Understanding a City’s Fiscal Base

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

By Yonghong Wu and Michael Pagano
January 8, 2020

Once rooted in the value of land and structures, municipal revenue systems have gradually changed. In most cases, the change has disconnected the fiscal system from the economic base.

Unfortunately, use of the now conventional indicators are not a good measure of a city’s revenue capacity because no city’s economic base is fully accessible to the municipal government for revenue-generating purpose. The ability to transform its economic base into government revenue depends on the types of legal taxing authority and the impact of state-imposed constraints on revenue. 

Therefore, we propose the concept of fiscal base, defined as the economic base that is tax accessible to a city government. This definition not only reflects the connection of economic condition to revenue-raising potential, but also incorporates the restrictive nature of relevant state laws on municipal access to various revenue sources. The fiscal base concept sheds light on how to reform state-imposed legal and institutional constraints to allow a better alignment between municipal revenue structure and the economic base that is necessary to modernize city finances in the face of changing economic conditions.

The subject of our research is how large the disconnect has become. We propose aggregating the three components of a city’s economic base—value of properties, value of retail sales and personal income—and then calculating the share of each component in the aggregate economic base. We also calculate the share of municipal property tax, sales tax and other own-source revenues in total own-source revenue. (Most city governments are authorized to levy taxes on real properties while more than half can collect a retail sales tax; but only approximately one in ten cities has the authority to levy an income tax). The deviation of the share of a broad-based tax from the share of its tax base is an indication of misalignment between the tax revenue and its base.

The 2010 data show quite substantial differences between the share of a particular tax and the share of its base. In Colorado Springs (CO), for example, the value of properties is 63% of its aggregate economic base, but the local property tax only contributes 2.6% of total own revenue. A similar pattern of misalignment exists with local sales taxation. Some cities have high shares of the value of retail sales (above 20% in Fort Wayne, IN and Jackson, MS) but very low shares of sales tax revenue (0.5% in Fort Wayne and 6% in Jackson) in 2007.

In some cities, the shares of municipal property or sales tax revenue (of own-source revenue) are below the shares of the respective tax base (of total economic base). In other cities, the tax shares are larger than the shares of the base. We call the former under-alignment cities and the latter over-alignment cities. It is noteworthy that the revenue-base misalignment demonstrates a fairly high degree of substitution. The over-alignment (under-alignment) of property tax is often accompanied by under-alignment (over-alignment) of sales tax. Cities with larger differences between the share of property tax revenue and the share of property tax base are quite likely those with smaller differences between the share of sales tax revenue and the share of sales tax base. The correlation coefficient between the two share differences is over 0.6 and significant at the 5% level.

The misalignment of a tax system with the underlying economic base has important implications for municipal finance. The contribution of each economic base to municipal revenue depends on the tax structure. For municipal governments, misalignment means that they either under-utilize or over-rely on a particular tax. In the case of under-alignment (under-utilization), municipal governments have foregone a substantial portion of their tax revenue potential. For instance, a substantial growth of property values matters more for cities that collect a larger proportion of their own-source revenues from property tax. A big increase in personal income may not help if a city collects little revenue from individual income tax. On the other hand, over-alignment (over-utilization) may create an undue burden on a particular group of taxpayers because they pay more than is proportionate to their share of the economic base.

Even a city that is granted the legal authority to tax a particular base may be subject to state constitutions or statutes that impose limits on the tax rate, tax base or tax levy. For example, under Proposition 2, the total property tax levy by a municipal government in Massachusetts can never exceed 2.5% of the assessed value of all taxable properties in its jurisdiction and cannot grow more than 2.5% from year to year. The legal limitations and underlying political forces have led to municipal revenue structures that have gradually become disconnected from their economic bases.

The substantial gaps between the share of tax revenue and the share of its tax base reflect varying accessibility to different components of economic base for municipal revenue. The extent to which a city’s economic base may become tax accessible to a city government depends on state regulations on municipal taxing authorities and a variety of statutory restraints on the quantity and growth of the tax revenue. As creatures of state governments, cities’ revenue structures are largely determined by state governments and the degree of home rule the cities possess. As states appreciate the misalignment between cities’ fiscal bases and their economic bases, adjustments to tax authority ought to be a high priority for the state. They certainly are for the city.

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Authors:

 Yonghong Wu is Associate Professor in the Department of Public Administration at the University of Illinois at Chicago (UIC) and a member of the Government Finance Research Center’s faculty advisory panel. His research focuses on state and local fiscal policy-making and public finance issues in science and technology policy arena.

Michael A. Pagano is Dean of the College of Urban Planning and Public Affairs at UIC and Director of the Government Finance Research Center.

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