Passing the buck.

In an all-too-common nightmare, legislators have to wrestle with a state budget that is out of control. The escalating bills for Medicaid, new prisons and schools eat up all the growth in tax revenue, leaving nothing for other programs. What to do?

Often, part of the solution is to pass the buck to local governments--let them share the pain of cutting budgets and raising taxes. Nationally syndicated columnist Neal Peirce has dubbed this phenomenon "shift-and-shaft federalism" (an expression he says was invented by San Jose Mayor Janet Hayes in the 1970s).

Actually, although it has not been widely noted, local taxes have been rising faster than state taxes for a long time. Even in the 1980s when state finances were healthy, local taxes were rising faster. In fact, in all but two of the 11 fiscal years from 1981 to 1991, local taxes went up faster than state taxes. The only exceptions were fiscal years 1984 and 1985, when state revenues were boosted by tax increases enacted in response to the severe recession of 1981-1982.

This trend is a reversal of that in the 1970s. From 1972 to 1980, state taxes rose faster in every year but one. Whether one calls it buck passing or problem sharing, this trend likely will not merely continue but actually accelerate in the 1990s. Consider these developments within the past two years:

* Arkansas has loosened restrictions on local sales taxes.

* California has taken property tax revenue away from cities and counties and given it to school districts, while inviting those cities and counties to raise their own taxes.

* Maryland allowed counties to raise their income taxes from 50 percent to 60 percent of state tax liability.

* Minnesota allowed counties to enact sales taxes for the first time in 1991.

* New York has slashed revenue sharing and other aid by hundreds of millions of dollars. In response, many counties have boosted their sales taxes, and all kinds of local governments have raised property taxes.

Minnesota is an interesting case because it has used a variety of approaches to shift tax burdens from the state to the local level. The half-cent county sales tax in 1991 was "optional" in only a technical sense: Any county refusing to adopt it would have lost all of its state aid. This year the Legislature dropped the charade and officially converted the half-cent tax to a state tax. Minnesota also acted to shift burdens to localities downward by imposing the state sales tax on purchases by local governments; and it shifted the cost of the state property tax circuitbreaker for homeowners to the fund from which local revenue sharing aid is distributed, thereby reducing the amount of aid.

Altogether, at least 15 states cut aid to cities and counties in 1991 sessions, although only five of the cutbacks were large--in Illinois, Maine, Maryland, Massachusetts and New York.

Why have local taxes been increasing faster than state taxes since 1981? No one has fully answered this question, but changes in federal and state aid are at least partially responsible.

Local governments have been hurt much more than states by cutbacks in federal aid. In inflation adjusted dollars, between 1980 and 1990, per capital federal aid was cut 55 percent to localities and "only" 14.5 percent to states. (These figures exclude aid for Medicaid and welfare programs, which increased so much that they make it appear as if federal aid to states actually increased. Because the growth of Medicaid assistance was matched by a growth of state spending for Medicaid, it was not really helpful to states.)

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State aid to localities has increased substantially, but it lagged behind the growth of state and local spending. Between 1980 and 1990, inflation-adjusted state aid per capita rose 17.5 percent while local spending per capita increased 24 percent and state spending rose 23.5 percent. These figures imply that so many state resources were committed to pressing needs like Medicaid and prisons that aid to localities was a relatively low priority.

Some other reasons are more speculative. It may be that federal mandates had a bigger impact on local than on state costs. Another hypothesis is that political resistance to local tax increases is not as great as it is to state tax increases because voters feel that they receive more for their tax dollars from local governments. Michael Rosenstein, director of the House Republican Appropriation staff in Pennsylvania adds another point: In Pennsylvania the state has been able to control its spending much better than local governments have.

John Shannon, a senior fellow at the Urban Institute, summarizes the situation this way: "There's an iron law: When the easy money disappears, our federal system starts pushing things down, down, down. First Reagan did it to the states and local governments, and now the states are doing it to local governments."

The shift from state to local taxation should not be blown out of proportion. In 1990, states still collected more than $3 out of every $5 of combined state-local tax revenue. Their share was down from 61.6 percent in 1980 to 60.2 percent in 1990. Although local taxes rose faster than state taxes in 27 states, state taxes were ahead in the other 23 states.

The high growth rate of local taxes in the past decade is surprising because it implies substantial increases in the least popular of all major taxes, the property tax. In 1990, the property tax still accounted for nearly three-quarters of all the taxes collected by local governments. Between 1982 and 1990, property tax revenue jumped from $3.27 to $3.57 per $100 of personal income.

Is the increased reliance on local taxes necessarily bad? Local officials complain loudly about it. Some academics back them up. For example, commenting on the policies in his state, University of Minnesota professor Paul Light says, "It is just a way of insulating the state legislature and governor from taking a political hit for raising taxes."

But there is another way of looking at the trend of rising local taxes. In some cases, it is not just an ad hoc copout. Implemented correctly, it may actually represent a rational response to the fiscal predicament of state and local governments in the harsh environment of the 1990s. Budget pressures are likely to be so unrelenting that states will have to reconsider many of their old policies.

There are at least three ways that increased reliance on local governments to raise more of their own money can have salutary effects: It increases their incentive to become more efficient; it enhances accountability; and it may make the tax system more balanced.

Efficiency

Walter Broadnax, director of the Center for Governmental Research in Rochester, N.Y., says that it is vital for New York to "keep up the pressure" on local governments in that state. Only when their backs are to the wall, he says, will local officials seriously consider difficult political actions like consolidating small units of government and attacking expensive sacred cows.

Accountability

"When the pleasure of spending money is divorced from the pain of raising it, funds may not be used as carefully as they are when spending and taxing are done together," observes Robert Ebel, a leading consultant to states on their fiscal policies. This is a problem in states that provide a large amount of unrestricted aid to cities and counties (as some do, but most do not) and in states that have generous tax credits that help reduce property tax bills.

Balanced Tax System

States vary widely in their reliance on local as opposed to state taxes. At one extreme are 12 states where the state collects at least 70 percent of combined state-local tax revenue. On the other hand, state taxes account for less than half the total in four states (Colorado, New Hampshire, New York and South Dakota).

Where the state raises a particularly large share of tax collections, the rate of the state sales or income tax tends to be unusually high, and the property tax rate generally low. By increasing reliance on the property tax, such states can have a more balanced tax system and can minimize increases in already-high state taxes. Among states where this occurred in the 1980s are Mississippi, North Carolina and South Carolina.

Although increasing local taxes can help the intergovernmental system to work better, it may also cause some serious problems. According to Robert Tannenwald, an expert at the Boston Federal Reserve Bank, "Each level of government understandably thinks about its own fiscal predicament. But distributional consequences are usually not fully taken into account. It's one thing for a city or suburb with a large tax base to take on more responsibility. What can a town that already has a high tax rate and a small tax base do?"

Besides, he notes, local sales and property taxes are usually regressive. Because most states rely on the income tax to raise a significant share of their tax revenue, their tax systems are usually not as regressive as local tax systems.

John Shannon sums up common thinking this way: "Increasing local responsibilities is good for accountability and efficiency. To heck with equity!" But, he emphasizes, "States can minimize equity damage with well-designed policies." Shannon was an official with the U.S. Advisory Commission on Intergovernmental Relations (ACIR) when it promulgated a long list of recommendations that could "take the rough edges" off a policy of increased reliance on local taxes. Important elements may include:

* Targeting financial aid to poor communities with heavy needs for public services.

* Designing limits on local sales and income taxes to ensure that tax rates do not vary too much between neighboring communities and that the rates do not make it too difficult for businesses to comply (for example, by requiring that localities use the same tax base as the state government).

* Imposing local taxes countywide, with revenue shared among local governments to ensure that tax enclaves do not reap huge gains (for example, from a regional shopping center).

* Providing state-funded tax credits to protect low-income citizens from the regressivity of local taxes.

Maryland provides an example of several of these points. Its local income taxes are countywide, and the tax rates are fairly similar throughout the state. When it authorized higher local taxes this year, it provided a safety net to guarantee that no county would receive less than 70 percent of the average statewide revenue per capita. This still places poor counties at a disadvantage, but it is better than having no floor under their revenue at all.

In 1986, NCSL's Task Force on State-Local Relations endorsed ACIR's suggestions and went further, calling for states to reconsider how responsibilities are sorted out between state and local governments. Some functions might be assumed by the state and others turned back to local governments. Aid programs also ought to be reviewed. Two examples:

* Corrections is one of the fastest growing parts of local budgets. Is it logical or merely expedient for states to require counties and cities to bear such a large burden for a program over which they have little control?

* Many states spend large amounts of revenue on property tax credits enacted in the 1970s (for example, to compensate for the repeal of property taxes on inventories). The benefits of those credits are often distributed with little if any relationship to local needs or fiscal capacities. Are there higher priorities for these funds?

Senator Stanley Aronoff, president of the Ohio Senate and chair of the NCSL task force that developed the recommendations for reforming state-local relations, urges states to use these recommendations as they wrestle with policies affecting local governments. "The task force was ahead of its time, but its recommendations can help states to chart a wise course through the 1990s."

One task force recommendation could be particularly helpful in avoiding local tax increases. It calls upon states to review the mandates they impose on local governments, regulations that force them to provide services or incur expenses that local citizens may not want to pay for. Many mandates embody important state policies that shouldn't be changed, like laws for open public meetings, but others may have outlived their usefulness or were inappropriate in the first place.

The phenomenon of rising local taxes defies universal generalization.

* Policies appropriate in states where local taxes are already high (like New Hampshire) do not fit states like Louisiana, where property taxes are very low.

* Issues that need to be confronted in states that have big aid programs or tax credits are not on the agenda in other states.

* Higher local taxes may help to enhance accountability and efficiency, but they may also cause inequities. Which effect predominates depends in part on policies laid out by the state government.

One of the most popular buzzwords of the day is "fend-for-yourself federalism." John Shannon originally coined it with reference to federal policies toward states and localities. Now, he notes, it applies as well to how states are treating cities and counties. If states carefully adapt to this new era, the result could be a stronger, more efficient federal system. If they just let change happen willy nilly, it could be ugly.

State Government Share of State-Local Revenue FY 1980 and FY 1990

(Percentage of Total)

State             1980   1990   Change
New England       55.3   61.4     6.1
 Connecticut      55.3   59.9     4.6
 Maine            64.1   64.4     0.3
 Massachusetts    55.1   66.0    11.0
 New Hampshire    39.3   31.7    -7.5
 Rhode Island     58.6   60.4     1.8
 Vermont          57.9   58.8     0.8
Mid Atlantic      53.4   53.1    -0.3
 Delaware         81.9   82.5     0.6
 Maryland         59.3   58.5    -0.8
 New Jersey       50.9   53.4     2.5
 New York         48.5   48.7     0.2
 Pennsylvania     62.4   59.9    -2.5
Great Lakes       59.4   58.8    -0.6
 Illinois         57.2   53.6    -3.5
 Indiana          66.0   67.5     1.4
 Michigan         59.7   59.0    -0.7
 Ohio             54.5   58.2     3.7
 Wisconsin        67.4   64.1    -3.3
Plains            61.3   62.5     1.2
 Iowa             62.0   63.4     1.4
 Kansas           58.0   58.3     0.3
 Minnesota        69.8   67.7    -2.2
 Missouri         56.1   62.2     6.1
 Nebraska         54.0   53.2    -0.8
 North Dakota     67.3   67.5     0.3
 South Dakota     49.7   49.7    -0.1
Southeast         69.1   64.7    -4.3
 Alabama          73.4   71.2    -2.3
 Arkansas         77.6   75.5    -2.1
 Florida          65.1   58.8    -6.3
 Georgia          64.9   60.7    -4.2
 Kentucky         79.2   77.3    -1.9
 Louisiana        67.8   62.0    -5.8
 Mississippi      77.2   73.7    -3.5
 North Carolina   73.2   70.8    -2.3
 South Carolina   76.0   72.2    -3.7
 Tennessee        62.6   62.2    -0.4
 Virginia         60.0   56.3    -3.7
 West Virginia    78.6   79.6     1.0
Southwest         62.4   57.5    -5.0
 Arizona          61.5   62.2     0.7
 New Mexico       81.0   78.7    -2.4
 Oklahoma         71.0   70.2    -0.8
 Texas            58.9   52.1    -6.8
Rocky Mountain    57.5   56.9    -0.6
 Colorado         52.1   48.4    -3.7
 Idaho            68.9   72.4     3.6
 Montana          55.4   59.8     4.4
 Utah             64.1   64.9     0.8
 Wyoming          58.9   61.0     2.1
Far West          69.2   66.1    -3.2
 California       69.8   65.7    -4.1
 Nevada           61.4   68.3     7.0
 Oregon           56.5   50.7    -5.8
 Washington       71.4   71.9     0.4
 Alaska           85.8   69.1   -16.7
 Hawaii           81.0   81.2     0.2
National          61.6   60.2    -1.3

Note: Rounding may affect change totals.

Source: U.S. Census Bureau, Government Finances: 1989--90; U.S. Census Bureau, Governmental Finances in 1979--80.