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Article Excerpt
INTRODUCTION
Fiscal disparities among parallel governments--municipalities within a state or states within the nation--represent a policy concern when the overlying government (state or nation) has an interest in levels of services and/or tax rates across its subdivisions. According to Yinger (1986), "fiscal disparities exist when some cities can provide a given level of local public services at lower cost or at less sacrifice than can other cities." In Massachusetts, residents are served by 351 mutually exclusive and exhaustive cities and towns; each municipality is responsible for the entire range of common local services, including schools, police and fire protection, public works, human services, libraries and recreation, etc. (counties and other overlying sub-state governments are virtually nonexistent). This very local character of city and town government makes Massachusetts prone to substantial inter-jurisdictional fiscal disparities. As other research indicates and as we show below, both the environment in which these services are produced and the resources available to finance them vary markedly across municipalities in ways that affect the cost or tax burden involved in providing common services of average quality. The resulting fiscal disparities lead to inequity and inefficiency, which are mostly outside the control of local governments (Yinger, 1986). Previous research suggests that the overlying government may counteract such disparities and improve social welfare through intergovernmental aid (e.g., Bradbury, Ladd, Perrault, Reschovsky, and Yinger, 1984; Yinger, 1986), and Massachusetts state government has a history of providing general-purpose municipal aid, in addition to earmarked school aid.
Partly because increases in state aid were concentrated on public schools during the 1990s and partly because state budget cuts during recent economic downturns have reduced non-school aid and generally made it unpredictable, cities and towns in Massachusetts are under considerable fiscal strain. In recent years, many communities instituted layoffs and cut services, and many raised property taxes (see Municipal Finance Task Force, 2005; Bluestone, Clayton-Matthews, and Soule, 2006). Because the two existing general-purpose municipal aid formulas are viewed as being unresponsive to communities' needs, (1) policymakers are exploring alternative formulas for distributing non-school aid.
Formulas to allocate local aid in most states-whether for schools or for general municipal purposes-typically distribute funds in inverse proportion to each jurisdiction's ability to raise revenue locally (that is, local revenue capacity) and/or in proportion to its needs or costs. (2) The revenue-capacity side of the calculation typically takes account of the size of the tax bases that local governments are authorized to tap. The cost/need--side is generally extremely simple or ad hoc, often using population alone (or enrollment in the case of school aid) to represent need. Our research develops new measures of both elements to reflect more accurately the realities and constraints of local government in Massachusetts.
To improve the measurement of revenue capacity, this paper focuses on accounting for the constraints of a tax limitation, for the first time in the literature. We incorporate the effects of Proposition 2 1/2--the local property tax limitation in Massachusetts--in our measure of local revenue capacity. Proposition 2 1/2 caps property tax rates and limits year-to-year growth in property tax revenues of each city and town, but allows local voters to override the growth limits. Because Proposition 2 1/2 differentially limits individual cities' and towns' ability to generate revenue from their property tax bases, many local officials argue that the existing lottery aid formula, which distributes aid in inverse proportion to communities' per capita property tax bases, is unfair. On the other hand, Proposition 2 1/2's annual levy limits cannot be treated as exogenous binding constraints because local voters can, and in many communities do, override them. Our research uses data on recent taxing patterns to develop a measure of the effects of the constraints on local property taxation--a measure not in the control of local officials or local voters--and uses that measure to adjust the size of the local property tax base in measuring revenue capacity. Also different from the standard approach, in which revenue capacity depends only on the size of the property tax base, our measure of revenue capacity takes account of the ability to raise revenue from other (non-property-tax) local sources. In addition, we explicitly remove the capacity not available for general municipal (non-school) purposes such as the funds the state government requires communities to dedicate to public schools.
On the cost side, unlike previous studies of either total spending or school spending, our research focuses on non-school spending. Following Bradbury et al. (1984), Yinger (1988a, 1988b), Ladd and Yinger (1989), and Ladd, Reschovsky, and Yinger (1991), (3) we use regression analysis and recent data to quantify the relationship between local non-school spending and environmental cost proxies that are outside the control of local governments, such as population density and commuters per capita. Our regressions also control for demand, efficiency, and institutional factors that influence spending.
The difference between these measures of municipal costs and capacity for each community represents a new measure of non-school fiscal "gap," which can provide the basis for a new aid formula to channel more aid to communities with larger gaps. For such a purpose, the measures of costs and capacity must be predetermined-not in the immediate control of local governments; otherwise, the formula would reward communities that are inefficient or put less effort into raising revenue, and would create incentives for local officials to change behavior in ways that increase the amount of aid-by adding to measured costs or reducing measured capacity. This search for predetermined--and still relevant--indicators is a critical challenge in measuring both costs and capacity. As discussed below, the estimates that are produced by our methodology may be subject to some of the same biases seen elsewhere in the literature. But Louis, Jabine, and Gerstein (2003) argue that developing rational and systematic estimates of cost and capacity, even if they are flawed, is still preferable to the ad hoc adjustments adopted in most formulas used to allocate intergovernmental aid.
LOCAL REVENUE CAPACITY
Local revenue capacity is defined as the ability of local governments to raise revenues from local resources. It should, therefore, reflect resources local governments could tax, not actual revenues raised, because local governments can choose to tax local resources at different rates. In addition to the relative wealth of resources that local governments can tap, a measure of capacity should also reflect external constraints on raising revenues from those resources, such as tax limitations or outright prohibition of specific revenue sources. The Advisory Commission on Intergovernmental Relations (ACIR) developed an approach to measuring revenue capacity called the "Representative Revenue System (RRS)" (ACIR, 1962, 1971, and 1986). RRS assigns a standard tax rate to each tax base of all local or state governments, so that the measured revenue capacity from taxes is strictly proportional to the size of the tax bases and does not depend upon how heavily they are actually taxed. This approach is widely used in measuring local revenue capacity, in particular, as there are usually no institutional differences among local jurisdictions within a state, which would make inter-community comparisons difficult.
Property taxes are often the largest source of local revenues. In most states' local aid formulas--including the lottery aid formula in Massachusetts--property tax capacity is measured as a constant proportion of the property tax base using a standard RRS approach. An important assumption underlying this approach is that all cities and towns can tap into their property tax base to the same degree. However, this assumption may not hold in states with local property tax limitations. If cities and towns face differential impacts of local tax limitations, then they are able to tap into their property tax base only to varying degrees. In a survey of existing general--purpose local aid formulas of the 50 states conducted in the spring of 2006, we found that none incorporates the constraints of local tax limitations in their measures of local revenue capacity.
Proposition 2 1/2, enacted by referendum in 1980, limits local property taxes in Massachusetts in two ways (Massachusetts Department of Revenue, 2005): (1) in the first three years after its enactment, it brought all municipalities' property tax rates down to 2 1/2 percent of the estimated market value of their property tax bases and permanently capped them at 2 1/2 percent (this rate limit is called the "levy ceiling"), which voters are prohibited from overriding except temporarily via capital or debt exclusions; (2) it set a "levy limit"--a limit on the annual property tax levy (that is, total property tax revenues)--that rises by only 2 1/2 percent per year plus an allowance for taxes on any value added to the tax base by new construction and substantial renovation ("new growth") plus overrides that local voters enact. Votes to override the growth limit raise the levy limit permanently, adding to the base to which the next year's automatic 2 1/2 percent growth rate is applied. The provisions of Proposition 2 1/2 for community i in fiscal year t can be represented as
[(property tax levy).sub.i t] [less than or equal to] min[((levy ceiling).sub.i t'] [(levy limit).sub.i t))],
[(levy ceiling).sub.i t] = 0.025 [(taxable property value).sub. i t']
[(levy limit).sub.i t] = 1.025 [(levy limit).sub i t-1]
+ [(new growth).sub.i t] [(property tax rate).sub.i t-1]
+ [(overrides).sub.i t].
The 2 1/2-percent tax-rate levy ceiling was binding in the early years of Proposition 2 1/2, but its importance has significantly decreased as a result of substantial growth in property values. By contrast, limits on levy growth remain important for many cities and towns in Massachusetts, with FY2006 levies in almost half of the 351 cities and towns within 0.1 percent of their levy limits, and over two-thirds within one percent. (4)
With levy limits as the relevant constraint in many cases, the simplest approach to incorporating Proposition 2 1/2's constraints into a measure of property tax capacity would seem to be to set the capacity measure equal to the levy limit. However, the levy limit includes overrides, which some communities manage to propose and pass, loosening the constraints, while others do not; some local governments, perhaps believing that they have no chance of passing an override, have never put one on the ballot. Thus, the levy limit, which appears at first blush to be an exogenous binding constraint, is not exogenous, and because of these differential impacts of Proposition 2 1/2, the ability of cities and towns to tap into their property tax bases varies. (5)
To model the ability of cities and towns to tap into their property tax bases under Proposition 2 1/2, we hypothesize that the ability increases with local residents' income. The intuition behind the hypothesis is grounded in consumer theory. Local residents in each community have limited incomes and face household budget constraints. They choose between publicly and privately provided goods and services in order to maximize their utility. Their income levels, thus, constrain their ability to pay for local public goods and services, and thereby influence their willingness to subject themselves to increased property taxation to support those services.
This hypothesis is consistent with observations in previous studies. Bradbury (1991) and Reschovsky and Schwartz (1992) find that Massachusetts communities with lower per capita incomes are less likely to propose overrides than those with higher incomes, other things being equal. Bradbury's analysis finds an even larger effect of income on the probability that an override will pass. In addition, Bradbury (1991) and Reschovsky and Schwartz (1992) show that a community's override choice depends on its preferences and "tastes"--which affect the demand for local public services--and on other community characteristics that determine the distribution of public spending benefits.
Combining their research findings and our hypothesis suggests that whether a community passes an override in a given year can be seen as a function of income as well as other factors. Income then enters the property tax levy equation, via its effect on override passage, reflecting the greater "ability to tap" the property tax base that overrides represent:
((property tax levy).sub.it = [g((taxable property value).sub.i t']' [(income).sub.i t'] [(taste variables).sub.i t'] [(distribution variables).sub.i t]).
Based on this model, we empirically investigate the relationship between income and property tax levies across Massachusetts cities and towns in 2000 in order to judge whether income might proxy for the ability of individual communities to tap into their property tax bases after operating under the constraints of Proposition 2 1/2 for almost 20 years. If so, because income (like the property tax base itself) is predetermined from the point of view of each local government at any point in time, it could be used to adjust the size of the local property tax base in measuring (constrained) property tax capacity.
One might question the exogeneity of either income or the property tax base in the equation, because when there are many geographically small local governments, as in Massachusetts, households and businesses may choose to locate in cities and towns with the local property tax rates that they prefer. Although "Tiebout sorting" may occur in the long run, it seems unlikely to be an important factor in the current context for several reasons. First, Yinger (1986) shows that mobility between adjacent communities and migration among urban areas--even with their associated housing price adjustments--do not eliminate fiscal disparities, including those related to capacity differences. Second, even if some location responses do occur, it is still the case that at any point in time, the income and the size of the property tax base--and, hence, a community's ability to raise revenue--are outside the control of...
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