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Local Finance

Local Finance

Types of arrangements

Financing of local debt


Local governments and their financial structures have been subjected to heavy strains by the rapid population growth, urbanization, industrialization, and centralization of the past century. A local government is usually constrained by limited territorial jurisdiction, restrictions on the functions it can perform, ceilings on the amount of permitted taxes and debt, and restrictions on sources of revenue. Not only is its freedom limited, but often most of its actions are ordered, and its behavior then supervised, by the central government. It is no surprise that under these conditions local governments have responded sluggishly to the great technological and institutional changes of the past century. Few generalizations can be made about local finance, since each nation has a different constitution and each has many types of local governments; but one statement which holds for most of the world is that local governments have become weak relative to central governments.

The most common argument explaining the relative decline of local government is a financial one. It is asserted that the most tax-productive bases are pre-empted by central governments and that it is not feasible for a local government to raise its taxes, since industry and persons will respond by moving to other locations. This is far too simple. Throughout the world, localities can be found with almost every type of tax, and the burden of local taxes is highly variable among nations. The tremendous variation in behavior casts doubt on statements of necessary relationship. Localities do have greater financial problems than do central governments, but solutions that enable the localities to be vigorous and relatively autonomous are available. The relative decline of local government has been accompanied by a refusal fully to exploit purely financial solutions to problems, and it indicates that nonfinancial factors are more significant.

Among nations, the United States has one of the most active sets of local governments, but even in the United States the ratio of federal expenditures on civilian activity to state and local expenditures doubled in the first half of the twentieth century. Despite this relative decline of local governments, in absolute terms local governments have grown greatly in importance. In 1902 local expenditures were less than $900 million, and by 1964 they were over $45,000 million in current dollars. State expenditures increased even more dramatically, from $134 million in 1902 to $24,275 million in 1964. Per capita state and local expenditures increased from under $13 in 1902 to over $360 in 1964. These growth figures are dramatic, but they are accompanied, though to a lesser degree, by the world-wide phenomena of an outright transfer of some functions to central governments and of a shift of financial support to central governments, with a consequent absorption of authority by the central governments.

Given the wide range of experiences in degrees of centralization, any simple set of hypotheses would most likely be wrong. Unfortunately, there has been very little research in comparative local finance, so that sophisticated arguments are not available; therefore, we will have to be satisfied with rather general explanations of the relative decline of local government and finance.

Local government, like the horse and the candle, has been the victim of technology. High among the list of significant technological breakthroughs have been the transportation and communication revolutions, which have greatly reduced spatial costs. While these innovations have completely changed industrial structures, have made markets national and international in scope, and have made resources, as well as production centers, highly mobile, local governments have remained fixed in spatial jurisdiction.

The increase in the size of input and product markets has resulted in a great increase in the number of local governments that can affect the efficient operations of the markets. A system of roads can be crippled by poor design of one part, or inadequate education in one area may mean a poor labor force for another area to which the population moves. Therefore, the supply of inputs or the market possibilities of a firm in a city may be strongly affected by the behavior of many distant local governments which it cannot directly influence. Mass-production, standardized industry expanded throughout the nation, while local governments remained fixed. It is not surprising that pressures were strong to create uniformity of tax treatment and of public services in the various parts of the nation—a reasonable uniformity which has been effected by transfer of functions to central governments and by central subventions to local governments.

The goal of uniform public service throughout the nation is not restricted to those services which are inputs to industry; it extends to products going directly to households. Uniformity in consumption of public services would not necessarily lead to centralization, were it not for a second major factor. Fiscal resources are not uniformly distributed among local jurisdictions. If localities were to apply similar tax structures to their economic bases, very different yields would result. If they sought to vary their tax systems in order to realize some-what equal per capita yields and similar levels of public services, they would have highly variable tax systems. This would have the undesirable consequences of complexity in taxation and nonuniform treatment. The latter might encourage mobile resources to move elsewhere to find another structure that might not tax them as severely. Achievement of uniformity in service without too much variation in tax structure requires the transfer of financing to a central government.

The simplest and most adaptable response of government to the changing economy is the design of a central administrative agency which can establish operational rules independent of past conventions and responsive to the new set of needs. This response has been the most common. The transfer of functions to a central government means a centralization of authority, control, and finance; but administration may be as widely dispersed as the pattern of local governments, or it may take an entirely new organizational form. From the point of view of attaining the most effective government response to the need for public services, this total centralization may be best; but the less radical solution of attempting to work through existing local governments is often adopted. Despite the relatively greater growth of the central administration, local administration is still important and probably will remain so, especially in the United States, where the vitality of local government follows from the constitutionally imposed federal structure and from the structure of political parties, which have their strong base in state and local governments.

Types of arrangements

The nations of the world have invented many financial arrangements by which to support local governments; these arrangements can be ordered into a few categories.

Local taxes on differentiated bases

In the United States the major illustration of a separate tax base is the property tax. The federal government makes no use of the property tax, and state governments have been reducing their use of the tax. Some local governments, especially single-purpose districts like school districts and irrigation districts, are restricted to the property tax. Although the property tax is still the principal support of local government, it has declined in importance; its base has been progressively narrowed as more types of property have been removed from the base and other sources of support have been introduced.

Local reliance on the property tax is not uniform. The average property tax rate for the United States was estimated to be 1.4 per cent of market value of locally assessed property in 1962, but this varied from 2.7 per cent in Massachusetts to 0.5 per cent in South Carolina. Comparable variation exists in the percentage of local government revenues collected from property taxes.

Although property taxes have become relatively less important, their role as the distinctive local tax has resulted in extreme pressure to increase the property tax yield because of the increased demand for local services brought about by the rapid increase in urban population, especially in the number of schoolage children. Although the demand for public services and property tax yields have increased, property tax payers have energetically sought to reduce their taxes through political action.

One way to reduce the property tax has been to introduce other financial sources, and these will be discussed below. Another way has been to limit the freedom of the local government in the use of the tax. This has taken the form of rate limits imposed by the state governments and of an erosion of the base through exemptions and poor administration. The property tax payer has been able to utilize his political power in the state capital to restrain local finance in one direction, but this has resulted in tax expansion in other directions.

Another political response to the increase in property taxes has been the adoption of fiscal profitability as a criterion for many local public policies, such as zoning, subdivision control, public facilities planning, and annexation.

In considering alternative land use developments, the local authority’s analysts compute the property tax yields and the public expenditures associated with each alternative and then adopt the alternative with the maximum difference between property tax yields and public expenditures. Sometimes the analysis is more sophisticated, involving consideration of all the revenues to the local government and all the local expenditures requiring local finance. The results of the analysis almost always show low fiscal profitability in residential use by low-income families with schoolage children and high fiscal profitability in industrial use requiring few transportation services, or in residential use by high-income families with few children. The outcome might be to encourage the development of clean industry and the residence of its executives and to discourage the workers employed in the plants from living in the area. Competitive behavior by all of the localities in the area would be self-defeating; on the other hand, if only a subset of the local governments adopted the criterion of fiscal profitability, then the entire area would develop inefficiently. Workers would travel longer distances, industry might not be optimally located, and so on.

The separate tax base does have the virtue of encouraging independent government, and certainly it has permitted American local government to be viable; but it has meant some loss in the efficiency of the operations of metropolitan areas. Although this separate (property) tax base is not likely to disappear, its role will decline because of the many defects of the tax per se and because of the endemic difficulties of independent financing of local governments.[seeTaxationarticle onProperty Taxes.]

Shared bases with separate levies

Two types of base sharing are practiced. One form is that of complete independence between the levels of government; the bases need not be identical and the rates are independently determined. In the second type the base is identical, although rates may be independently determined, and often there is common administration. Both types are common in all nations.

An illustration of complete independence is the income tax. Although this is usually considered a central tax, many localities use it as well. In the United States in 1964, it was used by two-thirds of the states and by 30 cities. Although the states may define their base so as to approximate the federal base, the local income taxes tend to be payroll taxes. Because its narrower base gives rise to charges of inequity, the local income tax is not likely to be used widely.

A more common form of sharing of bases is under some joint administration, either restricted to the definition of the base or extending to collection. The property tax takes this form within the structure of local governments and in some countries is shared by local and national governments.

In the United States property may be appraised by the state or county, and each of the hundreds of local governments may then independently determine the rate it requires to satisfy its revenue requirements. In some cases a common appraisal of the property is required, while in others it is simply economical for one community to accept the appraisal of another. In either event, the set of taxes may often be collected in one bill and then allocated among the governments.

Although this procedure does limit the power of the government to determine the base most advantageous to it, it has the advantages of uniformity and administrative efficiency while allowing each local government to determine the level and distribution of services it prefers.

A somewhat more centralized tax shared by state and local governments in the United States is the general retail sales tax. Over two-thirds of the states have retail sales taxes, and several thousand local governments add tax supplements onto the state tax. There is a marked trend to adopt this tax structure, with administration by the state or local government and local government option to share in the base. Generally there is a ceiling on the local supplement, and sometimes a specific amount is stipulated. Under this structure the local government has formal freedom, but the incentives for all local governments to develop a uniform policy are great.

The trend has been to move from overlapping taxation of a common base, with independent definition of the base and rates, to joint definition of the base and common administration, with independent rates, and then on to more restrictive rules about rates.

Shared taxes

A shared tax is simply the transformation of a local supplement to a national tax into a simple assessment of the tax by the national government, with some share going to the local governments. This scheme is fairly common throughout the world, though of relatively less importance in the United States. Generally the transformation has taken the form of extending state administration of the tax, returning some of the proceeds to the local government which had been using it, e.g., the development of state motor-vehicle license taxes out of local personal property taxes assessed against automobiles. The initial impetus to shared taxes was the desire to achieve simplification and uniformity, but rules of sharing have become increasingly complex. Issues of need have been introduced into the formulas, so that it is often difficult to distinguish between a shared tax and an intergovernmental grant. Although, in principle, these two forms of financing are very different, experience has shown that if the central government has authority over the sharing formula, it will exercise its discretionary power and the local government will lose control over the size of its budget and sometimes even over the use of these shared funds.

Intergovernmental grants

The most completely centralized form of local financing is tax assessment and collection by the central government, with a transfer of funds to local governments for financing their services. This type of finance has grown most rapidly. Control over finance does not logically entail authority over local public services, but experience has shown that this has been the usual result. Generally, the three preceding forms allow fairly complete freedom to the local government in the allocation of its budget and often in determining the size of its budget. But even if no financial controls are exercised by the central government, localities may not have autonomy, since in many nations local governments are required to provide specific services which sometimes are prescribed in detail.

There are two general types of financial transfers from central governments, basically distinguished by the amount of discretion which remains with the local government in the allocation of the funds at its disposal.

Unconditional grants. The free unconditional grant in its purest form would be a simple transfer of funds from the central government, which is considered the most efficient taxing body, to the local government, which is considered the best decision-making body. If the problem confronting local government were simply financial, one would expect to see these unconditional grants play a major role. In fact, their role is trivial. Few countries use them, and where they do exist, as in England, they are not a major factor in local finance.

Local government has long advocated that grants be made as unconditionally as possible, in order to retain as much local autonomy as possible. But even where only minimum conditions are accepted as desirable, redistribution objectives are introduced into the criteria by which the grants are allocated among communities; and these originally very broad redistributional objectives readily become more specific and thereby influence the quality and types of public services to be encouraged.

Conditional grants. Conditional grants to local governments carry with them specific requirements for local government behavior. Since the conditions must be policed, extensive audit procedures accompany the grants. Local governments generally oppose this form of support, since they dislike the administrative supervision by the central government and they oppose its direct control of their budget.

The motives behind conditional grants are many. In some cases, especially that of the United States, it is not politically feasible to establish a central administration, but the same results are sought through imposing very specific conditions. Two other important motives are the encouragement of specific services and financial equalization.

The encouragement of specific services is obvious when the grant does not require the local government to contribute to the support of the service. Some local governments might deplore that the grant is directed toward their less urgent needs, but at least it will not divert their resources. But often the condition of the grant requires matching outlays from the local government. Since the local dollar spent on the subsidized service will buy proportionately more of that service, it is clear that budgetary allocations will be affected. There will be incentives to expand local support of the subsidized services. This budgetary distortion has been resented by local authorities. The encouragement of specific services through local matching provisions has become less important.

Financial equalization has become more important. Although this objective was never absent, initial matching grants were more favorable to the wealthier communities. More complex formulas have since been devised to take into account local needs, local fiscal resources, and local fiscal effort. Despite the increasing sophistication and complexity of formulas, no consensus has developed about an optimal formula. Subsidies distort; their administration will be lax if there is no burden on the local government; and if a burden is imposed, then the localities may not have the appropriate incentive to expand the service or equity may not be served.

Financing of local debt

Another aspect of local finance which has dramatically changed in many countries is the financing of local debt. Even in the United States, where a local government usually goes to the capital mar kets very much as private firms do, changes have occurred. Not only have debt limits become common and referendums by the voters often required, but the approval of a state agency as to technical or financial feasibility of the project now is often required. A further change has been the growth of loans by the central government to the local governments. In some countries almost all loans are centralized; in the United States the loan program is one of the instruments of intergovernmental transfers. The loan is often administered by the agency which administers the grant program and which may be carrying on services as well. State governments also extend loans to local governments.

Although the centralization of government and finances has been the most important recent structural change, another reorganization, concerning metropolitan government, may be of comparable importance, especially in the United States. A typical metropolitan area is made up of hundreds of governments. Some are the residuals of an agricultural economy of a half-century past, others are the many new suburban cities, and still more are the special-function governments ranging from a small-area police district to a regional air-pollution control board. Most of them have taxing powers, while some can finance themselves only by user charges. The conflicts among these governments have focused on the suburban-central city rivalry for financial bases. Central cities have charged that suburbanites work in the central cities and use all of their amenities while living in the suburbs, where they pay their local property taxes. The suburbs charge that they bear the heavy burdens of education and residential services while the fiscally rich industrial and commercial properties are in the central cities or industrial enclaves. Issues of equity in finance and service have inhibited agreements about urban development programs, and meanwhile the government of the metropolitan area has deteriorated.

The problems of metropolitan government and finance have been elaborated in great detail. Solutions have been of an ad hoc nature, e.g., a federal subsidy for urban renewal, a new government for a mass rapid-transit system, or an additional tax base. Despite the muddling-through procedures, there has been a great deal of experimentation.

In the past decade, user charges have increased sharply at the state and local levels. The metering of water and on-street parking has expanded as a revenue source, and the value of user charges as rationing devices is beginning to be understood. User charges not only help to bring about an efficient rationing of limited public services, provide cues determining the scale at which services should be performed, and ease the financial plight of cities, but also lessen the conflict among governments. For example, if there is a charge on visiting the museum, it is irrelevant whether the school bus is discharging suburban or central city children: either school district would have to pay for cultural enrichment. Or it is unimportant if the parker is from the suburb or the central city if he pays the full incremental cost of making the street space available for his parked car. It is very likely that there will be a significant expansion of pricing of public services over a wide range of activities. [seePrices, article onPricing Policies.]

Innovations in local government arrangements have occurred in response to crises: many special authorities without taxing powers, or districts with taxing powers which move freely across old jurisdictional lines, have been created. From one perspective the ad hoc responses to crises have generated another layer of bureaucracies and assessing agencies, complicating still further the problems of rational management. But these governments are very fluid, their political bases are weak, and the possibilities of a more deliberative reshuffling of government and financial structures are not trivial. Metropolitan governments may develop out of the array of municipal governments and overlapping special districts and authorities, but it is likely that the state and federal governments will be the prime movers in metropolitan development and that the financial base of the metropolitan government may look very different from that of a mere composite of existing local governments.

Julius Margolis

[see alsoLocal Government; Taxation.]


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Burkhead, Jesse 1963 State and Local Taxes for Public Education. Syracuse Univ. Press.

Due, John F. 1963 Taxation and Economic Development in Tropical Africa. Cambridge, Mass.: M.I.T. Press.

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Humes, Samuel; and Martin, Eileen M. 1961 The Structure of Local Governments Throughout the World. The Hague: Nijhoff.

Margolis, Julius 1961 Metropolitan Finance Problems: Territories, Functions, and Growth. Pages 229–293 in Universities-National Bureau Committee for Economic Research, Public Finances: Needs, Sources, and Utilization. Princeton Univ. Press.

Maxwell, James A. 1965 Financing State and Local Governments. Washington: Brookings Institution.

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Philip, Kjeld 1954 Intergovernmental Fiscal Relations. Copenhagen: Institute of Economics and History.

Prest, Alan R. 1962 Public Finance in Under-developed Countries. London: Weidenfeld & Nicolson.

Simon, Herbert A. 1943 Fiscal Aspects of Metropolitan Consolidation. Berkeley: Univ. of California, Bureau of Public Administration.

U.S. Advisory Commission ON Intergovernmental Relations 1962 Measures of State and Local Fiscal Capacity and Tax Effort. Washington: Government Printing Office.

U.S. Advisory Commission ON Intergovernmental Relations 1964 The Role of Equalization in Federal Grants. Washington: Government Printing Office.

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U.S. Bureau OF THE Census 1964 Census of Governments: 1962. Washington: Government Printing Office. → See especially Volume 5, Local Government in Metropolitan Areas, and Volume 6, No. 4, Historical Statistics on Governmental Finances and Employment.

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