Creative Designs of the Patchwork Quilt of Municipal Finance

This paper by Michael A. Pagano examines different approaches U.S. municipal governments can use to deal with fiscal problems. Based on a historical analysis of general municipal revenue patterns from 1942 to 2002, he suggests different scenarios for urban fiscal policy. Property taxes were the main source of municipal funds in the early 1940s, accounting for over half of total revenue. Their importance decreased in the next 30 years as cities diversified their tax bases to include retail sales taxes and received large amounts of federal funding for urban renewal.

The declining share of property taxes in total revenue continued in the 1970s, with the tax revolt adding additional pressure on cities to shift to alternative revenue sources. Federal aid also decreased in the late 1970s following the oil crisis and the stock market crash. With the decline of these two revenue sources, incomes generated from user fees and public enterprises provided the key funding for municipal services and infrastructure. By 1982 user fees and charges were nearly 40 percent of total general funds, whereas property taxes and intergovernmental transfers were only 17 and 27 percent, respectively. The general revenue pattern for municipalities remained stable from the early 1980s on, with user fees and charges as the largest source of municipal revenue. This general trend notwithstanding, Pagano argues that it is difficult to design a single fiscal solution for all U.S. cities due to their heterogeneous fiscal structures. Some cities rely on just one tax source, while others depend on two or three different taxes to finance local services.

In reviewing approaches that cities may use to handle their budget deficits, Pagano asserts that the property tax might not act as a countercyclical revenue source in this recession because, unlike during other economic downturns, collections will decline. The slowdown of real estate markets that began in 2007 has caused decreases in property tax collections since fiscal year 2008, given the lag in tax assessments. If real estate markets do not recover in 2010, declining housing values will continue to reduce property tax revenues until at least 2011. This trajectory is problematic for cities because sales and income tax receipts also decreased in fiscal year 2009 and may continue to fall in 2010.

With projected reductions in tax revenues, some cities may increase their charges for local services. Pagano argues that user fees face less public resistance because their collection method is based on consumption, and they are thus perceived to be efficient and equitable. Pagano also believes that cities should explore the possibility of regional tax-base sharing such as common-pool funds for neighboring jurisdictions. His other proposals include (1) broadening the sales tax base to include services; (2) restructuring the property tax from a uniform to a split-rate system; (3) focusing on tax bases that have closer links to the local economic base; and (4) collaborating with regional partners to minimize adverse effects of interjurisdictional tax competition and spillovers.

This paper was presented at the Lincoln Institute’s Land Policy Conference of 2009 and is Chapter 5 of the book Municipal Revenues and Land Policies.