State and Local Government Chapters

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After reading this chapter, students should be able to understand:

1. The interdependence and diversity of the various levels of American government in matters of


2. The criteria for evaluating the various means of levying taxes.

3. The available types of state and local taxes and their advantages and disadvantages.

4. The effects that constitutional and statutorial limits in the states have on indebtedness.

5. The importance of revenue projections, the uses of rainy day funds, and the part politics and other

state and local financial management practices may play in fiscal planning.

6. The means available to nonnational governments for managing long-term debt obligations.

7. The changing financial relationship between local government and the national and state

governments in the new century.


The fiscal landscape in state and local jurisdictions has profoundly changed in the last few decades.

More change is certain as nonnational governments strive to meet taxpayer service demands

economically and creatively.

Historically, state and local governments depended on property taxes for their revenues. But today

citizens’ demands for an increased scope and level of services has led to tax systems that are more

diversified and equitable. The basic principles that describe evolving nonnational financial systems are

interdependence and diversity. Most of the money raised by state and local governments is own-source

revenue, but they also benefit from intergovernmental transfers. Federal grants, though declining from

previous years, still account for about 24 percent of all state and local government revenues. As federal

aid has declined, states have become the “senior financial partner” as they increased their monetary

support of localities, particularly for schools and social welfare.

The second basic principle of nonnational finance systems is diversity, and although each level of

government still depends more heavily on one type of revenue device than on others, state and local

fiscal systems are increasingly diversified. States vary in their “tax capacity,” but that does not mean all

states will maximize their tax-collecting possibilities. Between 1950 and 1985 spending by state and

local governments increased by 2,000 percent. Where that money is spent varies greatly from one

jurisdiction to the next, but in recent years large expenditures are being made for corrections and

Medicaid program costs.

State and local finance systems differ, but property tax is increasingly unpopular and diversification is a

common response. Political scientists and economists agree that the most important criteria for

evaluating these different tax options are equity, yield, elasticity, ease of administration, and political

accountability and acceptability. Today the major state and local taxes are the property, sales, and

income tax. User fees and “sin taxes” continue to be popular in the states and two old devices—

Chapter 12: Taxing and Spending 57

Copyright © Houghton Mifflin Company. All rights reserved.

severance taxes and gambling in the form of lotteries, casinos, or pari-mutuel betting on horses or

dogs—have regained favor in the last two decades.

National and regional economic downturns create conditions for severe fiscal stress. Older industrial

cities are particularly vulnerable. Concentrations of poor and minorities in deteriorating housing and

declining infrastructure pose problems that may not be solved without federal assistance. Meanwhile,

citizens ask for more services and government officials in the stressed areas face the realization that

jobs, firms, and investments are being “stolen” by low-tax states. Mismanagement of resources and

pressures from city workers and their unions drive up costs as intergovernmental revenues decline. The

circumstances are a well-tested recipe for fiscal stress, bond defaults, and even bankruptcy. To survive,

elected officials have had to decide which popular programs to keep and which taxes to raise. They

have been aided by an economic upturn since the early 1990s, which has produced increasing revenues

and some relief as state and local governments have been forced to be more creative and innovative.

Taxation and expenditure limitations reduce the discretion of nonnational governments. High-tax states

are in danger of losing jobs, firms, and investments to low-tax states. Earmarking taxes for popular

programs often ties the hands of officials to shift monies to other areas. Approximately 25 percent of

state tax revenues are earmarked. That percentage has decreased in the last thirty-five years, but the

number of dedicated purposes has grown markedly. The federal government has the most discretion.

States have less since they must meet federal mandates, and local governments must comply with an

increasing number of state mandates while their legal authority to raise revenues is severely curtailed in

most states. Because nonnational governments must balance their operating budgets, reliable revenue

estimates are doubly important. Only recently have the states and larger cities begun to employ more

reliable econometric models to derive estimates of future revenues. The quality of the data and the

validity of the economic assumptions may still color outcomes. Even so, politicians may intrude to

overestimate revenues as they seek support for a popular new program, or underestimate revenues so

that year-end budget surpluses can be chalked up to “good management.” Contingency funds become

necessary for states and localities faced with statutory or constitutional requirements for a balanced

budget. These “rainy day funds” are common at the state level and are more frequently used in local

government. State and local governments are becoming better, however, at managing cash and

investments. Investment management is found in such programs as the bond bank, whereby the state

government gathers bonds from the local jurisdictions and issues the total debt in a single state bond.

This lowers borrowing costs and saves expenses in marketing the bonds to investors. The most

important state and local investments are usually in the area of employee pension funds, which in

financially suffering governments are tempting sources of funds.

Increasingly, local governments are fixing their sights on the states rather than the national government

as a source of financial aid. The ability of local governments to raise money has traditionally been

highly restricted by state law, and through the 1960s and 1970s localities usually “bypassed” the states

and turned to the national government for financial assistance. But states’ insensitivity to the plight of

local government began changing in the 1970s, largely because reapportionment gave urban interests

increased standing in state legislatures. With the tax revolts of the late 1970s like Proposition 13 in

California, and the national-level retrenchment that followed, the states have become the single largest

source of local revenues. But like the federal grants-in-aid programs, state help comes with strings

attached. Some states allow more local freedom than others, but in states where local jurisdictions are

hampered in their ability to raise and spend revenues, the trend has been toward even greater


In the past, the federal and state governments could be counted upon to come to the rescue of local

governments in fiscal trouble. Today, the keys to surviving a financial crisis are intergovernmental

cooperation, burden sharing, capacity building, and citizen comprehension of the basic tax-service

relationship. The call for reinventing and reinvigorating state and local governments is being heard.

State and local governments remain laboratories of democracy, and hard times call for hard actions. All things considered, nonnational governments have been more fiscally responsible than the federal

government has been in modern times.
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