... the people behind the Urban Institute research. In traditional interview format, our experts talk about the nature of their work, offer insights on what they've learned, and describe the personal goals that keep them going.
Kim Rueben, a senior research associate in the Urban-Brookings Tax Policy Center, is an expert on state and local public finance. She has looked at taxpayer efforts to constrain state spending and was part of a research team examining federalism's breakdown after Hurricane Katrina.
Five Questions Archives
1. Why is state and local tax policy important?
Just think about the services people rely on day-to-day — schools for their kids, roads for commuting, and police and fire protection for emergencies. Some of the money comes from the federal government, but much is raised locally and, importantly, state and local governments deliver the services. If the federal government cuts back, then state and local governments have to provide fewer services to people or figure out how to raise more money.
States typically operate under a balanced budget rule. So, the amount of money they propose spending needs to equal the amount they expect to raise. States are allowed to go into debt, with restrictions, for capital projects or to meet the day-to-day functioning of government. But borrowed funds for day-to-day needs must be paid back within the year.
Urban Institute has looked closely at the expenditure side of what state and local governments do — especially the impact on working families. Going forward we hope to examine the interplay in federal, state, and local tax systems and also the ways those tax systems relate to services provided — the ultimate reason we have government.
At the Tax Policy Center, which has built a reputation by providing federal tax information, it's always been a goal to integrate state and local tax issues. Now we're building on earlier work, including conferences on the impact on states of the last recession and on state income tax systems.
2. What trends have we seen in recent years?
We have seen changes in dependency on state and local government revenue sources, with increasing state reliance in the late 90's on income taxes. This has led to an increase in the volatility of taxes. A number of states, most notably New York and California, were hit pretty hard after the last recession because they depended on progressive income taxes. So the disappearance of capital gains and stock options early in this decade significantly affected their tax bases.
Typically, state and local governments get their money through three main taxes — state income taxes, state sales taxes, and property taxes, with other revenue sources varying depending on circumstances. Alaska relies on money from oil reserves; Nevada relies on money raised from gambling. Neither state has a general income tax. In general, most state budget systems function best when all three main taxes are used to provide the most stability over time—the three-legged stool of tax policy. In certain states, a leg or two is missing. A handful of states like Texas and Florida don't have an income tax, so their property tax and sales tax need to do double duty.
One of the trends we need to watch is what's happening with property taxes — what kinds of property tax relief systems are different states putting into place and how are governments responding to unrest or dissatisfaction. Until recently, state and local governments were raising a declining share of their revenue from property taxes, but that's turned around in the last few years as property values increased substantially.
As taxes increase, there is more pressure from some taxpayers to curb government's ability to raise revenues, and this push can lead to the passage of tax-limit laws like Proposition 13 in California (where property values exploded in the late 1970s) or, more recently, the passage of overall revenue limits like the Taxpayer Bill of Rights law in Colorado.
In some cases, states have had to rely more on fees, such as park user fees, road tolls, or fines on library books. Some such fees move state finances in a positive direction. People pay for the services they're actually using.
There's also some talk about getting rid of the deductibility of state and local taxes from federal tax returns. The President's Tax Reform Panel proposed it as a way to raise about $45 billion a year in additional federal revenues and to replace revenues lost if we fix the AMT [Alternative Minimum Tax]. Though, this is pretty unlikely to be adopted in the next few years.
3. How did Hurricane Katrina reveal stress points on federal-state social programs?
A fair amount of money is required to rebuild Louisiana and Mississippi and to provide social services to hurricane victims. U.S. social programs, which are based on a state or local match, aren't well suited to such disasters. The two states have a relatively low ability to raise matching funds or to provide services. Plus, during the disaster federal-state-local communications broke down.
Many coordination issues make division of responsibility difficult. Who is responsible for providing money if the people who are eligible are not physically living in their city or state of residence? For example, who should pay for health care or welfare for New Orleans residents who are now living in Houston? Louisiana? Or Texas? Or, should the federal government step in?
Most people expect the federal government to reimburse Texas for the amount of money it's spending on storm evacuees. We don't know precisely how it's all going to play out. But what was also revealed after Katrina is that the systems we have in place, especially for disaster relief, are pretty much short-term systems. FEMA [Federal Emergency Management Agency] is interested in providing housing for 16 to 18 months rather than trying to figure out how we're going to replace low-income housing that was destroyed.
Katrina has illustrated that there are many parts of government that aren't all working together. As we pass the six-month anniversary, it's become clear that they aren't working much better today then they were last fall. Mississippi has started to rebuild fairly effectively. New Orleans has been much more of a coordination nightmare. It's not just a question of the money; it's a question of figuring out what needs to be done and who's going to do it.
4. What can we learn from looking at specific states?
I've conducted two studies on state responses in the aftermath of the passage of tax and expenditure limits. One I just finished looks at the economic growth rate in Colorado in the aftermath of TABOR (the Taxpayer Bill of Rights) and found that, in contrast to predictions of the bill's supporters, economic growth doesn't seem to have increased since TABOR was passed.
I also just finished a study on financing options for infrastructure projects in California. The governor is proposing over $50 billion in new bond funds for schools, highways, and flood relief. But voters in California, as in Colorado, have passed initiatives that limit the ability of state and local governments to raise revenues or pass new taxes.
The Taxpayer Bill of Rights movement — an extension of tax and expenditure limits that were passed beginning with California in the 1970s — is a way of constraining government spending. TABOR limits revenue growth to the change in population and inflation. Any new taxes proposed by either the state or any local government would also take a popular vote. Passing these rules constrains government and limits their flexibility to act when economic circumstances change. Colorado voters passed an override this past November that suspends TABOR for five years.
Proponents say TABOR jump-started Colorado's economy while opponents say it ratcheted down spending in Colorado and, if left in place, would gut things like higher education and social services to keep spending within the limits. We found that TABOR hasn't led to sustained growth in either Colorado's employment or gross domestic product. This is important since another 11 states are considering a similar kind of restriction, with measures on the ballot this year in Maine, Ohio and Oklahoma.
The paper on California examines policy options available to help pay for new state infrastructure projects. California's roads are some of the nations most congested. The state has relied more on bond financing rather than pay-as-you-go spending, partly because it shifts spending costs onto future generations. This makes sense if what's paid for this way is going to be used by future generations. However, some of the governor's proposals earmark money to pay back debt that is currently being used to help fund maintenance. We suggest that, with new research technology, the costs of new projects can be tied to those benefiting from them.
State and local governments are doing some things reminiscent of the federal government. For instance, a few years ago California — even though it has balanced budget rules on the books — went to voters and asked for over $20 billion to pay for current expenses. This is mostly the exception rather than the rule: currently, states are still more constrained — and thus responsible -- than the federal government.
5. What are the crucial areas to watch in state and local policy?
The expenditure pressures faced by states, especially with challenges in raising revenues. We should watch health-care costs — since Medicaid costs will keep rising. Recently, Medicaid costs surpassed education spending as the largest share of state budget expenditures.
Also watch state and local retirement programs and pension liabilities. Unlike most private companies, states still have defined benefit pension plans, which guarantee a certain amount of benefits at retirement. But the benefit received is independent of the contribution — it's based on salary and the agreements the state makes. As more state and local employees start retiring, these costs will be increasing. Already, a number of states have run into trouble calculating what their responsibilities will be — increasing benefits when programs seemed flush with inflated revenues in the late 1990s.
On the tax side, we need to watch the composition of revenues. Property taxes helped support services in the last recession since they increased at the beginning of the millennium even as income tax revenues faltered. State income tax revenues have mostly recovered, but we should stay aware of how our tax systems are doing as economic activity changes. Sales tax bases have been eroding with increasing Internet and catalogue sales and a growing service sector. Figuring out how these tax systems will continue to perform and what changes will ensure the fiscal health of state and local governments over the next few years is key. We need to understand whether tax bases are eroding and what actions states should take to avoid structural deficits.
Currently, states are raising more money than they forecasted. Figuring out whether they're making smart vs. dumb decisions with this extra money is really crucial. When state budgets are flush, governments can cut certain taxes and increase certain services. Both actions can limit state flexibility after economic downturns. In the past boom, for instance, some states cut their vehicle license fee. Yet, when cash-strapped states went to reinstate them, they weren't able to — leading in California's case to the recall of the governor.