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State and Local Fiscal Trends and Future Threats, Working Paper 025 Open Access

State and local public finance has never been more important. Economic, political, and technological developments have dramatically changed how state and local governments raise revenue as well as on what they spend that revenue. State and local public finance structures have not changed significantly over the past five decades. Indeed, the basic structure of the tax systems was designed for a different time and a much different economy. The world in which those systems operate has changed considerably. The U.S. economy has moved from a manufacturing base to one dominated by the service sector and intellectual property. The challenge for state and local governments is that neither services nor intellectual property have been part of their tax base. Moreover, the economy in which people primarily bought locally manufactured tangible personal property no longer exists. Businesses no longer produce and sell products in one or a few states, but throughout the nation and the world. Rapid technological advancements have also played a role in reshaping the fiscal landscape. The age of electronic commerce has revolutionized how people work, play, and communicate. Technology has affected all tax systems, but perhaps none greater than the traditional sales tax. Because state and local governments have been unable to impose sales taxes on most electronic commerce, they have lost billions in tax revenue. These loses have put enormous pressure on governments to find alternative sources of revenue or curtail public spending. In the end, the economy in which most of the state and local revenue systems were designed to operate has been replaced with a high technology, global economy where purchasing services or products from India and Italy is only a few keystrokes away. The global economy has produced a new dimension into the use of fiscal policy to foster economic development. State and local governments have long engaged in a competition against each other for business investment and jobs. Over the past quarter century, political leaders have used their tax laws to encourage companies to relocate to (or to refrain from leaving) their state or locality. Such competition has put enormous pressure on state and local governments to keep tax burdens low, while providing the highest possible level and quality of public services. The globalization of the economy has magnified the scope of the competition. State and local governments are no longer competing with each other, but with nations around the world. Another development with which states and local governments must contend is the changing scope of their duties. American subnational governments are providing more public services than ever before, and the need for revenue has never been greater. The states, for example, are not only providing the traditional services (state police, prisons, higher education, and highway maintenance.) They are also providing many services that were once almost exclusively provided and paid for by the federal and local governments. Since the 1980s the federal government has been steadily shifting more and more responsibilities to the states. The states have been asked (or just as often have been forced) to administer and pay for many programs that traditionally have been the responsibility of the federal government. Welfare, Medicare, Medicaid, and highway maintenance are just some examples in which the states have replaced the federal government as the administrative body responsible for providing the services. While the costs of assuming many of these programs have been offset with increased federal funding and protections against unfunded mandates, this phenomenon, commonly called “devolution” in academic circles, has nonetheless contributed to the growth of state, and to a lesser extent, local government budgets. This trend is likely to continue as the federal government, laboring under large deficits, devotes more resources to national defense and homeland security. State and local governments will be asked to do more. At the same time, as the result of political pressure and a flood of legal challenges, state governments have taken on an increasingly greater share of the costs of public education. While elementary and secondary education was traditionally the financial responsibility of local governments, state governments have, over the past decade, paid a decidedly greater percentage of school finance costs. In addition to the financial pressures from shifting responsibilities, state and local governments have experienced what could be called the “politics of anti-taxation.” Since the late 1970s there has been a concerted effort to politicize, even demonize, taxation. This often fervent anti-tax sentiment has festered at all levels of government during the past quarter century. Anti-tax politics fueled the passage of Proposition 13 in California and spurred property tax revolts around the country. Tax cutting became a regular theme for gubernatorial or legislative candidates seeking election in virtually every state. It has also helped spawn the initiative and referendum movement, a process that has traditionally been dominated by anti-tax crusaders. The politics of anti-taxation has limited state and local government ability to raise revenue precisely when the demand for services and education spending has increased. This report provides a detailed description of state an d local fiscal systems and how they operate given the developments discussed above.

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