2018 Urban Forum White Papers
These briefs are abbreviated versions of the white papers authored for the 2018 UIC Urban Forum. The longer versions of the papers are available here.
UIC Urban Forum White Papers
“The contemporary fiscal situation of cities” Author: Yonghong Wu (UIC), Shu Wang (Michigan State), Michael Pagano (UIC)
Yonghong Wu (University of Illinois at Chicago)
Shu Wang (Michigan State University)
Michael A. Pagano (University of Illinois at Chicago)
The Great Recession, by any measure, had a damaging impact on the nation and its cities. Municipalities, after a decline of some 12% in general fund revenues between 2006 and 2012, have yet to experience the return of their fiscal position to pre-recessionary levels, while both the federal government and the states reached that milestone several years ago.
As a result, cities’ general funds, which typically provide financial support for general operations, including police and fire services, have not rebounded to the pre-2007 levels.
Hasn’t the long stretch of a robust national economy (the continuity of which may be in some question right now), produced an unremitting boom for city governments? Not necessarily, for a variety of reasons, which form the underpinnings of this paper.
The national economic picture is not simply reflected in the streams of revenues that go into municipal coffers. One example can be found in the less-than-stellar growth in revenues that one would expect would come from the dynamic growth of consumer sales since the end of the Great Recession.
Although retail sales surged after 2009 (the official end of the recession), the growth rate of retail sales tax collections was lower than would otherwise have been the case largely because internet sales were not collected in most cases. State and local governments received less retail sales tax revenue because of forgone internet sales than they would have had, if those sales had been made in a brick-and-mortar store.
That issue, which can be prejudicial to Main Street merchants, was addressed by the Supreme Court at the end of its 2018 session. No longer does ‘physical presence’ in a material way need to be demonstrated, now that an electronic presence of most sellers is ubiquitous. Moreover, the Court ruled that a tax on internet sales would not jeopardize interstate commerce. The seller is now required to collect and remit appropriate sales taxes. The impact on sales tax collections nationwide could be substantial and slightly more than half of the nation’s municipalities should benefit.
Property taxes, which are collected on the assessed value of land and structures, have been improving over the last few years, but the future growth in property values may not approach the pre-hyper growth era of the late 1990s. If that holds true, growth in real estate taxes will most likely be modest.
Though property and sales taxes dominate the fiscal stage in most municipalities, fortunately, there are alternative streams of cash. These include utility taxes, telecommunications taxes, water and sewer fees, building inspection fees and others. These are referred to as own-source revenues, which are the fees and charges over which a municipality has control. Surprising to many, these sources of cash have generated more revenue than the ubiquitous property tax since the early 1980s. Charges and fees now amount to approximately two of every five dollars collected by municipalities, while property taxes have generated slightly less than one-third of own-source revenues. This shift in prominence from property tax domination to charges/fees is not likely to reverse itself. Indeed, user fees and charges will probably continue to grow in stature over time.
When the States Step In
Cities operate within an institutional framework laid out by state governments. Scholarly research generally argues that revenue diversification is a tool to enhance stability. As a result, the more states restrict sources of income, the likelier it is that stability is at risk.
Take income taxes. Among the three major taxes, an incomes tax is used the least. Only five states including Pennsylvania, Ohio, Kentucky Michigan and Alabama allow general access to the income or wage tax. And even when their use is permissible, approaches vary. In Ohio and Kentucky, for example, the earnings tax is imposed on net business income and on wages earned at both the place of employment and the place of residence, meaning that it is also a commuter tax.
States can also impose limits on the level of property tax levied by local governments. The limits, also known as tax and expenditure limits (TELs), can be caps on millage rates, assessment growth, property tax levy growth, or combinations of these caps. By 2015, 29 states imposed levy limits, 32 states imposed rate limits, and 15 states impose limits on assessed value growth. Five states (Arizona, California, Colorado, Nebraska, and New Jersey) also imposed limits on local revenue and spending growth.
It is noteworthy that the impact of TELs depends on the interaction between their design and local economic condition and taxing efforts. Consider a state that sets the limit on local assessment growth at 10 percent. This limit would constrain the property tax growth for cities where assessed values of properties grow at a rate greater than 10 percent, but have no practical impact on cities where assessed values do not grow as quickly
Beyond the capacity of the states to restrain their municipalities revenue-raising options, actual state aid to cities is a critical matter. Ways in which states distribute their funds to cities vary widely. States can provide discretionary funding or help through project- or need-based grants.
Earmarking is one tool often used by states when distributing aid to cities. Local governments other than school districts are the beneficiaries of earmarked state taxes in 46 states; the taxes most commonly earmarked are motor fuel taxes (22 states) and general sales taxes (17 states). The most common expenditure for which municipalities use earmarked funds are local roads and bridges.
Since the United States Constitution does not suggest what type of authority local governments should possess nor are local governments mentioned at all, the Tenth Amendment reserves authority-giving powers to the states or to the people. When those powers go to the people, this is generally known as “home rule,” a state constitutional provision or legislative action that provides a local government with self-governance ability.
The local authority is usually granted through local charters and state statutes, both of which are initiated by the state legislature. There is a wide variation across states in terms of the policy areas over which local governments have discretion. States define home rule differently and grant local governments different degrees of autonomy for different fields, such as functional responsibilities, administrative discretion, economic development, and revenue-raising power. Even when local governments are granted home rule authority, in many states local policies are only valid when they are not contradictory to state statutes.
When the federal government steps in
Although direct federal aid has been declining in significance to local government finances, the federal government has continued subsidizing state and local governments in other indirect ways. For example, the interest income received by investors in state and local government bonds is not taxed by either federal individual or corporate income taxes. The federal tax exemption of state and local bond interest started when the federal income tax became constitutional in 1913. The exemption allows state and local governments to issue bonds at lower than market interest rates and therefore subsidizes state and local borrowing, particularly capital investments. Although the uses of tax-exempt debt by state and local governments have been restricted over the years particularly in the Tax Reform Act of 1986, this form of federal subsidy has remained and even survived the most recent reform of federal tax system under the Trump Administration.
Also dating from the first federal Income Tax Act of 1913, another indirect federal subsidy through the federal income tax system is to allow deductions for certain taxes paid to state and local governments. In itemizing deductions for federal income tax, taxpayers can include deductions for state and local property taxes, general sales and income taxes. By reducing the income which is susceptible to the federal income tax, a portion of state and local taxes is offset by a lower federal income tax liability. For example, if one federal income tax filer paid $20,000 in property and general sales taxes and her marginal federal income tax rate is 28%, she can reduce her federal income tax by $5,600.
Given the substantial variation in the percentage of filers who claim the State and Local Tax deduction (SALT) and their amounts, the impact varies across states, especially because the standard deduction increases under the new tax law. The Tax Cuts and Jobs Act of 2017 places a $10,000 cap on deduction for certain states and local taxes. The law still allows filers who choose itemized deduction to subtract state and local property tax and income tax or general sales tax from their federal taxable income within the limit. While the provision will reduce federal tax expenditures, it will affect some taxpayers because they will have to claim smaller amounts of taxes they pay to state and local governments. As a result, their federal income tax liabilities will rise and after-tax incomes for those affected will shrink. This results in fewer filers who itemize deductions. Much of the attention has concentrated on a handful of large and rich states such as California and New York.
Cities vary substantially in their revenue structure, economic condition and intergovernmental context. The impact of misaligned revenue systems, state control, and federal intrusion is and will be heterogeneous across cities in the American federal system. Therefore, caution is advised when generalizing the findings from this paper to a particular municipal government.
Still, the fact that the recovery of municipal general-fund revenues does not keep pace with the rebounding economy generally indicates a problematic alignment of a city’s economic base to its fiscal architecture, including ramifications of state and federal actions.
It may appear from this paper that it is the goal for cities to increase their revenues despite restrictions from the states, a narrow range of tax streams and so on. The reality is that, even absent these issues, elected officials are reticent to raise taxes at all; particularly when election day comes near. The underlying effort should not be to raise taxes, per se, but to make sure that revenue streams are a reasonable match for each city’s unique economy and to use whatever political power they have to persuade states to leave them as much flexibility to create a balanced tax stream as possible.
“Long-term Liabilities: Pensions, OPEBs and Infrastructure”
Martin J. Luby (University of Texas at Austin)
Gary Strong (University of Texas at Austin)
David Saustad (University of Texas at Austin)
Local governments can create short-term savings by underfunding long-term liabilities such as pensions, post-retirement health care and repair and maintenance of fixed asset and infrastructure. But such practices cannot continue indefinitely without creating serious fiscal challenges for local governments that have been a topic of considerable interest in recent years.
The underfunding of pensions has received the most attention of all local government long-term liabilities. For most local governments, pensions are structured as a defined benefit pension plan whereby local government workers defer compensation which is deposited into pension funds with contributions made by the sponsoring government. These contributions along with interest earnings from the fund are used to make pension payments to these government employees and sometimes their spouses in retirement for as long as they live. The local government has flexibility in terms of the timing and amount of its contributions. This (mis)use of this flexibility has been one of the driving factors in the underfunding of local government pensions.
Joshua Rauh, director of research and senior fellow of the Hoover Institution at Stanford University has often been cited in his estimations of local government pension liabilities. Based on 2015 data, he reports that the 40 largest cities reported total unfunded pension liabilities of $163.61 billion, while the 25 largest counties reported $51.9 billion in total unfunded pension liabilities, for a combined total of $215.51 billion.
Rauh argues, however, that local governments use overly optimistic assumed investment returns when calculating their ARC payments and further exacerbate the problem by using a discount rate for future obligations that mirrors the potentially inflated assumed investment returns.
These obligations translate into heavy burdens as a share of local government revenue. In 2015 Chicago had the highest percentage of its own revenues going to cover pension obligations at a whopping 23.1 percent, while 11 of the other 40 biggest cities had over 10 percent of their own revenues consumed by pension obligations.
Other post-employment benefits (OPEB) represent additional deferred compensation that most local governments also provide their employees. The largest such benefit is retiree health insurance which these governments subsidize for their workers in retirement. Historically, most governments have not pre-funded their OPEB liabilities like they have for pensions. Rather these governments paid for these costs on a pay-as-you go basis as an annual expense. Due to the sharp rise in health care costs and health insurance premiums, the Government Accounting Standards Board (GASB) promulgated new guidelines in 2007 (GASB 45) that required governments to account for their OPEB liabilities on an accrual basis rather cash basis. GASB 45 incentivized some researchers to estimate state and local OPEB liabilities on individual government and national aggregate bases as has been performed for pensions.
In 2013, the Pew Charitable Trusts performed an analysis of their sample of 61 key cities on their OPEB liabilities. The 61 key cities had an estimated $118.2 billion in OPEB liabilities that translated to an anemic 6 percent funded ratio. The Government Accountability Office (GAO) ran a more limited study of 39 large local governments based on 2008 data and found that their unfunded OPEB liabilities exceeded $129 billion. There was significant variability between these local governments ranging from only $15 million for a county in Arizona to a staggering $59 billion for New York City.
Infrastructure, the third category of underfunding, is not technically a long-term liability but rather refers to the condition state of a government’s physical capital assets. However, disinvestment in the nation’s infrastructure essentially represents a liability, as such investment will have to be made at some point in the future, at which point it will require more resources than if such investment was made today.
Based on an estimated $2 trillion funding gap, in which state and local governments own 90% of the physical assets and bear 75% of the costs of the assets they own, subnational governments in the United States are responsible for $1.35 trillion of the $2 trillion infrastructure deficit (i.e., $2 trillion x 90% x 75%). Assuming a 63%/37% split between local and state governments, local governments in the United States would bear $850 billion of the infrastructure deficit. Of course, there is likely much diversity in the infrastructure deficit among local governments.
Not surprisingly, the underfunding problem does not seem to have just one or two causes but is due to a multitude of factors.
Politics enters the equation when elected officials make decisions mainly to maximize the likelihood of their success at the next election. To the extent elected officials defer spending on pensions and OPEB, they can spend more money in other policy areas that curry favor with the citizenry. One of these policy areas is prominent capital projects that are instantly visible to the public through a traditional ribbon-cutting ceremony. Alternatively, skirting their pre-funding responsibility of pensions and OPEBs provide additional revenues that local governments can use to justify cutting taxes or providing rebates (e.g., increasing the homestead exemption for property owners) to its taxpayers.
There are also institutional causes of underfunding long-term liabilities, which mainly relate to restrictions on the fiscal autonomy of local governments. The increase in tax and expenditure limitations (TELs) at the state and local levels have in many cases reduced local governments’ ability to meet fiscal needs. With fewer cash reserves, local governments will find it difficult to navigate through economic recessions. Moreover, property tax limitations can reduce the amount of revenue local governments realize from their most important revenue source. State restrictions on the types and structure of other local government taxes have the same effect.
In addition to political and institutional causes, fiscal issues have contributed in a number of ways to the underfunding of local government long-term liabilities. First, the declining base of the sales tax has resulted in slower growth of sales tax revenues compared to the growth of the economy as a whole. The base has declined as a result of two changing consumption patterns. First, the US economy has increasingly become a more service based and less goods-based economy with many services not taxed at the state and local level. Second, US consumers over the last three decades have increasingly bought their goods online with such purchases often untaxed or taxed at lower rates. Both of these buying patterns have reduced the base of the sales tax which has reduced the available resources for local governments to fund long-term liabilities. The declining sales tax base has also reduced capital spending since many local governments sell bonds backed by their sales tax revenues. To the extent that the sales tax based has been narrowed, there are fewer sales tax revenues available to support such bonds which results in smaller bond sales to fund capital spending.
On the spending side of the fiscal equation, local governments, like the federal government, state governments, individuals and private sector firms, have been budgetarily challenged by escalating health care costs over the last couple decades. At the local level, these budgetary expenses have increased as a result of increased health premiums for current employees and greater health care costs associated with more expensive medical care provided by local governments as well as an increase in the population served by local government health care providers as a result of people not purchasing insurance due to rising insurance premiums.
Consequences of Underfunding
Of course, the deeper and the more prolonged a local government underfunds it long-term liabilities, the more difficult and painful it is to address at some point in the future. The state of Illinois, for example, has underfunded its pension liabilities for decades which has resulted in an annual structural budget gap that has persisted for over a decade. This budgetary deficiency has been a significant factor in the state holding the lowest credit rating of all 50 US states which speaks to the severity of the problem and the budgetary pain that will likely need to occur to rectify it.
In addition to the more direct budgetary impact, the underfunding of long-term liabilities has significant economic consequences that arrive over both the short and long-term. First, as mentioned above, delays in funding a local government’s long-term commitments will necessitate more dramatic revenue activities in the future. Depending on how acute the underfunding, this may involve significant tax and fee increases. Based on traditional economic theory, taxation creates deadweight loss which is a loss in economic efficiency in the overall economy.
Sizeable unfunded liabilities also impact the economic decisions of firms and individuals (Aubry and Crawford, 2016). For example, vendors to local governments may not provide their services or may price them higher than normal to local governments in which there is a risk of non-payment due to the budgetary pressure of unfunded pensions and OPEB liabilities. More dramatically, individuals or business may not locate or may exit jurisdictions where they believe that their tax liabilities will sharply increase in the future to deal with these unfunded liabilities
The extreme underfunding of local government long-term liabilities also may result in a shift in fiscal federalism. Local governments that need financial bailouts from its state government or changes in state law to help ameliorate their fiscal situation my find themselves in a weakened state going forward in terms of intergovernmental relations. For example, the underfunding of pension and health care liabilities as well as sizeable long-term bonded indebtedness contributed significantly to the decline in fiscal health of the city of Detroit.. This fiscal stress necessitated that city seek help from the state of Michigan in 2012. Ultimately, Michigan Governor Rick Snyder appoint Kevyn Orr emergency manager of the city to oversee all financial operations.
Subsequently, Orr recommended Detroit enter bankruptcy which had to be approved by Governor Snyder. The case of Detroit offers an extreme example of how a local government can lose policy/fiscal autonomy as a result of underfunding its long-term liabilities.
One possible institutional change that may reduce the likelihood of local governments underfunding their long-term liabilities is to increase the stringency of balanced budget requirements and/or tax and expenditure limitations. Such increase in stringency would include a statutory or even constitutional requirements that unfunded liabilities are reduced or funded at certain levels year over year in the context of the local government’s annual budget process. Under such regime, local governments would be statutorily forced to deal with their long-term liability funding issues rather than providing these governments flexibility to address this fiscal area. Many local governments already have such statutory requirements so changes would really be related to enhancing existing requirements. The 2017 state legislation that increased the City of Chicago’s funding ramp of its municipal pension fund is an example of this approach (Shields, 2018a). Of course, all of the fiscal problems associated with TELs/balanced budget requirements previously discussed would be present under such a regime. In addition, such increase in budget stringency will necessitate a reduction in the flexibility for governments to allocate their
The causes of underfunding are myriad and the consequences vary based on the previous fiscal policy choices made by local governments. While there is no shortage of changes that local governments can implement to mitigate such underfunding in the future, there are also no “silver bullets”, changes may not be politically palatable and some options have been shown to offer mixed results in the past as used by other governments. Furthermore, some of these changes may come at a cost that local governments may not be willing to bear in terms of changing the balance of power between the state and local government. Nevertheless, many local governments need to consider changes in the way they makes decisions related to the funding of their long-term liabilities as such policy decisions in the past have resulted in serious fiscal pain that these governments continue to grapple with.
"When Public Pension Reforms Fail, What Then?
James E. Spiotto (Chapman Strategic Advisors, LLC)
The problem of underfunded public pensions confronts a number of local governments and states in the U.S.. Many face large unfunded liabilities, the payment of which strains their ability to provide basic services including sanitation, water, streets, health and so on. Past failures to set aside sufficient money to meet pension benefit obligations are central to many governments’ pension woes.
It is widely accepted today that public pensions are effectively contracts, with the legal protections that the law provides for them. As a result, solving the public sector pension problem can’t be easily accomplished.
Raising taxes would seem to be the most expedient way to better fund pensions. But hiking taxes faces political and economic challenges and raises fears of business and individual taxpayer flight, which results in loss of revenues. Similarly, cutting services does not tend to garner votes come election day. The only remaining option is to enact meaningful reform to pension plans.
Since 2009, there have been over twenty-six major state court decisions dealing with pension reforms by state and local governments. Over seventy-five percent (20 out of 26) of those decisions affirmed the reform, which frequently reduced benefits including cost of living adjustments, increased employee contributions, and plan conversions from defined benefit to defined contribution.
However, the ability of state legislation modifying pension obligations to withstand legal challenges is by no means assured. This is particularly true in states that have constitutional provisions that prohibit the government from reducing pension benefits
A number of authorities have set forth the possibility of municipalities and states turning to protection under Chapter 9 bankruptcy laws, which could allow them to re-write their pension contracts. But while this is far easier considered than accomplished there are routes to that end.
Courts hearing Chapter 9, municipal debt adjustment cases, have unanimously ruled that labor and pension contract obligations can be changed where impairing pension benefits is necessary to save the municipality’s financial and operational future
The examples of Bridgeport, Connecticut, Detroit and other financially distressed governments have demonstrated that if the government raises taxes and reduces services to pay for unaffordable and unsustainable costs, the result will be that individual and corporate taxpayers will leave and less revenues actually will be collected to the detriment of all.
Even so, since 2013 and the Detroit Chapter 9 filing, no city, town, village or county has filed for Chapter 9 relief (except Hillview, Kentucky). Some of the reasons for this are the perceived stigma of Chapter 9, its cost and expense, and the uncertainty of the process and its results. The expense of Chapter 9 is a problem as demonstrated by the fact that the professional fees incurred in Chapter 9 for Detroit were over $170 million.
Still, if state constitutional and statutory provisions are obstacles to any needed pension reform efforts, the answer should not and cannot be that the government reduces funding for essential governmental service. When services decline to unacceptable levels, the government declines financially and corporate and individual taxpayers leave. As horrific and unacceptable that result, it is the probable reality states and local governments face if needed pension reform is not capable of being implemented. This is not the case of unwillingness to pay, which never is an acceptable excuse for not funding public pension obligations. Rather, this is the financial and practical inability to pay and still provide the services that are mandated by the vital mission of government.
Some approaches that could help ease the arduous road to Chapter 9 include:
- Creation of a Special Bankruptcy Court for Insolvent Public Pension Funds. The government employer and pension fund, with the help of such a specialized court designed to balance the best interest of the workers and retirees, and the best interest of taxpayers, citizens and local business interests, should help expedite and rationalize the process.
- Establishment of Model Guidelines for a Constitutional Amendment or Legislative Public Pension Funding Policy Where State Constitutional and Statutory Provisions and Court Rulings Appear to Prohibit or Impair Needed Pension Reform
- Formation of Proposed Model Guidelines for Pension Protection Provisions in State Constitution or Statute
Any legislative action for reduction or modification of pension benefits should provide that there is determination of a governmental emergency caused by the cost of pension benefits. Examples might include instances in which the absence of necessary infrastructure improvements adversely affect the health, safety and welfare of the government’s citizens. Similarly, claims of a governmental emergency can exist when funding for governmental services at an acceptable level is insufficient and the ability to raise taxes is practically or legally impossible.
Waiting until infrastructure collapses or a significant percentage of taxpayers and businesses have exited is too late and the threat of a death spiral too great. Further, the legislative body should in good faith determine that there is no further reduction of expenses or services that can be justified without impairing the health, safety and welfare of its citizens.
The goal will be to pay as much as can be paid on pension obligations while assuring full funding of essential governmental services at an acceptable level. Again, the purpose of the new special bankruptcy court is to provide a fair and just resolution of the pension fund insolvency with an objective independent determination of: (a) what is sustainable and affordable, (b) whether there should be an increase in contributions or taxes or both, if necessary, and (c) what is the best method of adjusting pension obligations to a level that is feasible and affordable for the benefit of all.
If, for any reason, Chapter 9 remains an undesirable alternative, governmental entities can also consider a constitutional amendment or statutory public pension funding policy. These can follow the Model Guidelines and U.S. Supreme Court precedent for modification or adjustment of contractual rights for a higher public purpose to protect the health, safety and welfare of citizens.
The public pension obligation could then be paid to the fullest extent possible without crowding out full funding for needed essential services and infrastructure. Also, the actuarially determined contribution for the annual pension fund payment would be calculated and mandated to be paid each year. That would assure public workers and retirees that government employers will not repeat past underfunding practices and will make adequate contributions in the future.
Chapter 9 and its alternatives are conceptual proposals to be further refined and developed through the constructive dialogue of interested parties. While voluntary resolution of unfunded pension problems is the preferred and most appropriate approach, when all else fails, these methods provide a realistic and practical way of resolving pension underfunding and preventing a government service and financial meltdown.
The answer should never be that the needed public pension reforms have failed or appear impossible to such a degree that the government itself fails and all parties suffer the worst outcome possible.
Rebecca Hendrick (UIC)
How should governments pay for the goods and services they provide? They have a number of options, of course, but ability-to-pay and benefits-based methods of financing are a critical and expanding means for balancing budgets. A strict benefit-based financing method levies charges or taxes based on the benefits received by citizens. This method also provides public goods and services only to the citizens who pay for them and at the level citizens are willing to pay for.
From a normative perspective, benefit-based financing yields more efficient outcomes in terms of citizens receiving the level and bundle of public good and services that they desire (allocational efficiency). Ability to pay financing, such as progressive income taxes, results in a more equitable distribution of the burden of paying for public goods and services according to the criteria of non-regressive taxation.
Some experts place property taxes in the category of benefit-based taxes. But a number of others disagree because it is a general tax that is used to fund many public goods and services for which it is hard to assign unique benefits. By comparison, government user charges, which are considered to be the method of financing that is closest to the ideal of benefit-based financing, provide financing for one service or good only to those who pay for it.
Local governments have reduced their reliance on property taxes greatly since the mid-20th Century and have increased their reliance on charges and other funding sources. Some speculate that the severe recessions of 2001 and 2008 exacerbated these trends and portend the continuation and even intensification of the trend toward benefit-based financing into the future.
Theoretically, benefits-based financing allows governments to provide goods and services more efficiently and in a manner that better satisfies citizens’ demands compared to a system in which the government or political process determines the level and quality of benefits that citizens should have according to some vague and ill-defined notion of ‘public utility.’ Similar to a market system in the private sector, direct benefit financing provides government with signals about citizens’ willingness to pay, which allows public goods and services to be valued or priced at the marginal cost of their production. Acting on this information, government can allocate scarce public resources to their most highly valued uses according to the relative amounts that people, in the aggregate, are prepared to pay.
Additionally, citizens become more knowledgeable about how much government costs them when the charges or taxes they pay are linked directly to specific benefits. As a result, some types of benefit-based financing can be viewed as a fair method of distributing public goods and services because citizens pay only for the benefits they desire.
Although benefit-based financing seems to be a desirable on several dimensions, these methods are not appropriate or workable for all government goods and services. For example, the government cannot exclude people from benefiting that do not pay for the benefits of non-excludable goods and services that are shared among all citizens
Citizens have no incentive to pay for a good or service voluntarily if they receive the benefits of the good or service without paying. In this case, unlike pure private goods, the government cannot rely on citizens’ willingness to pay to provide signals about their preferences for or the benefits they receive from public goods and services.
Examples of pure or almost pure public goods at the local level are public health services to fight contagious diseases, services to handle harmful natural events, such as weather warning systems and stormwater management, and police services.
Although many local public services such as education and roads provide significant unique benefits to citizens that consume them, and are somewhat exhaustive, the goods have significant positive spillovers to citizens that do not use the service. A well- educated population provides well-educated workers to the private sector, and good roads stimulate jobs and economic development. Such spillovers of benefits make it hard to determine and assign charges or levy taxes in a manner that reflects the unique preferences of citizens for these goods and service and the benefits they receive.
Types of Benefit-Based Financing
The most common ways to bring in revenues for explicit services are charges or fees for services such as water, sewer, and garbage collection. User fees, also called license taxes, are often distinguished from user charges when applied to goods and services that are truly voluntary, but where government is the monopoly provider, such as building inspection fees.
Other government services for which charges are appropriate, such as higher education, are partially financed with general taxes that are levied based on the ability to pay principle. These services are often distributed, in part, according to merit or need because citizens value this outcome over one produced entirely by user charges.
Special assessments are the broadest example of benefit taxes that are not user fees.
They are a method of funding improvements to properties and sometimes services that benefit only property owners within a designated area, called a special assessment district (SAD), rather than all property owners or citizens within the jurisdiction. These districts have different names, including community facilities districts
The Case for and against More Benefit-Based Financing in the Future
Research on local government finance has identified three reasons for governments’ migration away from property tax and greater reliance on charges and other funding sources since the mid mid-20th Century. First is the public’s dislike of the property tax and the visibility of their property tax burden. The public’s dislike of property taxes is evident from the nation-wide imposition of local tax and expenditure limitations (TELs) by states beginning with Proposition 13 in California in 1978, This trend is the second explanation for why local governments have migrated away from the property tax.
Fiscal stress is the third reason given for governments migrating away from property taxes and towards direct-benefit financing as a means of recovering the costs of more services that are appropriate for such methods. As recessions, declining state aid, and pension obligations threaten local governments’ ability to fund services at current levels, they seek to tap more sources of revenue than in the past.
Ultimately, all three conditions for applying benefit-based financing are about information gathering and the degree to which the beneficiaries of the public good or service can be identified, and their benefits precisely measured. Underlying all conditions is an expectation that government has the capacity to collect and process this information and can allocate costs correctly among those who pay. Trends in the Revenue Structure of Local Governments
The Application of Benefit Based Financing in Practice
There is much written about how governments should design user charges. Textbooks and reports from public economics and financial management describe pricing principles and basic user charge and fee designs for government services generally. Publications from professional associations and commissions in specific services areas such as water, transit, libraries, and tollways apply these principles and elaborate on these designs in their service areas.
Two basic pricing designs are recognized by this work. In marginal-cost pricing, charges are based on the cost of providing an additional unit of service. In markets where the service provided by governments is competitive, charges will be equal to marginal costs and resource will be allocated optimally. Marginal-cost pricing can be short-term, which recognizes only the variable costs in providing the service, or long term, which includes both fixed and variable costs. This method can also be structured to recognize different marginal costs for different service attributes, such as type of user or level of service output.
The second basic user charge design is average-cost pricing in which all costs or a portion of the costs of providing the service- fixed, variable, operational, and capital- are averaged among all users. Marginal-cost pricing does not work under many conditions for government services, and average-cost pricing is often useful in these cases.
Although technology and techniques for establishing more efficient charges are available, it is not clear whether governments have improved the design of user charges and collection of information to produce accurate pricing of their enterprises. Indeed, there appear to be many governments in which budgetary needs in non-enterprise areas drive charges in enterprise areas higher or where political preference drives enterprise charges lower than what is needed to fully fund operations and capital investment.
With respect to the other service areas that provide exclusive benefits to users- transit, solid waste, airports, water ports, highways, libraries, fire, and parks and recreation- all have characteristics that make charges an undesirable method of financing these services. Solid waste, for instance, has significant positive spillovers in terms of improving the cleanliness of neighborhoods and reducing disease and vermin. The reported figures show that charges for solid waste have increased since 1997 and constituted 86 percent of operational spending in 2012. Thus, there is not much room for increasing charges for this service further and doing so may reduce the public benefit by encouraging unapproved disposal of solid waste.
Although recent trends show an increase in charges or user fees for non-enterprise public services, it is not a panacea. As noted, this method is inappropriate for pure public goods and does not produce efficient outcomes when used alone to finance goods and services that have distinct individual benefits but also provide significant public value. The key for municipalities is to carefully analyze its fiscal structure in order to determine the best means for financing its work. Benefit-based financing is one important tool, but it’s far from the only one.
Jered B. Carr (UIC)
Michael D. Siciliano (UIC)
Political authority in America’s major metropolitan areas is highly fragmented, often divided among dozens of cities, counties, and special districts. Local government scholars initially attacked political fragmentation as increasing the costs of government; later generations lamented its encouragement of intergovernmental competition for infrastructure and economic development; and more recently, it has been blamed for facilitating economic and racial segregation. Additionally, business and civic organizations commonly express concern about the large number of distinct governments in their states.
In a time when an abundance of governmental entities is increasingly seen by the public as unaffordable, officials in several states have launched efforts to encourage mass consolidations. Given the significant challenges, both political and legal, to addressing the consequences of fragmentation through elimination of local governments, this paper examines an alternative approach, intergovernmental collaboration, to address the challenges political fragmentation poses.
Four critical issues related to intergovernmental collaboration are examined. First, what is the rationale for using networks as a tool for addressing public problems instead of traditional structures? Second, what factors influence the selection and establishment of network partners? Third, how are formal and informal mechanisms used to reduce the risks associated with collaborating within networks? And finally, what strategies are used to measure and promote success in the networks?
Factors Driving the Creation of Local Government Networks to Address Public Problems
Intergovernmental networks enable municipal officials to work together across political boundaries, achieving the scale necessary to develop solutions to the problems affecting their residents. Empirical research has found that minimal geographic distance between governments, and low transaction costs can ease the route to collaboration. Many intergovernmental agreements are formed through the independent actions of local governments, but these networks may also be mandated or incentivized by higher authorities.
Federal and state legislation often encourages intergovernmental collaboration around specific problems, such as transportation, environmental, and public health challenges. For example, the US Department of Housing and Urban Development requires the use of a continuum of care model to access funds through the McKinney-Vento Homeless Assistance Act Supportive Housing Program. The continuum of care model requires communities to demonstrate they have a collaborative network in place involving a number of homeless-serving agencies that provide services ranging from emergency care to permanent housing.
Bases for Partner Selection in Collaborative Networks
Local governments that use networks to deliver public services confront collaboration risks and partner selection may help to mitigate these risks. The empirical literature suggests the structure of the overall network has implications for the level of transaction costs and risk in the relationship. One way local government officials may reduce the risks involved in collaborative agreements is to partner with similar local governing units, a process known as “homophily.” Similarity aids in the establishment of trust, reducing the risk of opportunism, lowering monitoring and enforcement costs, and reducing the time required to negotiate agreements. The two types of configurations that have received the most attention in the literature are those associated with “bonding” and “bridging.” Bonding structures are dense and characterized by numerous ties connecting participants with each other, increasing the chances of fulfilling the promise of the network.
Bridging structures, on the other hand, have few ties, resulting in many participants that are not directly connected to one another. This results in less oversight of individual partner’s actions.
Local governments can also reduce risks to service through “multiplex” service production arrangements. These occur when local governments engage with multiple other units simultaneously. Multiple service contracts that link more than one service can reduce credible commitment problems and minimize the potential for defection.
Collaboration Risk and Institutional Mechanisms
The empirical literature has identified three general sources of collaboration risk confronting public officials seeking to create intergovernmental arrangements:
Risks due to Coordination Costs: This involves the challenges in persuading local governments to collaborate.
Risks due to Division Costs: These issues crop up when local governments agree on the general goals for the collaboration, but encounter difficulty in dividing and distributing the expected benefits among the group.
Risks Due to Defection Costs: Defection problems emerge when one party does not comply with the agreement. Without a credible commitment, one or more of the negotiating parties has an incentive to defect and free ride on the efforts of others.
Local governments utilize a range institutional mechanisms to support intergovernmental collaborations, including informal networks, councils of governments, service contracts, regional authorities, and managed networks. These arrangements vary substantially in terms of the extent to which decision-making is integrated by the collaboration.
Measuring Success in Networks
Evaluating performance at the network level focuses either on the participatory processes that characterize the network or the direct outputs and outcomes of those processes. Evidence of the effectiveness of networks is surprisingly scarce. One reason for this is that evaluating performance in the public sector, even for a single bureaucracy, is a challenge.
The inherent challenges of measuring performance in the public sector become even more pronounced when working within networks. One major impediment here is that networks are multi-organizational collaborations where each actor represents its own constituency and stakeholders and individual players in network arrangements often produce just a portion of the overall service or program. This leads to differing perceptions on appropriate performance metrics.
The current empirical literature on networks may best be characterized by its ambiguity. Much of what we know about networks and their potential for success remains uncertain. The mixed empirical findings may be a result of the different risks perceived by local government officials as they enter into collaborative relationships and the different goals these actors may seek. More research is needed to help practitioners identify and measure the costs and benefits associated with a given collaboration and the appropriate institutions to best manage risk in hopes of producing positive outcomes for their citizens.