Tax Limits Can Erode Local Fiscal Resiliency

Local governments play a critical role in daily American life, providing essential services such as responding to emergencies, maintaining and improving infrastructure, and supporting the economy. These important functions, and their costs, have been underscored during the pandemic.

As a result, it’s become increasingly important to understand the ways in which local government revenues  can be constrained by state limits on local tax collections. A state may prohibit its cities and counties from levying a tax entirely; alternately, it may restrict the tax rate, tax base, or total taxes collected. Many local governments face multiple constraints.

Our research at The Pew Charitable Trusts shows that although tax limits are often designed to benefit individuals and businesses by curbing high tax growth, some limits can impair the ability of local governments to manage fiscal crises and meet the needs of residents. Because the consequences for local budgets and local communities can be harmful and long-lasting, we offer several strategies for states to consider to increase local fiscal flexibility now and in the long term. This added flexibility may be critical if the pandemic continues to reshape the economy and affect local revenue sources—for example, by accelerating the shift to remote work and changing the landscape of commercial real estate.

Local tax limits can hamper recession recovery and long-term fiscal stability

Certain tax limits can prevent revenue from fully rebounding after a recession, leaving it at an artificially low level even as the economy recovers. This so-called “ratchet-down” effect can continue to damage a locality’s tax base over multiple business cycles.

Michigan provides a good example. After property values in the state fell dramatically during the Great Recession, property tax revenue struggled to recover under the state’s limits even as real estate values rose. As a result, in 2019, some Michigan communities still had not seen property tax revenue return to 2008 levels.

There are other ways that local tax limits can prevent revenue growth from keeping up with service demands as economic conditions change. A New York law that took effect in 2012 restricts local property tax revenue growth to the lesser of 2% or the previous year’s inflation rate. When inflation fell to a fraction of 1% a few years ago, local officials were forced to override their property tax cap to keep up with their communities’ day-to-day needs, including garbage collection and park maintenance. Conversely, now that inflation is the highest it’s been since 2008, these localities may struggle to keep up with rising costs.

During a statewide period of rapid economic growth, Wisconsin capped annual property tax revenue increases at the rate of new construction (the value that construction adds as a percentage of total taxable property). But the Great Recession ended the construction boom. Years later, the nonpartisan, independent Wisconsin Policy Forum found that for more than 60% of cities and villages in the state, the average rate of new construction from 2012 to 2017 was 1% or less—lower than the inflation rate for most of that period.

The continual challenge of having reliable revenue sources to pay for ongoing expenses can take a toll on communities over time. Faced with a narrow set of revenue options, local leaders may have to make permanent service cuts that reduce a community’s quality of life, which can drive residents away and further erode the local tax base—creating a vicious cycle that’s hard to break.

States can consider steps to increase local fiscal flexibility

The needs of local communities vary greatly, so—to identify ways to give local officials more flexibility in serving their residents effectively—states would benefit from evaluating the constraints they place on their local governments.

We recommend that state lawmakers consider the following strategies:

1. Temporarily lift tax limits, thus giving local officials more options for responding to extraordinary fiscal challenges.

   States can temporarily lift revenue restrictions on a case-by-case basis, or in reaction to a recession or natural disaster. For example, New Jersey Governor Phil Murphy signed legislation in August 2020 to allow the state’s local governments to borrow for pandemic-related expenses and back those bonds with property taxes that are not subject to the state’s tax limits.

2. Adjust limits that may prevent revenue from fully recovering after a downturn.

   Limits are meant to curb the long-term growth of revenue and spending. But revenue growth following a recession helps cities and counties rebuild their budgets and reverse cuts to the services residents expect. After a recession, states should allow the pace of economic recovery—rather than an artificial cap—to determine if and when revenue returns to pre-recession levels.

3. Increase local budget flexibility in the long term.

   States can grant more flexibility to their local governments in various ways other than modifying tax limits. Many localities must, by law, adopt their state’s sales tax base. States can consider opportunities to better align that tax base with changes in the economy, however, which would boost both state and local revenue. Of the 45 states that have a sales tax, 44 can now tax online retail, which has been a boon during the pandemic. States can also permit and support partnerships between local jurisdictions to jointly deliver services, which could help localities ensure service quality and even save money.

Healthy, resilient local governments benefit states and residents

When state constraints on revenue collections leave local governments struggling to provide vital services, residents pay the price. States can take an important step in supporting their cities and counties by evaluating the effects of local tax limits and considering ways to give local leaders more tools for ensuring fiscal resiliency. Additional flexibility may be especially important now, so that localities can adapt to the pandemic’s potentially lasting impacts on the economy and on their tax bases.

Jeff Chapman is a director and Alexandria Zhang is an officer with The Pew Charitable Trusts’ state fiscal health initiative. This piece was originally published by the Government Finance Research blog on August 23, 2021.