The Reliable Revenue Source Even in Rough Times

As the economy weakens, the "three-legged stool" tax base in these jurisdictions has been losing its fragile balance. Budget deficits are occurring all over the country, and states and municipalities are having to come up with tax and borrow schemes they might never have considered before to make it through the next fiscal year. But beyond these stop-gap measures, now is the time to rethink the long-term strategy of public finance. An article in USA Today describes the current situation, and provides some insight that shines light on the way forward.

To get through the recession, the Federal government has massively increased aid to state and local bodies, providing stimulus spending on infrastructure, health care, and other essential services and investments designed to spur a recovery and protect vulnerable populations. This federal funding level is unprecedented:

In a historic first, Uncle Sam has supplanted sales, property and income taxes as the biggest source of revenue for state and local governments.

The shift shows how deeply the recession is cutting. Federal stimulus money aimed at reviving the economy and a sharp drop in tax collections have altered, at least temporarily, the traditional balance of how states, cities, counties and schools pay for their operations.

The sales tax had been the No. 1 source of state and local revenue since the mid-1970s, according to the Bureau of Economic Analysis. Before that, property taxes were the primary source. That changed in the first three months of 2009.

The problem, of course, is that it is only a temporary measure necessary to get the economy back on its feet. Once the stimulus funds run out, which is expected beginning 2012, the states and cities will have to return to local revenue sources, that mainly being taxes. The "three-legged stool" theory says a mix of income, sales, and property taxes is the best approach. How is each holding up right now?

Many jurisdictions, including Philadelphia, are turning to a higher sales tax to plug gaps in their budget. But will receipts keep up with expectations, especially if tax revenue anticipation notes are issued to stay afloat through the rough waters, which could last for several years?

Sales tax. Collections started falling at the end of 2008 for the first time since the Bureau of Economic Analysis first reported data in 1958. The drop in sales of automobiles and construction materials has taken a big bite out of sales tax revenue.

Sales taxes are dependent on people making purchases, which in turn depends on consumer confidence--which can be very unstable during uncertain economic times. But even if people don't spend much money, they still will continue to earn it, so perhaps income taxes are more reliable?

Income tax. The most volatile tax produces big increases during boom times and giant declines during hard times. California, New York, Oregon, Connecticut and other states that depend heavily on taxing year-end bonuses and capital gains on investments have been hardest hit by the worst income tax drops since 2002.

The last option is the property tax, which used to be the primary source of revenue for state and local government. Is it time to dust off this old stand-by?

Property tax. The most stable tax is generating increasing revenue, mostly for schools, despite plunging property values. One reason: Forty-six states limit how fast property taxes rise or fall.

As jurisdictions begin picking up the pieces of their broken stools, they should pay attention to which leg can still stand the best. A property tax, especially when adapted into a land value tax, will provide the revenue needed while putting the public finance system on a solid foundation.