In September, 2009 Dr. Coleman released the white paper “State Government Finances: Outlook for New Jersey and Implications for Its Local Governments.” The paper provides an excellent review of the causes of the current crisis and its effect on local governments. The full text of the white paper can be found at www.njlmef.org/policy-papers.html. We have excerpted the Introduction and Summary and Conclusions sections here.
I. INTRODUCTION Economists Therese McGuire and Gene Steuerle have observed that “at least once a decade over the past 30 years or so, the economy has taken a downturn, and state revenues have failed to keep pace with state expenditures (1).” The recession of 2007 seems to be no different. The headlines from around the country tell the story:
Few, if any, states seem to have been spared. Center on Budget and Policy Priorities analysts McNichol and Lav explain, “some states have not been affected by the economic downturn…Mineral-rich states—such as New Mexico, Alaska, and Montana—saw revenue growth as a result of high oil prices. However, the recent decline in oil prices has begun to affect revenues in some of these states. The economies of a handful of other states have so far been less affected by the national economic problems (2).”
Moreover, there appears to be no immediate end in sight for this “worst-ever” crisis. This paper reviews the current fiscal conditions for state governments, how they have responded to the crisis, and a few policy options that may prove useful. The underlying interest is on the fiscal outlook for New Jersey and the implications for local jurisdictions in the state.
Balanced-Budget Requirements Most states operate on a fiscal year that runs from July 1 to June 30. Twenty-nine states operate on an annual budget and 21 on a biennial budget. Within the prevailing budget cycle, 49 of the 50 states (all but Vermont) are required to balance spending and revenues, although the nature of the balanced-budget requirement varies significantly. As observed by Brian Knight, Andrea Kusko, and Laura Rubin,
… the manner in which state governments must correct shortfalls in operating budgets depends on the requirements’ details, which vary substantially across states. These rules are either stated explicitly in the state’s constitution or are part of the laws of the state, and some states have multiple provisions that require a balanced budget. Balanced budget requirements can be placed into the following five categories, according to the state’s most stringent provision:
- governor must submit a
balanced budget—that is,
one that contains no projected shortfall (1 state);
- legislature must pass a
balanced budget (5 states);
- state must correct any shortfall in the next fiscal year (7 states);
- no carryover of shortfall
into the next biennial budget cycle (7 states); and
- no carryover of shortfall
into the next fiscal year
(29 states). (3)
When states encounter problems in generating revenues to match expected expenditures within their prevailing budget cycle, fiscal shortfalls (i.e., projected budget deficits) and a fiscal crisis result. These fiscal shortfalls generally reflect either a cyclical or a structural imbalance, or both.
Cyclical Versus Structural Imbalances (4) The nature of the fiscal crisis facing states varies by causes, severity, and appropriate policy responses. For example, the deficit confronting a particular state may be caused by downturns in the overall economy, which is called a cyclical deficit, or by more chronic long-terms disparities between revenues and spending, which is referred to as a structural deficit. In other words, a cyclical budget shortfall occurs when, during an economic downturn, state revenues fall while spending pressures increase. Revenues decline because personal income decreases, consumption by individuals and businesses decreases, and business profits decline, which combine to reduce the revenue yield for the state’s personal income, (general and selective) sales, and corporate income taxes, respectively. Spending increases because poverty and unemployment increase, which leads to increased demand for public assistance, housing assistance, healthcare assistance, etc. Cyclical imbalances are certainly a cause for concern, but they are generally felt to be temporary and will likely be reduced or eliminated as the economic recovery occurs. Budget reserves, including year-end balances and Rainy Day funds, coupled with special assistance from the federal government, can often cushion the impacts of cyclical downturns.
Structural deficits are said to exist when recurring revenues are not adequate to cover recurring spending needs. These deficits are considered chronic or long-term, and often reflect the fact that the state’s revenue system is not responsive to the need for more revenues as the demand for and costs of providing needed public services increase. Perhaps more importantly, structural deficits are believed to result because the tax or revenue system for many states has not adapted to reflect evolving economic, demographic, or technological conditions.
Of course, a state may suffer from either one or a combination of these budget deficits. Because of their chronic nature, structural deficits are considered to represent the more serious long-run threat to the state government. In 2005, Iris Lav, Elizabeth McNichol, and Robert Zahradnik summarized several recent studies which suggest that between 27 and 44 states, including New Jersey, were experiencing significant structural gaps in their budgets (5).
Primer: How Do State Finances Affect Local Finances? (6) As noted by economists Rueben, McGuire, and Kellam, “when tough economic times depress revenues at the top, jurisdictions at the bottom bear the burden (7).” This statement often seems to characterize the relationship between states and their local units.
There are several linkages between State finances and local finances, including State aid, State-mandated local spending, and fiscal controls on local revenue-raising efforts. The primary connection between state and local finances in New Jersey is through the property tax.
In New Jersey, there is not a single property tax, but rather a separate property tax for each jurisdiction that is authorized to impose the tax. The municipality is the property tax collection agent for all local government in the state, collecting from homeowners and businesses not only what is needed for municipal services, but also those imposed by school districts, counties, and other special-purpose local entities, such as library and fire districts.
In many other states, a property tax rate (often called a millage rate) is established and applied to the assessed value of property within the taxing jurisdiction. Things work a little differently in New Jersey where the amount (or property tax levy) that a jurisdiction needs to get from property taxes is the difference between how much the jurisdiction will spend and how much it can get from other, non-property tax sources—such as federal and state aid, fees and charges, interest earnings, the sale of assets, and so on. As such, property taxes in New Jersey are residual taxes. That is:
- Property tax levy = (local spending minus revenues available from
- Each jurisdiction, every year, comes up with a property tax rate, the
percentage of a home or business’ assessed property value that will go for taxes. The amount of money needed and the total property value in the local jurisdiction determine the tax rate in that jurisdiction, or:
- Property tax rate = (Property tax
levy ÷ Property value)
Any change that increases local spending and/or decreases non-property tax revenues will increase the property tax levy, all else being the same. If state aid or some other component of non-property tax revenues declines or simply fails to keep pace with the growth in local spending, upward pressures on local property taxes will result. Likewise, any decrease in property values, due (for example) to a reduction in the number of households and businesses or to an increase in the amount of property that is exempt from taxation, will reduce the size of the tax base and put upward pressure on local tax rates.
The state government in New Jersey influences the level and rate of property taxation in several ways. First, local spending is determined by the responsibilities that the state prescribes for local government. For example, to use a somewhat extreme example, if primary and secondary education was provided directly by the State government, as is the case in Hawaii, more than half of local spending responsibility would be removed. In a less extreme sense, if the State of New Jersey assumed a level of responsibility for financing public education similar to the average for other states (i.e., just over 50 percent versus the current contribution of around 40-42 percent), approximately $2 billion in local property taxes could be eliminated. More generally, where the State mandates that local units spend for specific services, it adds to the pressure for local property taxes and directly influences local finances
In addition to local spending, the State also influences local revenue. This occurs primarily in three ways. First, State aid is the largest source of other (non-property tax) revenue available to local jurisdictions. Indeed, all of the proceeds of the State’s gross income tax and a portion of the general sales and use tax are dedicated to property tax relief, including State aid. While school aid has grown significantly over the last 30 years, primarily reflecting court decisions on school-funding equity, much of that incremental aid has been targeted to a relatively small number of jurisdictions. Non-school State aid to counties and municipalities has failed to keep pace with local spending requirements over the years, although it should also be noted that the State also provides non-cash and other in-kind forms of assistance to local jurisdictions that also lessen the pressure to raise property taxes. Still, the level, rate of growth, and distribution of cash assistance from the State is a major factor affecting local jurisdictions.
A second manner in which the state influences local revenue raising is through fiscal controls over the types of revenue instruments available to local units. In New Jersey, 98 percent of local tax revenue comes from property taxation. In other states around the country, local jurisdictions have access to local-option taxes, especially on personal income and sales. While arguments could certainly be made that the property tax is much better suited for local revenue raising because of its stability and predictability as a revenue source, it remains a fact that local units in many other states have far more diversified revenue bases than is the case in New Jersey.
Third, so-called “caps,” or limitations on the use of the property tax, also constrain local revenue raising. Similar limitations are also imposed on the types of investments local jurisdictions can pursue with surplus revenues and on the fees and charges imposed by local governments.
Finally, growth management controls, affordable housing requirements, and property tax exemptions granted under the state constitution or statutes may limit the growth of the property tax base in some jurisdictions, thereby (ceteris paribus) imposing upward pressures on property tax rates.
In sum, the property tax burden in a given place relates directly to:
- The level and rate of growth of local spending
- The amount and distribution of state aid and other alternative
- Property values, which reflect both real and inflation-induced growth
Of course, State policies and actions may affect local finances in other ways, such as through requirements for binding arbitration, pension financing, and so on. Still, the property tax mechanism is the most direct and significant in New Jersey.
IX. SUMMARY AND CONCLUSIONS
A compelling case can be made that the future outlook for state finances does not bode well for local jurisdictions. This conclusion reflects the fact that the economic recovery may still be a ways off, and that state finances will not likely rebound for quite some time even after the recovery commences. Moreover, unless state revenue systems are modernized, they will continue to poorly serve state budgets. As seen by Adrianne Berman, “until the tax systems of local and state governments are fundamentally restructured, localities will be funded at the whim of the state legislatures and will be at their mercy during times of recession (65).”
Moreover, when these archaic revenue systems are combined with spending pressures that states will face during and after the fiscal crisis, budget shortfalls are likely to persist. This pattern seems to be emerging for New Jersey and other states around the country.
Indeed, in New Jersey (in the absence of court-ordered school funding assistance from the state), one can question how much of a state funding priority local jurisdictions have been over recent decades. New Jersey localities may well be firmly entrenched in what John Shannon has called the era of fend-for-yourself federalism.
*Affiliation is for purpose of identification. The author bears sole responsibility for the views and interpretations contained in this paper.
1. Therese J. McGuire and C. Eugene Steuerle (2003), “A Summary of What We Know---And Don’t---About State Fiscal Crises,” State Tax Notes (August 4), p. 357.
2. Elizabeth McNichol and Iris Lav (2009), “New Fiscal Year Brings No Relief from Unprecedented State Budget Problems,” Center on Budget and Policy Priorities (September 3), p. 4.
3. Brian Knight, Andrea Kusko, and Laura Rubin (2003), “Problems and Prospects for State and Local Governments,” State Tax Notes (November 3), p. 391.
4. This section draws heavily from Henry A. Coleman (2006), “State Government Finances: A Review of Current Conditions and the Outlook,” in Carl Van Horn (editor) The State of the States, fourth edition (Washington, DC: CQ Press), pp. 121-122.
5. Iris J. Lav, Elizabeth McNichol, and Robert Zahradnik (2005), Faulty Foundations: State Structural Budget Problems and How to Fix Them, (Washington, DC: Center on Budget and Policy Priorities)
6. This section draws heavily from Henry A. Coleman (2003), “Fiscal Stress: It’s Not Just a Big City Problem,” New Jersey Policy Perspectives.
7. Kim Rueben, Therese McGuire, and Susan Kellam (2007), “Navigating State and Local Finances,” Land Lines (October), p. 11.
65. Adrianne Berman (2009), “Can Local Governments Get through a Recession when State Aid Is Cut?” State Tax Notes (June 15), p. 905.
The article above was originally published in the January 2010 issue of New Jersey Municipalities Magazine