II. REVENUES AND EXPENDITURES IN THE PUBLIC SECTOR
Historically, the United States has relied on a mixed private-public economic system, with public sector economics applied when the market system fails to satisfy social goals.
Rationale for public sector economic activity includes:
(1) Provision of public goods (parks and recreational facilities, primary and secondary education, public health facilities and programs, etc.);
(2) Allocation and distribution of resources (public welfare, differential incidence in the costs and benefits of public programs);
(3) Correction of market imperfections--natural monopolies, externalities, and others;
(4) Provision of collective risk
When under-supplied or unsupplied, government assumes production of the good or service and exacts a price from consumers in the form of taxation.
Governments may encourage or discourage the production and consumption of other goods and services by the regulation of economic behavior (e.g., through tax incentives or tax levies, performance standards, codes and inspections, etc.).
The federal and state governments have primary responsibility for policies impacting the distribution of wealth.
Revenues used to support many local services are not based on user-benefit, resulting in a regressive impact with respect to income.
Stabilization and growth are concerns of local governments in terms of maintaining an adequate economic base, an adequate level of public service, an appropriate level of capital investment, and reasonable stability of public revenue.
Government may assume ownership to circumvent monopolistic pricing (e.g., a public utility) and/or regulate the pricing of these goods and services.
Multiplicity of local jurisdictions and balkanization of responsibilities makes it difficult to achieve economies of scale in the delivery of public services.
Local government revenues are relatively inelastic, that is, most local sources of revenues are not particularly responsive to changes in the overall economy.
The tax structure forces local governments to rely heavily on property taxes which have proven to be relatively unresponsive in meeting increasing demands for public services and facilities.
The deterioration of urban infrastructure is a serious problem of national scope. recognition of which comes at a time when resources are constrained at all levels of government.
The phrase "property tax" is ordinarily used to describe a group of taxes which are levied on the value of different kinds of property determined by the individual states to be subject to taxation --usually on an ad valorem basis, i.e., according to value.
Local property taxes usually take two forms:
(1) Real property tax is levied on the assessed valuation of taxable land and improvements, thereupon
(2) Personal property tax is, or has been, applicable to the assessed value of taxable tangible personal property, e.g., furniture and equipment, automotive equipment, animals, and inventories, and taxable intangible personal property, e.g., money, stocks, bonds, and other assets representing a property right that is not tangible in character.
Exemptions to real property taxes often include churches, cemeteries, schools, and public property, homes of the elderly and veterans, "homesteads" (southern tier states), new industry (south), mining enterprises (west), and nonprofit organizations. Tax Assessment
Real property is classified as to use; personal property is classified on the basis of its tangible and intangible characteristics.
The principal functions of the assessment process are:
(1) To assure that all properties appear on the roll, with a proper notation as to the taxable status of each property.
(2) To ascertain values under which each taxable property can be made to bear its equitable share of the tax load.
The basic objective of the assessment process should be to determine internally consistent values so that taxpayers can be subject to the same effective millage rates.
Real property is assessed at some percentage of true market value.
In some localities, assessed value is set at less than 100% to provide some "margin" for further adjustment without increasing the millage (tax rate).
Many local governments operate under legal restraints as to the tax rate.
The debt limit is typically expressed in terms of a percentage of taxable property values.
The principal advantages claimed for the property tax are:
(1) Stability: in periods of economic adversity, it continues as a consistent income producer.
(2) Contributions can be required of the owners and/or occupants of property proportionate to the services being rendered.
(3) Absentee property owners are required to pay their "fair share".
(4) Property taxation is difficult to evade, facilitating administration by local governments.
(5) Owners of properties which are nonproductive or of marginal value are encouraged to develop the properties or to sell them to others.
(6) Property ownership is an index of a person's wealth.
(7) Enables local governments to maintain relative autonomy from state and federal control.
The property tax represents a tax on unrealized gains--a tax on wealth rather than on income --and is particularly onerous for those who are "property rich" but "cash poor," such as elderly residents living on a fixed income.
Among the other disadvantages frequently cited are:
(1) The tax is regressive --tends to absorb a greater proportion of the income of low income families than higher income families.
(2) The increasing list of exemptions tends to accentuate the inequities in the tax.
(3) The yield is not as flexible as some other kinds of taxation; in periods of inflation, assessments fail to rise in relation to actual changes in value.
(4) The problems of administration are very substantial and improvements tend to be rather expensive in relation to yield.
(5) Making improvements, or even careful current maintenance, tends to hold values above levels than would otherwise exist and, in turn, requires higher tax payments.
(6) The lump sum payments (annual or semi-annual) are a burden on some residents.
(7) Differentials between adjacent tax districts result in competition both for the location of new residential developments and for the location, or relocation, of economic activities necessary to the sustenance of the entire economic and social community.
Alternative to property taxes include:.
o Increased use of state and federal levels in the performance of governmental functions.
o Imposition of user charges rather than use of general taxes to finance certain public services, e.g., transportation, parking facilities, recreational activities.
o Increase taxes on non-property.
o A tax on the value of land alone or heavier tax rates on land values than on buildings.
Significant reliance on non-property taxes is a relatively recent phenomenon (beginning in the 1930's).
General Retail Sales Tax
Local sales taxes are primarily taxes on retail sales of tangible personal property; however, the tax base may include one or more specific services, such as public utilities.
Exemptions are designed to eliminate the regressiveness of the tax and give more flexibility for using higher rates.
The sales tax is not inelastic, but varies less widely during business fluctuations (especially inflation) than do the yields of net income taxes.
Safeguards are needed against inequity, maladministration, and damaging economic effects.
Gross Receipts Taxes
Gross receipts taxes are imposed on businesses and occupations and are measured by the gross income of the undertaking.
Gross receipts tax rates usually are low and uniform for businesses n the same class.
When levied at uniform rates, the gross receipts tax bears no relationship to the profitability of the entity being taxed.
Such taxes hit low profit businesses harder than those with a high profit margin.
Selective Sales Taxes
Numerous municipalities levy excise taxes on specific commodities or services in lieu of applying a general retail sales tax.
o Public utility taxes are good revenue producers, without requiring heavy administrative expense, but the tax is almost always passed on to the consumer.
o Local taxes on tobacco, where authorized, are used extensively.
o Admission and amusement taxes are (a) readily administrable; (b) tax so-called nonessential expenditures; (c) obtain revenue from nonresidents using local facilities; and to some extent, (d) are benefit taxes--recouping some expense of special services such as police, fire protection, traffic regulation, and inspection.
Motor fuel and motor vehicle license taxes are based on the benefit principle in taxation.
o Most states remit to the local governments portions of the state-collected motor fuel taxes--based on the amount collected within the county or municipality.
o Motor vehicle license taxes are widely used as a local non-property tax.
Business license taxes, unless frequently revised, are likely to be discriminatory and bear little relation to benefits received or the ability to pay.
Income Taxes
In its broadest application, the income tax applies to:
(1) Gross income from salaries and wages of residents earned within and outside the city;
(2) Gross income from salaries and wages of nonresidents earned within the city;
(3) Net profits of professions and unincorporated businesses of residents from activities wherever conducted;
(4) Net profits of professions and unincorporated businesses of nonresidents from activities conducted within the city; and
(5) Net profits of corporations from activities conducted within the city.
Local income taxes create problems of double taxation in the levy by overlapping governments and the application both at the place of origin of the income and at the domicile of the taxpayer.
Licenses and Permits and Service Charges
Payment is classified as a license or permit fee if the charge is less than or equal to the cost of the administration of a government activity.
Service charges are based on the benefit principle, generally bear a direct relation to the cost of providing the service, and free up tax funds for other applications.
Miscellaneous General Revenue
Interest earnings consist of earnings on deposits and securities, other than the earnings of insurance trust funds or employee retirement systems.
Receipts from the sale of real property and improvements thereon, excludes the disposition of commodities, equipment, and other personal property and from the sale of securities.
Special assessments, imposed on property, differ from taxes in that they relate to specific benefits, need not be uniform throughout the jurisdiction, and generally allow no exemptions.
Intergovernmental Revenues
Intergovernmental revenues may be derived from either the federal or the state government and may be given in the form of grants-in-aid, shared taxes, or revenue sharing.
The function of grants-in-aid is:
(1) to give disadvantaged municipalities revenues to increase their capability for providing needed services; and
(2) to provide grants to expand particular functions or for specific purposes whereby the receiving government is required to meet a set of minimum standards.
Direct federal aid to local governments began in the 1930's with relief programs and was extended to low-income housing construction and payments in lieu of taxes.
Shared taxes allocate to localities their portion of a tax collected or imposed by a higher level of government.
The sources of shared taxes include a state sales tax (usually allocated by locus of the retail activities), a state income tax (allocated by locus of economic activities or by residence of income earners), or a state property tax.
With the ever-increasing gap between local ability to provide services and the cost of such services, states have also stepped in with grants-in-aid and shared tax programs.
Other alternatives for state aid include:
(1) State assumption of performance of services, thus obviating the need for local financing;
(2) Increased state technical assistance in areas such as investment and marketing.
Estimating Local Revenues and Expenditures
Since the end of World War II, local governments expenditures have been increasing at phenomenal rates, often outstripping the overall growth of the national economy.
The Elasticity of Local Revenues and Expenditures
Relationship between changes in local government expenditures and the Gross Domestic Product (GDP) can be examined by a useful measure elasticity. [1]
The elasticity of local spending is defined by the following ratio:
ELS = Percentage Change in Local Government Expenditures
Percentage Change in GDP
The elasticity of local revenue sources can be defined 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 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 near total dependence of local governments on the property tax stems from one inescapable fact--the lack of viable options.
Ability to accumulate capital reserves or to borrow to finance long-term capital investments is conditioned by overall financial solvency.
A community that cannot meet its short-term public demands from existing (and projected) sources of revenue will find difficulty in securing willing investors for its long-term bonds.
Current Projection Practices
Techniques for making revenue and expenditures projections, with few exceptions, have remained virtually unchanged over the past fifty years.
o Revenue and expenditure expectations for the coming year are determined by applying the observed percentage changes between the previous and current fiscal years.
o Alternatively, a trend line may be developed by fitting a series of historical data and then extrapolating these "trends" to obtain the projection.
While this approach has the advantage of simplicity, it leaves many problems unresolved.
o The population and the economy often are treated as if they will remain stable regardless of recent rates of growth.
o The rate of salary increase of public employees and changes in other major cost factors are treated as if they will remain constant.
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.
Uncertainties surrounding intergovernmental assistance give rise to the need for long-range forecasting to justify requests for such funds and to map out contingency plans.
Financial Analysis: Estimating Local Revenues
The financial analysis 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 best fits the future public service and capital expenditure needs in light of the limitations placed on the jurisdiction's fiscal capacity.
An analysis of available revenues under existing fiscal policies provides basis for determining the means by which revenues and expenditures can be brought into equilibrium.
o Probable amounts to be received from present tax rates and miscellaneous charges must be estimated after analysis of collection trends and conditions affecting the yields.
o 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.
Each source of revenue may require a different formula in order to make a reliable forecast and should be tabulated over a sufficiently long period to establish valid trend lines.
The following procedural steps are suggested as a basis for sound revenue estimates:
(1) A file should be prepared for each revenue source, containing a summary of the legal background, schedule of rates or charges, and a list of factors which influence the yield.
(2) A data sheet on each revenue source should be prepared, showing collection information by months and totals by years.
(3) 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, i.e., data on building construction activity, real estate turn-over, retail sales, employment and payrolls, and other indices of business activities.
(5) Advice should be sought of department heads administering public service for which special charges are made.
(6) Preliminary revenue projections should be prepared based on trend factors to serve as a guide to the determination of fiscal policy.
(7) Final estimates should be prepared immediately prior to the transmission of the budget document to the governing body.
Ramifications of alternative fiscal policies should be analyzed in terms of:
(1) ways by which income from existing revenue sources might be increased or decreased;
(2) availability and/or feasibility of new sources of revenue; and
(3) effect of varying borrowing policies on available resources.
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.
The following points illustrate the items that should be covered in statements of fiscal policy.
(1) 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) Role of state and federal assistance.
(4) Relationship between the capital and operating budgets.
(5) Fiscal policies with regards to current outstanding debt.
(6) 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) Types and maturities of bonds to be issued for the financing of capital improvements.
(8) Relationship between self-supporting and tax-supported public improvements and terms and conditions under which self-liquidating facilities are feasible.
Estimating Local Expenditures
Each class of expenditure should be projected accounting to various explicit assumptions regarding the supply and demand associated with a particular public service.
Three 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.
Explicit statements concerning service levels permit the testing of the impact of decisions to expand or contract particular public services in some defined period. [2]
This approach yields estimates and projections that are more independent (i.e., not influenced by past trends) and can deal with a wide range of assumptions simultaneously.
An advantage of the independent projection is that additional categories can be readily added where deemed appropriate.
Estimates of future expenditures should be built on estimates of expenditures arising from personnel and those linked to non-personnel related expenditures.
Personnel projections are related to the demographic characteristics of the population and to policy decisions as to the level and quality of services provided.
Nonpersonnel items--contractual services, materials and supplies, travel costs, utilities, equipment, and debt service charges--should be estimated using linear regression equations that express the functional relationship between nonpersonnel and personnel expenditures.
Methods of Financing Capital Improvements
"Pay-as-you-go" financing: (1) encourages local government to "live within its income;" (2) minimizes premature commitments of funds; (3) eliminates the cost of borrowed money; and (4) conserves credit for times of emergency when ample credit may be vital.
Under a reserve fund (or capital reserve) a portion of current revenue is invested each year in order to accumulate sufficient funds to initiate some project in the future.
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.
Short-term borrowing (a year or less) takes various forms--bills, certificates, or notes sold to banks or other investors; bank loans; warrants paid out in lieu of cash--and is used to smooth out irregularities between expenditure and income flows and to finance governmental operations temporarily when tax receipts fall off unexpectedly.
Intermediate borrowing (one to five years) may be used by jurisdictions operating largely on a pay-as-you-go basis when exceptional expenditures cannot be met from current revenues.
Long-term borrowing is appropriate under the following conditions: (1) the project will not require replacement for many years, such as a city hall, auditorium, major health facility, or sewage disposal plant; (2) the project can be financed by service charges to pay off bond commitments; (3) needs are urgent for public health and safety purposes or other emergencies; (4) special assessment bonds are the only feasible means of financing improvements in the absence of subdivision regulations or other controls; (5) 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--amount of debt outstanding, plans for new capital expenditures, and expectations concerning future interest rates.
Summary
An analysis must be made of various revenue sources currently available under existing fiscal policies, and in particular, those 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] James Heilbrun, Urban Economics and Public Policy (New York: St. Martin's Press, 1974), pp. 324-330.
[2] 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).