull the administrator into the pitfall of routine estimating.

The following procedural steps are suggested as a basis for sound revenue estimates:

(1) A file should be prepared for each source of revenue, containing the following information:

(a) a summary of the legal background, including date of adoption and reference to ordinances or legislation establishing the charges;

(b) a summary schedule of rates or charges; and

(c) a list of factors which influence the revenue yield.

(2) A data sheet on each revenue source should be prepared, showing collection information by months and totals by years.

(3) The percentages collected each month should be compared to annual totals for the past three to five years to indicate seasonal influences and to establish monthly or quarterly revenue estimates for budget control purposes.

(4) Up-to-date information should be maintained indicating local economic conditions and trends; of particular value are data on building construction activity, real estate turnover, retail sales, employment and payrolls, and other common indices of business activities.

(5) The advice should be sought of department heads administering public service for which special charges are made.

(6) Before the budget process is begun for any given fiscal period, preliminary revenue projections should be prepared based on trend factors; these predictions can serve as a guide to the determination of fiscal policy.

(7) Final estimates--based on trends, economic projections, departmental estimates, and other related factors--should be prepared immediately prior to the transmission of the budget document to the governing body.

In developing this analysis, all assumptions concerning methodology and current fiscal policies should be carefully recorded. Basic methods used in forecasting are: (1) extrapolation, (2) correlation, and (3) some form of mathematical technique for curve fitting. It is inappropriate, however, to place too much reliance upon statistical formula for computing future trends. Rather, a careful analysis should be made of the various possible factors that may alter past trends or establish new ones.

The second step in the financial analysis is to explore the ramifications of alternative fiscal policies. This step should include an analysis of: (1) ways by which the income derived from existing revenue sources might be increased or decreased; (2) the availability and/or feasibility of new sources of revenue; and (3) the effect of varying borrowing policies on available resources. This analysis must be a continuous process, particularly in light of the ever increasing demands being placed on local governments for services and facilities.

Information on the availability of revenues under existing fiscal policies and analysis of alternative methods of financing must be brought together to focus on recommendations regarding future fiscal policies. This comparison should provide the chief executive and the governing body with the basis for a clear, explicit series of policy statements to guide the programming of capital improvements. The following points illustrate the items that should be covered in statements of fiscal policy.

(1) The total amount of funds to be expended annually in order to achieve and maintain some desirable level of public service.

(2) Policies with regards to new sources of revenues.

(3) The role of state and federal assistance.

(4) The relationship between the capital and operating budgets.

(5) Fiscal policies with regards to current outstanding debt.

(6) The ratio to be applied among the various methods of financing capital improvements, i.e., what portion of the required allocation will be available from annual revenues and how much must be financed through borrowing or other methods of financing.

(7) The types and maturities of bonds to be issued for the financing of capital improvements.

(8) The relationship between self-supporting and tax-supported public improvements and the terms and conditions under which self-liquidating facilities are feasible.

Every effort should be made to level off and reduce the outstanding debt of government at the earliest possible date. Capital expenditures must be carefully scheduled to ensure a reasonable outstanding debt structure in relation to the general level of the economy, the sources of revenue available, and the overall ability to pay for these improvements. Bond issues should have a limited life period to minimize the debt service charges. In terms of the ratio among the various methods of financing capital improvements, it may be suggested from experience that at least 20 percent should be financed from current revenues. While this level will vary from area to area and from year to year, as a matter of fiscal policy an effort should be made to establish a clearly defined range within which these adjustments can be made. In accordance with recognized finance principles, annual debt service charges payable from general revenues should not exceed 25 % of the total funds available.

Estimating Local Expenditures

A similar "divide and conquer" approach should be applied in estimating local expenditures. Each particular class of expenditure should be projected accounting to various explicit assumptions regarding the supply and demand associated with a particular public service. Three major sets of variables should be considered:

(1) Salary variables: projections of the levels or rates of increase for public employees in various salary and wage classes.

(2) Service variables: projections of the way in which the level of service or manner in which services are provided will change, given some assumed change in the demand for services by the population.

(3) Population variables: including projections of the size, age, and racial composition of the population.

Each expenditure estimate should be associated with specific statements concerning the values of these major variables, supplied by those local government officials best qualified to predict as a consequence of their access to pertinent facts. In instances where a high degree of confidence cannot attached to a particular projection (due to uncertainty), different assumptions should be tested (using sensitivity analysis techniques).

Explicit statements concerning service levels permit the testing of the impact of decisions to expand or contract particular public services in some defined period. Separate information inputs should be provided for each year over which projections are to be made. Unlike simple extrapolation techniques, this approach yields estimates and projections that are more independent (that is, are not unduly influenced by past trends). This approach can deal with a wide range of assumptions simultaneously--some services can be expanded, some contracted, other held at their present level. The capacity to test different alternatives is not readily available in the more traditional techniques.

Separate estimates of future expenditures should be provided at a reasonable level of detail. For complex categories, further sub-divisions may be made so that separate activities/responsibilities within departments can be examined in some detail. One of the advantages of the independent projection feature of this approach is that additional categories can be readily added where deemed appropriate. Since major activities are projected using separate equations, it is possible to depict interrelationships between activities within the same category and to examine the implications of various expenditure patterns arising from different program mixes. [11]

Estimates of future expenditures should be built on two basic sets of factors: estimates of expenditures arising from personnel and those linked to non-personnel related expenditures. Projections should be made for each department (or category of expenditure) regarding the total number of employees and their distribution among various skill and wage levels. With these data as a base, both the number of employees in a particular wage or salary class and the average annual salary or wage and staff benefit costs for that class should be projected and summed to produce total personnel expenditures.

Personnel projections are related both to the demographic characteristics of the population (which can be used as a measure of the demand for public services) and to policy decisions (or policy alternatives) as to the level and quality of services provided. The use of policy variables permit assumptions to be made regarding the appropriate response to be made in terms of supply as a multiple or fraction of some observed relationship between changes in demand and the prior levels of services provided.

Nonpersonnel items consist of contractual services, materials and supplies, travel costs, utilities, equipment, and debt service charges. These items should be estimated using linear regression equations that express the functional relationship between these nonpersonnel expenditures and personnel expenditures (or, alternatively, total number of personnel). Some nonpersonnel items are closely related to staffing levels (for example, office equipment, supplied, travel costs). Other items are more directly influenced by pricing considerations.

Methods of Financing Capital Improvements

The options for financing public facilities are similar to those available to any individual or family: (a) pay cash out of current earnings, (b) save money for future acquisitions, or (c) borrow on anticipated earning power. A sound program for financing capital improvements will seek to develop an appropriate mix among these three methods.

Supporting capital improvements from current revenues encourages government to "live within its income," minimizes premature commitments of funds, and conserves credit for times of emergency when ample credit may be vital. Pay-as-you-go financing avoids the added cost of interest payments and therefore, is less costly than borrowing. On the other hand, the pay-as-you-go approach may result in an undue burden being placed on present taxpayers to finance some future need from which they may not fully benefit. Thus, it may be argued that public projects that provide services over many years should be paid for by people according to their use or benefit--that is, should be financed on a "pay-as-you-use" basis.

Financing capital facilities through a reserve fund (sometimes called a capital reserve) can be thought of as the opposite of borrowing in that the timetable is reversed. A portion of current revenue is invested each year in order to accumulate sufficient funds to initiate some project in the future. The amount (N) that must be placed annually at compound interest (r) for a term of n years to create a reserve fund (S) can be calculated by means of the following formula:

N = r / S [(1 + r)^n] - 1

Should the objective be to develop a reserve fund (S) of $2 million at the end of ten years(n), an investment of $151,736 per year (N) would be required is the rate of return on the investment (r) was 6 percent.

Like all governmental powers, the capacity to borrow must be used with critical regard for its justifiable purposes and a clear understanding of its safe and reasonable limits. A sound borrowing policy is one that seeks to conserve rather than exhaust credit. The ability to borrow when necessary on the most favorable market terms is an objective that applies to governments just as it does in business and industry.

States often impose borrowing limits on local governments. These limits typically are cast in terms of dollars of outstanding debt as a percentage of the jurisdiction's real property tax base. Beyond any state imposed limits on borrowing, municipalities are restrained by the fact that this year's borrowing must be paid back from revenues in subsequent years. When the debt service burden of a municipality becomes overly large in comparison to its the tax base, the bond rating of the municipality may be lowered and the cost of borrowing may increase. Companies that rate municipal bonds (and thereby, influence the interest rate that must be offered to place such bonds) emphasize the importance of "good fiscal stewardship" in this regard.

Government loans are marketed with maturities ranging from a few days to several decades. Short-term borrowing takes various forms--bills, certificates, or notes sold to banks or other investors, bank loans, warrants paid out in lieu of cash, and unpaid bills and claims--and is most frequently used to smooth out irregularities between expenditure and income flows and to finance current operations on a temporary basis during periods when tax receipts fall off unexpectedly. Bond Anticipation Notes (BANs) are issued for immediate financing of projects that eventually will be financed through long-term bonds. Notes may also be issued to finance municipal operations in anticipation of future tax receipts (TANs), future revenues (RANs), or with the expectation of receiving grants from the state or federal government (GANs).

Intermediate borrowing has limited but definite uses. Jurisdictions operating largely on a pay-as-you-go basis may resort to intermediate borrowing when the requirements for capital expenditures are exceptionally high and cannot be met from current revenues (e.g., in times of emergency capital needs). A city may discover favorable opportunities to convert a portion of its outstanding debt by floating a new intermediate loan at a lower rate of interest.

In general, long-term borrowing is appropriate under the following conditions: (1) where the project is of a type that will not require replacement for many years, such as a city hall, auditorium, major health facility, or sewage disposal plant; (2) where the project can be financed by service charges to pay off the bond commitments; (3) where needs are urgent for public health and safety purposes or other emergency reasons; (4) where special assessment bonds are the only feasible means of financing improvements in the absence of subdivision regulations or other controls; (5) where intergovernmental revenues may be available on a continuous basis to guarantee the security of the bonds; and (6) for financing projects in newly annexed areas or areas of rapid expansion where the demands on local tax resources are comparatively large and unforeseen.

Calculations should be made regarding debt service requirements, applying information regarding the amount of debt outstanding, plans for new capital expenditures, and expectations concerning future interest rates to derive forecasts of the principal and interest payments on public debt. Policy variables should be used to examine the mix of financing techniques for long-term capital expenditures.

Summary

Financial analysis and planning provide the foundation for effective financial management. An analysis must be made of the various sources of revenue currently available under existing fiscal policies, and in particular, an examination of the revenue sources under the direct control of the local jurisdiction. Alternative fiscal policies and methods of financing should be explored to include an analysis of adjustments in the tax rate (millage) and other fee schedules and the current debt structure. Fiscal policies should be formulated in light of these analyses to deal with revenues, operating expenditures, capital improvement, debt commitments, and relationships between and among these fiscal components.

Endnotes

[1] Robert L. Bland, A Revenue Guide for Local Government, 1995, p. 34.

[2] Stella M. Capek and John I. Gilderbloom, Community Versus Commodity: Tenants and the American City, (Albany, N. Y.: SUNY Press, 1992), pp. 15-51.

[3] Peter H. Rossi and Eleanor Weber, "The Social Benefits of Homeownership: Empirical Evidence from National Surveys," in Housing Policy Debate 7 (1997), pp. 1-35.

[4] At the state level, there is some evident support for acknowledging the renter's payment of property taxes. A 1994 study by the Advisory Commission on Intergovernmental Relations noted three states (Indiana, Massachusetts, and Wisconsin) permit renters an income deduction in lieu of property taxes. The National Conference of State Legislatures (1994) noted property-tax circuitbreaker programs for all renters in 13 states, for all households with dependent children under the age of 18 in one state (Kansas), and programs for elderly renters in 28 states. New Jersey has new legislation for all renters effective for 1996 returns.

[5] Donald A. Krueckeberg, "Property for Everyone and How to Achieve It: The Resident's Property Tax," in Journal of Planning Education and Research, Vol. 18, No. 2 (Winter, 1998), pp. 171-175.

[6] Bland, op. cit., p. 106.

[7] James Heilbrun, Urban Economics and Public Policy (New York: St. Martin's Press, 1974), pp. 324-330.

[8] Jesse Burkhead, State and Local Taxes for Public Education (Syracuse, N.Y.: Syracuse University Press, 1963), p. 70.

[9] Benjamin Bridges, Jr., "Past and Future Growth of the Property Tax," Property Taxation-USA, edited by Richard W. Lindholm (Madison, Wisc.: University of Wisconsin Press, 1967), pp. 31-37.

[10] Public Works Committee, Long-Range Programming of Municipal Public Works (Washington, D.C.: National Resources Planning Board, 1941), p. 7.

[11] For a further explanation of how this approach might be applied, see: Claudia DeVita Scott, Forecasting Local Government Spending (Washington D.C.: The Urban Institute, 1972).

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