Funding States and Cities: The Arguments (Part 2)

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Guest Essayist: Nicholas Jacobs

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Intergovernmental Competition: Are we in a “Race to the Bottom”?

Grants are just one way of transferring money and there are alternative financial arrangements that better meet the standards of joint-influence and joint-benefit, such as GRS. Rarely is it the case that the specific goals outlined by narrow grant programs perfectly meet the needs or desires of a state community. And, the costs of administering a grant seldom justify the federal government’s insistence that states participate. It is often overlooked that states could simply fund the government program themselves, without federal oversight or administrative duplication, if enough political will existed within the state community for that service.

Nevertheless, we should first recognize that the federal government might have certain advantages when it comes to taxing and spending, which helps to justify the need for any intergovernmental cooperation at all. The states do not exist independent of one another, and an important principle outlined in the last essay was that the taxing and spending decisions reached by one state government necessarily affect the fiscal capabilities of all the other states.

In the best case scenario, this has huge advantages for a diverse national community. People get to choose what their states look like, and they can exercise an important check on state governments that tax and spend the peoples’ money unjustly: they can leave!

States, therefore, compete with one another for residents, for business, and ultimately, for tax dollars. And those competitive pressures incentivize state and local governing officials to provide the best government for the lowest cost.

Yet, sometimes that competition has negative effects — what political economists might label a “negative externality.” When the savings created by one state’s actions impose costs on other political communities, competition produces inefficiencies. This is best illustrated by state variation in how much is spent on environmental regulation and clean-up. States that are literally “up-river” can exact exorbitant costs on other states through their inaction. Likewise, in trying to attract business to their state, one state might dismantle regulations placed on corporations; neighboring states might follow suit in order to keep business from leaving. State-level variation and competition might, in other words, work against certain national goals, creating a “race to the bottom” where states undercut one another to create advantages in the short-term, but impose long-term costs on the national political community.

Such is the rationale for the single largest intergovernmental program in the United States: Medicaid. The provisioning of Medicaid reflects a national goal (healthcare for the poor) and is structured so as to reduce the degree of competition between states in administering benefits. Almost a third of all state spending goes towards Medicaid payments, and that number is increasing; 20 percent of funding is raised solely by the states, up from just 9-percent in 1990. The federal government dictates minimum eligibility requirements, but each state is left free to fund the program to desired levels and set additional requirements on recipients and providers of Medicaid services. The 2010 Affordable Care Act — “Obamacare” — would have required states to enroll citizens who made up to 133% of the federal poverty line, but the Supreme Court struck down mandatory expansion, which reinforced the joint-nature of the program.[1] As of early 2019, only 36 states have expanded Medicaid as a result. Moreover, under the Trump administration, a number of states have experimented with requiring work requirements for eligible participants. The federal courts have struck down three states’ efforts, but it is an open legal battle over just how flexible Medicaid will remain, as it consumes a larger portion of state budgets.[2]

Fiscal Independence: Should we Blame the States?

No doubt some readers, in thinking through the examples about the “race to the bottom” might view such competition as a healthy impulse: it has the high potential to limit environmental regulation and corporate taxation, for instance. One man’s race to the bottom is another man’s dream of limited government.

However, American political history suggests that, in the long run, rather than maintaining a de-regulated system of limited government, excessive competition between the states has provided the federal government an enduring rationale to step in and impose requirements on a national level, with little involvement from the states or cities. Hamilton warned of this possibility in 1789, writing that while “the people of each State would be apt to feel a stronger bias towards their local governments than towards the government of the Union,” this would only be the case “unless the force of that principle should be destroyed by a much better administration of the latter [federal government].”[3]

The logic of concurrent taxation and the promise of intergovernmental competition should make us reconsider one of the dominant strategies promoted by proponents of limited government in the 20th century: tax restrictions within state constitutions.

As discussed in the previous essay, citizens of the various states have long turned to their own state constitutions to regulate the public coffers, often saving future generations from unmanageable levels of government debt. In 1978, voters in California continued this tradition and passed Proposition 13 — a citizen-led ballot initiative that placed hard restrictions on the ability to increase property tax rates and reassess the value of commercial and residential real estate.

On the one hand, such restrictions have forced government officials to scrimp, save, and justify every expense, particularly at the local level, and often to the benefit of the taxpayer. In this regard, the “tax revolt” unearthed by Proposition 13 worked. In 1976, Californians had the sixth-highest “tax burden” in the country, at 12.2-percent — a measure of how much annual income each resident pays in state and local tax. In 2019, they rank 11th, with an individual’s burden down to 9.47-percent of annual income.[4]

On the other hand, it is not so clear that constitutional prohibitions — in California or in other states — always produce a system of public finance that allows Hamilton’s paradoxical logic to function properly. In restricting a state government’s taxing powers, it loses the ability to check the federal government, thereby reducing the amount of fiscal competition (and cooperation), the framers of the Constitution favored. Competition among the states, in other words, must be balanced out by competition between the states and the federal government. While it is also fair to critique the redistributive effects of the constitutional prohibitions — Proposition 13 overwhelmingly favors long-term residents over new arrivals, decreases the financial incentive for selling a home, and inflates property values — it is this intergovernmental consequence that is most problematic. Local governments, dependent on property tax, responded not by curtailing services that citizens still desired, but by requesting assistance from the state. State governments grew in power, but then faced financial hardship of their own as they competed with localities over a diminished tax base. The state government then turned to the federal government. Overall spending, when considering intergovernmental transfers, has climbed, as have debt levels. And, since those restrictions are protected by high constitutional thresholds, they limit the ability of residents to take back authority from the general government.

In closing, I emphasize that if we are to understand what state and local governments do– and what they are capable of doing — we need to follow their money. Budgeters and politicians can devise any number of complicated schemes for regulating the public purse, but, as Hamilton, again, forewarns, the entire constitutional system is “left to the prudence and firmness of the people; who, as they will hold the scales in their own hands, it is to be hoped will always take care to preserve the constitutional equilibrium between the general and the State governments.”[5]

Public finance is ultimately a decision about what type of government people want. And such confusion and discord in state and local finances is the clearest indication that few Americans actually know what type of government they want. They want low taxes and lots of services. The types of trade-offs — between revenues that can go to the public purse, and services provided by multiple governments — are seldom discussed, and increasingly, fail to meet the standards of constitutional federalism as a result.

Nicholas Jacobs is a Faculty Research Associate in the School of Civic and Economic Thought and Leadership at Arizona State University, where he also serves as the assistant project director of the Living Repository of the Arizona Constitution. He has published numerous scholarly articles on intergovernmental politics, American political history, and the American presidency.  

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[1] National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012)

[2] Nicholas F. Jacobs and Connor M. Ewing. 2018. “The Promises and Pathologies of Presidential Federalism.” Presidential Studies Quarterly 48 (3): 552-569.

[3] Federalist 17

[4] Tax Foundation. State and Local Tax Burdens. URL: https://taxfoundation.org/state-and-local-tax-burdens-historic-data/

[5] Federalist 31

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Funding States and Cities: The Arguments (Part 1) – Guest Essayist: Nicholas Jacobs

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Guest Essayist: Nicholas Jacobs

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Although written more than 230 years ago, the United States Constitution contains a highly sophisticated — some might even say, modern — theory of public finance.[1] Other regimes had tried federated or confederated government (including the United States from 1781 to 1789 under the Articles of Confederation). But, the type of federalism outlined by the Constitution was an unprecedented experiment, because it gave the general government and each of its smaller, constituent governments independent taxing authority — a system known as concurrent taxation.

Hamilton’s Argument

In establishing an arrangement for concurrent taxation, the Constitution increases the likelihood that budgetary decisions reflect the needs and wishes of the country’s diverse political community, and decreases the likelihood that government spending is wasteful, obscure, and overly burdensome on specific groups of taxpayers. In short, by creating more government, Americans should pay fewer taxes.

This logic is explored — as much of the Constitution is — in The Federalist Papers. Essays number 10 and 51 might get all the fanfare, but at least a dozen individual essays, primarily written by Alexander Hamilton, deal exclusively with the logic of taxing authority. And, while Hamilton’s persuasive and innovative theories of concurrent taxation might not make for an exciting Broadway musical, these essays are among the most enduring and consequential arguments for designing government here in the U.S., and throughout the 19th and 20th centuries.

First, the Constitution is an arrangement that gives each government independent authority for raising revenue. Arguably, this is the single most consequential revision to the Articles of Confederation, which had made the national government dependent on state governments for all its revenues. It is the proximate cause of nearly all objections levied by the Anti-Federalists, because, independent taxing authority is an unambiguous method for creating a more powerful federal government.

As Hamilton describes, the new federal government needed financial independence from the state governments because “a complete power…to procure a regular and adequate supply of revenue, as far as the resources of the community will permit, may be regarded as an indispensable ingredient in every constitution.”[2] During the American Revolution, and in its immediate aftermath, the general government struggled to finance its most basic obligations, including the maintenance of an Army during war. In giving the federal government taxing powers, the framers gave the federal government independence.

However, the Constitution not only establishes independent taxing authority, it also underspecifies the various sources of tax revenue each government can levy.[3] The 1787 Constitution prohibits taxation on just one type of revenue: taxes on exports. And, it reserves only one type of tax to the general government: taxes on imports, or tariffs. It is silent on every other conceivable form of taxation. That silence, though, is not an omission, but a deliberate design principle. First, it ensures that all governments within the constitutional order have access to funding sources in the event of some unforeseen exigency. Drawing on the experience of Great Britain’s Parliament, Hamilton was especially concerned with how the new federal government would raise money during times of war or insurrection. Limiting the federal government to just one type of revenue, say, tariffs, would handicap needed revenues, and potentially cause adverse economic effects domestically and abroad.

The under-specification in revenue sourcing also has important implications for the states. For one, they maintain the same guarantees for exigent expenses as does the federal government. They possess access to resources in order to respond to citizen demands, and they are not constitutionally prohibited to raise monies from new sources as needed. Not only that, but, as Hamilton makes clear, the new Constitution provides plenty of opportunity for the states and federal government to cooperate in the collection and distribution of revenues. As he writes in Federalist 36, if the general government begins to tax a revenue source already occupied by the states, “the United States [federal government] will either wholly abstain from the projects preoccupied for local purposes, or will make use of the State officers and State regulations for collecting the additional imposition. This will best answer the views of revenue, because it will save expense in the collection and will best avoid any occasion of disgust to the State governments and to the people.”

Therefore, concurrent taxation encourages intergovernmental cooperation. It is a cooperation defined first and foremost by efficient tax collection — the reduction of government expense by the sharing of administrative processes — as well as transparency. In the above passage, the guardians of the public revenues are the state legislatures, who have an interest in maintaining their own fiscal authority and independence, and, most importantly, the people themselves, who have little desire to give away their hard-earned dollars to a wasteful government. Governmental cooperation — land grants, targeted appropriations, administrative assistance — had to be “substantially mutual and reciprocal.”[4] If states and the federal government wanted it, and if both benefited from the intergovernmental scheme, nothing in the Constitution prohibits such arrangements. In fact, the Constitution seems to demand it if it is in the people’s best interest.

Moreover, as John Kincaid notes, such under-specification of tax authority gives special power to the House of Representatives as a “regulator” of federalism. While most constitutional analyses emphasize the Senate and the Electoral College as the safeguards of American federalism, Hamilton’s analysis reminds us that it is ultimately the people who get to decide what type of federalism they want. All revenue bills must, after all, first be introduced in the House of Representatives, which is, as Madison writes, the “most complete and effective weapon with which any constitution can arm the immediate representatives of the people.” And since revenues are the lifeblood of any government, the institution with the greatest influence on that relationship occupies a prominent place not only at the national level, but within the states and localities as well.

Intergovernmental Concurrency: Was Hamilton Right?

Just because Hamilton ordained fiscal-federalism to be so, does not mean that the United States developed according to plan. In certain important respects, the current system of intergovernmental finance (including the independent revenue authority of the states and localities) fails to meet Hamilton’s lofty predictions for how the new Constitution would operate.

Since most of the federal government’s cooperation with states and localities takes place through the use of grants (as described in the last essay), it makes sense to consider whether this fiscal instrument fulfils the constitutional spirit outlined in The Federalist. To be sure, the U.S. Supreme Court has clearly ruled that grants are constitutional,[5] but asking whether the system of grants-in-aid maintains financial concurrency is not a legal question. Do grants satisfy the institutional principle of mutual and reciprocal cooperation?

There are more than 200 individual federal grants to the states and localities, administered across 30 different federal agencies. There are some, to be sure, that meet the rigorous standard of mutuality — equal benefit for state and national goals — and reciprocity — equal influence by the states and federal government. But changes to the American political system and the expansion of federal spending authority has limited the extent to which the grant system meets these standards.

First, it would be a mistake to neglect the significant amount of mutual and reciprocal cooperation that did take place throughout the 19th century and early 20th century. These demonstrate that such type of cooperation can, and has, existed in the U.S. For instance, the national government in 1862 passed the Morrill Land Grant Act, which provided states tracts of federal land to fund state colleges with a specific focus on agricultural and mechanical sciences. States were not compelled to participate, but could choose to if it advanced the community’s interest. Given the extraordinary broad discretion granted to state legislators for selecting the location, choosing the courses of study, and the establishing the governing body of the college, every state participated.

Few grant programs today operate in this way. For one, most states are compelled into participation because failure to participate in one negates participation in another. Rather than forfeiting a small sum of money tied to one particular program, a state risks losing all federal funding for a large area of government services. Additionally, as discussed in the previous essay, grant funding is also used to impose mandates on states and localities, which means that federal grants only fund a portion of the true cost of any one federal program. States must make up the revenue elsewhere either by raising taxes, or cutting state governing expenses.

Grant programs vary in the amount of discretion given to states and cities for setting program goals, eligibility criteria, and benefits paid. Yet, even among the most flexible grant programs — often called “block grants” — goals are set by federal departments and agencies with minimal state involvement. The 1978 revision to the Community Development Block Grant, for instance, mandates that states spend 30-percent of all granted funds in rural areas, regardless of the states’ demonstrated need or preference. But even when goals are left undefined, grants might have perverse political effects that conflict with state-level goals (or even national ones). For example, the 1968 Safe Streets Act and its successor, the 1996 Local Law Enforcement Block Grant, was a testament to intergovernmental cooperation. In providing millions of dollars to localities to modernize police forces, states and cities eagerly pursued these grants to help fund police services. Yet, as scholars have recently identified, these programs created demand for government services — namely, prisons and policing — when little demand existed before. Moreover, following the terrorist attacks on September 11th, localities used these grants to purchase military-grade weapons from the federal government — lest they lose available money — with little knowledge from the policed community.[6] If a hallmark of liberal democracy is that government policy reflects the will of the governed community, police militarization and mass incarceration raise important questions about how decisions to finance the expansion of local, state, and federal governments were reached and sustained. It is a question about taxes and spending.

Hamilton likely under-estimated the political potency that federal grant programs have. When states refuse to participate and risk losing federal funds, citizens accuse government officials of leaving money on the table — and not without cause. Federal transfers to the states are funded, after all, by citizen tax dollars. In recognition of this fact, for almost fifteen-years, the states and federal government experimented with general revenue sharing (GRS) agreements, which took the place of narrower grant programs. States were provided an incentive to spend money, thereby reducing some of the negative pressures from turning down funds for grant programs. State and local officials celebrated GRS for its consistency and flexibility; officials could use the funds without restriction. Congress, with the support of the Reagan administration, abolished GRS in 1986, and re-converted many of the programs to categorical grants more susceptible to political control. In the end, GRS demonstrated that budgets are political tools, and politicians are not likely to give up the control that comes with taxing and spending authority.[7]

Nicholas Jacobs is a Faculty Research Associate in the School of Civic and Economic Thought and Leadership at Arizona State University, where he also serves as the assistant project director of the Living Repository of the Arizona Constitution. He has published numerous scholarly articles on intergovernmental politics, American political history, and the American presidency.

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[1] Vincent Ostrom has made this connection most explicit in a rich and detailed exploration of The Federalist: Vincent Ostrom. 1987. The Political Theory of a Compound Republic: Designing the American Experiment, Second Edition. Lincoln, NE: University of Nebraska Press.

[2] Federalist 30.

[3] This is the primary subject of Federalist 35.

[4] John Kincaid. 2017. “The Eclipse of Dual Federalism by One-Way Cooperative Federalism.” Arizona State Law Journal 49: 1062.

[5] While the Supreme Court dismissed Massachusetts’s claims against the 1921 Shephard-Towner Act, which provided $1-million in grant assistance to states for prenatal and newborn care, Justice Sutherland’s unanimously supported obiter dicta demonstrated that the court did not view voluntary grants as unconstitutional infringements on state sovereignty: Massachusetts v. Mellon, 262 U.S. 447 (1923).

[6] Christopher J. Coyne and Abigail R. Hall. 2018. Tyranny Comes Home: The Domestic Fate of U.S. Militarism. Stanford, CA: Stanford University Press.

[7] Timothy J. Conlan. 1998. From New Federalism to Devolution: Twenty-Five Years of Intergovernmental Reform. Washington, D.C.: Brookings Institution Press.

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Funding States and Cities: How Dollars Work (Part 2)

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Guest Essayist: Nicholas Jacobs

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Intergovernmental Finance

Every nickel spent by a state or local government ultimately comes from the pockets of some private entity, but often public monies are exchanged between governments. Intergovernmental transfer payments account for 23 percent of all money spent by state and local governments.

Most intergovernmental transfer payments point “downwards” in the federal system, moving from larger governments to ones of smaller size. The federal government delivered $621-billion to the various states in 2016, and state governments sent $524-billion to various localities in that same year.[1] Overtime, intergovernmental payments have grown as a share of state and local government revenues — a trend we will evaluate in the next essay — and the federal government has even come to make direct payments to localities in some specific instances.

Most forms of intergovernmental revenue take the form of grants — direct payments to a state or local government agency, with a specific purpose outlined by the grantee. The federal government, for example, sends billions of dollars it collects to the states for the purpose of constructing and maintaining highways. Likewise, state governments send some tax revenue it collects to localities for funding public health programs. The federal government even sends money to the states that the states then divide up and send to the localities.

Intergovernmental payments can be rigidly formulaic — a set number of dollars for a set number of persons — that treat governments of similar size equally. Payments can also be re-distributive, taking tax dollars from one political community and giving it to another. Most local school systems, for instance, fund their expenses through property taxes raised in the local community they serve. Increasingly, however, state governments re-distribute some of those monies, taking local revenues from towns, counties, and cities with higher property values, and sending it to communities with lower property values, and, consequently, lower revenues.

Beyond its redistributive effects, larger governments tend to send revenues to governments of smaller size out of recognition that money can be spent more effectively at the local level than a state-wide or national level. In fact, grants and other types of intergovernmental spending account for over 17% of all federal monies that the Congress appropriates each year.[2] As such, much of what the federal government does is, in fact, done by governments of smaller size. But in exchanging monies, intergovernmental transfers are one way in which larger governments set new restrictions on smaller governments, sometimes with little relevance to the funding purpose. For example, in 1984, Congress passed a law requiring states to raise the minimum drinking age as a condition for receiving its share of federal highway funds. More recently, the federal government imposed requirements on local public schools to develop and administer specific tests for all enrolled students: The 2001 law, No Child Left Behind. As a result, if local governments fail to follow federal guidelines, they risk losing all federal grant payments for education, which account for just 10% of all local education expenditures.

Public Finance in a Federal System

The revenue decisions reached by representatives within each government set hard constraints on the other powers and actions of governing officials, but taxing decisions also affect how people behave, even when there is no specific government program.

For example, many cities have recently imposed a tax on plastic bags, like the type often used at convenience stores and supermarkets. The stated goal is not so much to raise money (although most of the time these taxes fund specific environmental programs) as to discourage the use of plastic bags. States also experiment with other types of “excise” taxes — fees placed on specific goods — to discourage tobacco, liquor, and even soda consumption; these often have the more politically-palatable name, “sin tax.” However, in a federal system where one government’s rates differ from a nearby government’s, such taxes might simply distort behaviors, rather than end them. New York State, for example, has the highest excise tax on cigarettes: $4.35 on every pack sold in its borders. Half a day’s drive away in Virginia, the state levies just 30-cents per pack. It is not a coincidence that an estimated 56% of all cigarettes smoked in New York are currently smuggled in from out-of-state.[3]

As previously mentioned, when governments of smaller scale levy certain types of taxes, the economic incidence paid by taxpayers might better reflect the actual economic circumstance of that community. This is not always the case. The United States is a very large country, and when the national government levies taxes, particularly on income, it treats each citizen in the country equally, regardless of where they live. A person making $40,000 in Alabama pays the same marginal tax-rate as a Californian who makes the same amount, but who pays more in state and local taxes, and spends a proportionately higher amount of that $40,000 on rent, food, and transportation, due to variation in cost-of-living. Consequently, citizens in some states pay more to the federal government than they get back in government goods and services — an issue known as a state’s relative balance of payments. Residents of New Jersey have the worst balance of payments — receiving just 74-cents back from the federal government for every dollar they send — while residents of New Mexico get back $2.21 for every dollar they pay in taxes.[4]

As a closing note: one of the most consequential political developments in American history has been the legal restrictions citizens have placed on state and local governments for amassing public debt. It was routine in the 1800s for cities, in particular, to go bankrupt. At the turn of the 20th century, state governments limited the ability of municipalities to run annual deficits, but, with time, states began to spend more than they took in. Through ballot initiatives and legislative action, citizens enacted state-constitutional amendments that required balanced budgets for their governments. As such, the U.S. federal government is the only government that can formally spend more money than it raises.

These restrictions further complicate the way states and localities fund themselves, especially during hard times. For instance, property and sales taxes are highly “elastic,” which means that when the overall economy slows down, revenues can quickly fall. Debt restrictions and high elasticity create a peculiar circumstance, and often increase state and local demand for intergovernmental transfers. Following the 2007-2008 recession, which depressed home prices (decreasing local property tax revenues) and slowed consumer spending (decreasing state sales tax revenues), the federal government had to increase its own debt levels in order to finance state and local government services. Of the $787 billion Congress authorized as a part of the American Recovery and Reinvestment Act, or “stimulus,” more than a third was sent directly to state and local governments.[5]

States and cities can also sidestep legal prohibitions and gather additional funds by issuing bonds for “capital improvements” or by dipping into reserved funds, such as a state employee pension fund. State and local governments, collectively, hold about $3-trillion in public debt. Many pension funds have remained unbalanced for decades and the solvency of these accounts is one of the largest financing hurdles state and local governments will have to overcome as the American population grows older, and the “Baby Boomer” generation retires.

All of these developments notwithstanding, the constitutional foundation for America’s system of public finance is largely unchanged. The complex arrangement of varying tax sources, rates, and redistribution is the hallmark of a federal system that empowers multiple governments to act simultaneously within the same political jurisdiction. In the next essay, we will look more closely at the argument for why federalism — and independent budgetary authority — creates a more robust system of public finance, even if it appears to be more complicated and unwieldly. This is not to say that the modern system is perfect, and so we will also evaluate several leading proposals to fix the country’s federated financial system.

Nicholas Jacobs is a Faculty Research Associate in the School of Civic and Economic Thought and Leadership at Arizona State University, where he also serves as the assistant project director of the Living Repository of the Arizona Constitution. He has published numerous scholarly articles on intergovernmental politics, American political history, and the American presidency.  

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[1] Data on intergovernmental transfers, including the data graphed in Figure 2, was retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/. All dollar amounts are pegged to their corresponding calendar year, and are not seasonally adjusted.  Last accessed, April 11, 2017.

[2] Congressional Budget Office. 2013. “Federal Grants to State and Local Governments.” Government Printing Office, 5 March. Retrieved on March 14, 2018 (https://www.cbo.gov/publication/43967).

[3] Scott Drenkard. 2017. “Cigarette Taxes and Cigarette Smuggling by State, 2015.” Tax Foundation. URL: https://taxfoundation.org/cigarette-tax-cigarette-smuggling-2015/

[4] Rockefeller Institute of Government. 2017. Giving or Getting? New York’s Balance of Payments with the Federal Government. State University of New York. URL: https://rockinst.org/issue-area/giving-getting-new-yorks-balance-payments-federal-government-2/

[5] Timothy Conlan and Paul Posner. 2016. “American Federalism in an Era of Partisan Polarization: The Intergovernmental Paradox of Obama’s ‘New Nationalism.'” Publius: The Journal of Federalism 46 (3): 281-307.

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Funding States and Cities: How Dollars Work (Part 1)

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Guest Essayist: Nicholas Jacobs

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If, “in this world nothing can be said to be certain, except death and taxes,” in the United States, taxes are a little more certain than death. Americans, after all, pay taxes to not just one national government, but to at least two additional ones as well: their state and locality. Paradoxically though, the framers of the U.S. Constitution believed that by establishing a system of multiple governments with independent taxing authority, the total tax burden placed on citizens would be less than it would be if one gargantuan government existed.[1]

For anyone that has ever filed your own taxes, you know that it is highly technical and subject to precise calculations, lengthy procedure, and numerous exemptions. Yet, at its most basic level, the methods by which governments acquire money are political determinations — reflective of each community’s unique history, size, political culture, and available resources.[2] The variation across different levels of government and between governments of similar scale reflects the political diversity American federalism nourishes. Understanding that variation in all of its complexity is the first step towards evaluating how federalism, despite creating many governments, can actually reduce the total tax burden placed on the American taxpayer.

Financing Local Governments

Local governments receive about 17.6 percent of every dollar that Americans pay to government each year, totaling just over $1-trillion.[3] Historically, the revenue decisions reached at the local level had the largest influence on Americans’ day-to-day lives. Municipal corporations were the leading provider of government services, establishing school systems, transportation networks, and welfare assistance before the states and national government. Much of this system remains and over time, additional types of local government emerged, each with their own taxing and spending authority; unincorporated county-governments, consolidated government units, and independent school districts — like towns and cities — all collect revenues to operate.

Remarkably, taxes account for just two-thirds of all revenues local governments raise. Localities amass considerable sums by charging fees on the use of hospitals, sewers, harbors, and airports. Some even rake in a small amount through the sale of school lunches. These “user fees” are like taxes, but they are non-compulsory and are only paid by those who use the service (sometimes provided by a private entity). Like usage fees, most local governments also raise revenue from utilities, such as a city’s water supply or transit system. Many Americans might also live in local, special-purpose districts, which are established for specific functions, and which have separate budgetary powers.

When considering taxes — compulsory, generalizable, and unavoidable legal obligations to pay the government money — local governments have a more limited “base” on which to rely. By far, the largest source of tax revenue for local governments, nationwide, is the property tax, which accounts for nearly half of all money local governments raise. But some local governments also take in money by taxing personal income and through localized sales taxes, especially on food and alcohol sold in restaurants.

Local governments derive such a significantly high percentage of their revenues from property taxes largely because of historical circumstance (they were the easiest to assess and collect), but also because they are pegged to the relative cost of living in any one, localized political jurisdiction. For instance, the rate set by the city of Boston might make sense for a densely populated, urban community where people make high incomes, property values are high, and citizens expect expensive government services. That same rate, however, might bankrupt the small family farmer in Western, Massachusetts, who owns considerably more land, and expects much less from government.

Financing State Government

State governments rely on all the same techniques as do local governments, including property taxes on possessions such as automobiles, and usage fees on services, such as parks and highways (tolls). However, there is much more variation between the states in how government finances itself.

Most states (46/50) have a general sales tax – a percentage added to each commercial transaction in the state, which retailors and merchants deliver to the state government. Sales taxes account for nearly half of all tax revenue raised by states. However, that percentage varies drastically. Some states, such as New Hampshire and Montana, do not have a general sales tax (although both states charges sales tax on specific goods such as food and lodging).  Other states, such as Tennessee and Arkansas, impose sales taxes that approach 10% on all goods purchased within the state.

Most states (43/50) also levy a state-wide income tax, which accounts for about 37% of all tax revenue at the state-level. Like the sales tax, these rates vary, and often move in relation to the state sales tax. For instance, Maine levies a 7.15% tax on the highest levels of income, which is one of the highest rates in the country; however, it charges just 5.5% on goods and services, one of the lower sales tax rates in the U.S.

This variation is important, and represents a healthy federal system. Decisions over what type of revenue source to tap generally reflect a state’s particular economy and the livelihoods within them. Taxpayers generally want to limit the amount of burden placed on themselves, so most governments try to “export” their state’s tax base. Property taxes paid on vacation homes, gasoline taxes paid by visiting motorists, and purchases made by tourists are all examples of how state governments get money from non-residents. In Nevada, nearly 80 percent of state taxes come from sales taxes, where in Illinois, state governments rely on a broader base of economic activities, including a 7% tax on corporate income, which brings in the state $3.3-billion each year.

The difference between taxing property, sales, and income is also reflective of underlying political beliefs. Most states that rely more on income tax revenues use a “progressive” rate, so that individuals who earn higher annual incomes pay more tax. In contrast, most budgeters consider sales tax to be a “regressive” measure. Although not pegged to income, individuals with lower incomes, on average, pay a higher proportion of their annual income in sales taxes than do individuals with higher incomes. Importantly, the determination to impose one type of tax over another is not a technical or objective calculation: it is the result of competing ideas about fairness, and varied expectations for government spending, which federalism encourages.

Nicholas Jacobs is a Faculty Research Associate in the School of Civic and Economic Thought and Leadership at Arizona State University, where he also serves as the assistant project director of the Living Repository of the Arizona Constitution. He has published numerous scholarly articles on intergovernmental politics, American political history, and the American presidency.  

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[1] Vincent Ostrom. 1987. The Political Theory of a Compound Republic: Designing the American Experiment, Second Edition. Lincoln, NE: University of Nebraska Press.

[2] Otto A. Davis,, M.A.H. Dempster, and Aaron Wildavsky, “A Theory of the Budgetary Process,” The American Political Science Review 60 (1966): 529-547.

[3] All figures, referenced in the following two sections on state and local finance, including the data graphed in Figure 1 are drawn from the U.S. Census Bureau’s 2016 State & Local Government Finance Historical Dataset, which is publicly available at https://www.census.gov/data/datasets/2016/econ/local/public-use-datasets.html

 

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