Local governments face budgetary dilemmas, paper warns.(News & Numbers)(Report)

Looming budgetary pressures mean a "pessimistic" outlook for local governments, according to a recent working paper written by economics professor Richard F. Dye for the Federal Reserve Bank of Boston's New England Public Policy Center. Dye recommends responses such as identifying alternative revenue sources and making adjustments to state aid formulas.

The largest sources of revenue for local governments are state aid and property taxes. Dye notes in the paper that these sources are linked "because state aid formulas usually take the capacity of local governments to collect property taxes into account. They are linked implicitly because local officials look first to state aid, which comes to them at lower political cost, and second to property taxes, which their constituents remind them are painful." Local policymakers cannot control state aid, however, while they do generally have some choice in setting the level of property taxes.

Of the average $3,914 per capita local governments collect in a year, intergovernmental revenue from federal and state government comprises 38.9 percent, based on U.S. Bureau of the Census figures for 2005. Another 38.6 percent comes from taxes--mostly property taxes, at 27.8 percent.

The amount of tax revenue collected fluctuates as economic changes affect income and consumption, the paper notes. When state tax revenue declined after the recession in 2001, one of the ways states responded to fiscal pressure was by cutting aid to local government, or restricting increases. Some local governments appear to have responded to this strain by increasing property taxes: "In almost half the states, real state aid per capita fell from 2002 to 2004, and real property tax collections per capita increased over the same period, with only a few exceptions," the paper says.

At the same time, the same demographic and health-care cost pressures that threaten federal budgets will also affect state and local governments, Dye notes in the paper. No one is predicting a decrease in health-care costs, which have been rising farther than other costs for some time. In addition, people are living longer, which means they will collect benefits over a longer timeframe. And the baby boomer generation is about to start retiring, while lower birth rates mean there will be fewer people to support retirees through output and taxes. In addition, many states provide property tax relief to retirees, which will affect state tax collections as the population ages.

"We can look at the recent past and expect continuing pressure for states to 'do something' to help local governments maintain services and keep property taxes from rising by increasing state aid," Dye says in the paper. Given the increasing economic and demographic pressures on state budgets, however, municipal governments cannot count on state grants-in-aid to ease their own situations. "Local governments are going to have it hard," he concludes.

The full paper is available at http://www.bos.frb.org/economic/nepp c/wp/2008/neppcwp0801.htm.

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