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Coping With Fiscal Shocks: Are Small Municipal Governments Masters of Their Fates?

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Rebecca Hendrick
January 12, 2020

Local governments provide an array of services to residents and businesses within their boundaries. But while a great deal of attention is paid to the big cities, smaller townships, counties and special purpose governments are hugely important as they provide a substantial portion of services provided by all local American governments.

According to the 2017 Census of Government, there are 14,722 municipalities with populations less than 5,000 and 12,646 with populations less than 2,500. There are only 754 municipalities with populations greater than 50,000 and only 302 with populations greater than 100,000.

Furthermore, approximately 135.2 million people reside in localities with population less than 5,000 and unincorporated areas compared to 124.4 million people in municipalities with populations greater than 50,000 and 92.8 million with populations greater than 100,000.

These entities are particularly important for delivering sufficient and necessary local services that protect the health and safety of their residents and visitors. In order to achieve these objectives, however, they must have good fiscal health and the ability to respond successfully to fiscal shocks, such as the Great Recession and the current COVID-19 pandemic, which reduce revenue and increase the need for more spending.

But small municipalities and townships with populations of less than 5,000 are fundamentally different from larger governments with respect to financing and financial structure. These differences more greatly constrain small governments compared to large governments in both revenues and spending, which make small governments more vulnerable to the effects of fiscal shocks and also the actions of state government.

Based on calculations using data from the 2017 Census of Governments, the median operational expenditures for governments with populations less than 5,000 is only about $529,000. The median percentage of total revenue that is intergovernmental is 22% for these governments, but it is only 15% for municipal governments with populations greater than 50,000. This means, of course, that the smaller governments are far more at risk for cutbacks of state or federal dollars.

The percentage of own-source revenue that comes from general and selective sales and property taxes is 14% and 46% respectively for small governments but 27% and 38% respectively for large governments. Similarly, the median value of charges for non-enterprise services in small governments represents 12% of own-source revenues as compared to 18% in large governments.

Other revenue (licenses, fees, fines and other taxes) as a percentage of own-source revenue is 2.9% for small governments and 6.5% for large governments. Consistent with these figures, revenue is also much less diversified in small governments. To summarize, municipalities with populations less than 5,000 depend more on property tax and intergovernmental revenue (grants and shared revenue) and less on other sources of revenue than municipalities with populations greater than 50,000.

We know from research and professional associations that governments that experience fiscal shocks need slack resources, such as fund balances to replace lost revenue or increased spending in the short run until the shock passes. If the shock is severe or long-term then governments must make more obvious and disruptive changes to revenues and service delivery. In this case, governments need flexibility to adopt new sources of revenue and increase rates of existing revenue.

Unfortunately, flexibility in operational spending is often not possible in small governments. Other things being equal, large governments have greater capacity to adjust revenues and spending than small governments in response to long-term fiscal shocks and actions from state government.

For the most part, small municipal governments, especially ones that are not in metropolitan regions, have fewer options for coping with fiscal shocks. These governments have fewer slack resources compared to large governments with sizeable workforces, significant capital expenditures, more assets to leverage and exploit and so on.

Although small governments compared to large governments build higher fund balances relative to total spending to compensate for fewer slack resources, most small governments simply do not have the flexibility to lower spending without jeopardizing service delivery. Small municipalities also do not have the level of commerce found in large municipalities that provides more opportunity to levy sales taxes and increase the variability of revenue sources.

Most local governments in the United States are subject to property tax. Because small governments rely more on property tax and intergovernmental revenue than large governments, they have less control over a large share of their revenue. Although the greater reliance on property taxes for small governments means that their revenue is likely to be more stable than large governments, property tax limitations, state spending mandates and reductions in shared revenue and grants to municipalities will have a greater effect on small governments than large governments.

Ultimately, the options available to small governments to adjust to fiscal shocks are somewhat more limited than large governments. Small governments, to put it simply, are not masters of their own fates and are forced to deal with that unfortunate status on a regular basis.

Author: Rebecca Hendrick, Professor Emeritus, Department of Public Administration, University of Illinois, Chicago and Faculty Panel Member, Government Finance Research Center

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