LA: Mi’. Q?-fa é Government Pubiications A --V > c-Un_i.tMc AUG 0 4 1994 Report No. 86-2 E x'*wzwz' 3. rg in E fie: W% h in??? :3 Sffiimz -” - . mg l}fiit'€iSIfy Lxbranes ; :. oL. Lows, Ma 53130 “.>,5“L.,!7:; * I """ ‘* ‘ ~ V THE EFFECT OF FEDERAL TAX AND BUDGET POLICIES IN THE 19803 ON THE STATE-LOCAL SECTOR by Lillian Rymarowicz Analyst in Public Finance and Dennis Zimmerman Specialist in Public Finance Economics Division January 2, 1986 HJ 275 A : '1 A _~ ‘ niverslt on; on 1: O(f[l)]ilI(i,TIiIi’T'i1l'I1iilJlljr]!Il’i a I Ill! 94043 The Congressional Research Service works ex(:lusiveljv for the Congress,'conducting research, analyzing legislation, and providing information at the request of committees, l\/lem~— bers, and their staffs. The Service 1nal<_es such research available, without partin san hiasq in many forms including studies, reports, compila-= tions, (ligests, and background briefings; Upon request, CR5 assists committees in analyzing legislative proposals and issues. and in assessing the possible effects ofthese proposals and their alternatives. The Services senior specialists arid subject analysts are also available for personal consultations in their respective fields of expertise. ABSTRACT This report discusses the recent history and current direction of Federal budget and tax policy as it affects the State-local sector. The reduction of Federal financial support at a time of real growth in total Federal spending re- flects the Administration's efforts to reevaluate the desirability of providing Federal assistance to some State-local programs. CRS-v CONTENTS O O O O O O O O O O O O O O O O O O 0 O O O O O 0 O O O O O O O O O O O O O O O O O O O O O O I O O O O O O O O O O O O O O O O O O O O O O _O O O O O O C O O O 0 O 0.0 O O O O O O 0 O O O O O O O O O O O O O O O O O O O O O O O O O O O O O 0 O O O 1 I. FEDERAL BUDGET POLICIES ........................................... 5 A. Federal Grants to State and Local Governments ................. 5 B. Federal Policies Causing Grants to Decline .................... 7 C. The State-Local Response ...................................... 14 I10 0000000000000OOOOOOOOOOOOOOOOOO000000000000 III. FEDERAL TAX POLICIES .............................................. 23 A. Deductibility of Nonbusiness State and Local Taxes ............ 23 B. Exclusion of Interest Income from Tax-Exempt Bonds ............ 30 C. Tax Credit for Rehabilitation Expenditures .................... 34 D. State-Local Income Tax Linkage to the Federal Income Tax ...... Jo E. Tax Bases Exempt from State-Local Taxation by Federal Law ...... 39 IV. FISCAL IMPLICATIONS OF SUPREME COURT'S GARCIA DECISION ............ 41 V0 0000OOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOO TABLES 1. U.S. Budget Outlays by Selected Categories of Expenditure ............ 6 2. Grants to State and Local Governments Which Are Also Payments to Individuals by Function and Selected Program .................... 9 3. Grants to State and Local Governments by Function and Selected Programs, Excluding Grants Which Are Also Payments to Individuals .. 11 4. The FY1980-84 State-Local Response to the Loss of Federal Grants ..... 16 5. General Revenue Sharing Payments to Cities as a Percentage of Total Tax Revenues by Population Size of Cities .......................... 20 6. General Revenue Sharing Payments to Counties as a Percentage of Total Tax Revenues by Population Size of Counties .................. 21 7. Federal Revenue Losses from Income Tax Provisions Affecting the State-Local Sector, FY1980-1985 .................................... 24 8. The Effect of the Administration and Rostenkowski State-Local Tax Deductibility Proposals on State-Local Itemizer's Marginal Tax Price .............................................................. 27 9. The Potential Short-term Impact of Comprehensive Tax Reform on State 00000000OOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOO00000 CRS-vi APPENDIX TABLES U.S. Budget Outlays by Selected Categories of Expenditures in OOOOOOOOOIOOOOOOOOOOOOOOOOOOOO Index of Change., Fiscal Year 1980 = 100 -- U.S. Budget Outlays by Selected Categories of Expenditures in Current Dollars, Fiscal Years IOOOOOOOOOOOOO0O00000000000OOCOOOOOOOOOOOOOOOOOOO0000000000000 U.S. Budget Outlays by Selected Categories of Expenditures in Constant Dollars (l980=l00), Fiscal Years 1980-85 ooooooooooooooooooooooooooooo Index of Change. Fiscal Year l980=100. U.S. Budget Outlays by Selected Categories of Expenditures in Constant Dollars, Fiscal Years 1980-85 47 49 50 51 THE EFFECT OF FEDERAL TAX AND BUDGET POLICIES IN THE 19803 ON THE STATE-LOCAL SECTOR INTRODUCTION This report discusses the recent history and current direction of Federal budget and tax policy as it affects the State-local sector. The focus is on those Federal spending programs and tax provisions designed specifically to af- fect the State-local sector, such as General Revenue Sharing and the deductibil- ity of State-local taxes, rather than on fiscal policy in general. It can be said, of course, th-t Federal fiscal policy often has a greater impact on State-local fiscal health than do changes in Federal programs specific to the State-local sector -- one often hears that a rising tide lifts all boats. But Federal fiscal policy is not driven by considerations of intergovernmental fiscal relations. One must look to changes in Federal programs and tax laws spe- cific to the State-local sector to evaluate the evolving Federal view of the ap- propriate Federal and State-local roles in providing public services. Two reasons are often cited for Federal financial support of the State-local sector. First, it is argued by some analysts that the State-local sector is prone to provide less than the desirable amount of a public service because of the limited geographic reach of any State or local government. If, for example, the costs of pollution from one community are carried downstream or downwind to the citizens of another community, it is likely that the first community will provide too little pollution control. Or, if many of the benefits from its pub- lic education system are received by non-residents, a community may provide less CRS-2 than the desirable amount of public education. It may be necessary for the Fed- eral Government to provide a financial incentive to State-local governments in order to increase the level of such public services. The second reason is to reduce fiscal disparities among jurisdictions. The per person tax base varies substantially from State to State, requiring taxpayers in one State to make a greater tax effort (pay a higher tax price) than taxpayers in another State in order to provide equivalent public services. This unequal tax-base wealth of taxpayers in different States and its potential effect on the provision of basic services in different States has often been used to justify Federal subsidy of the State-localsector. The purpose of this study is to identify the major Federal programs and tax provisions which directly affect the State-local sector, and to describe and quantify the recent history of and proposed changes in this Federal financial support. 1] No effort is made to evaluate the merit of these changes as a suit- able response to society's changing views on the Federal responsibility to in- crease State-local services provided or to equalize differences in fiscal capac- ity. Chapter I traces Federal expenditures for State-local financial assistance from 1980 to 1985. Changes in these grant expenditures are discussed within the context of the concurrent expansion of the Federal budget. The major grant pro- grams are identified, and the primary Federal policy changes which contributed to the change in expenditures are listed. The State-local response to the re- duced Federal grant expenditures is discussed. .l/ Both the budget and tax reform were proceeding through Congress while this report was being written. The most recent tax reform version discussed in the report is the Rostenkowski proposal, since the House Ways and Means Commit- tee proposal did not appear until December. Also, no effort is made to assess the potential effect of the automatic spending reduction targets proposed in the House and Senate versions of the Gramm-Rudman-Hollings budget reform proposal. CRS-3 Chapter II is devoted to a discussion of General Revenue Sharing (GRS), one of the major grants targeted for elimination by the Congress. GRS receives more detailed attention because it is restricted to local governments and represents a very different share of revenues for different types of local governments. Chapter III discusses three Federal income tax provisions which directly affect the State-local sector -- State-local tax: deductibility, tax-exempt bonds, and rehabilitation tax credits. Federal revenue losses from these provi- sions are are identified. The proposed treatment of these provisions in the Ad- ministration and Rostenkowski proposals is discussed. The automatic change in State income tax revenues which tax reform would produce because of the tax link- age of State and Federal income taxes also is discussed. Chapter IV presents a brief discussion of the potential implications of the Garcia decision by the Supreme Court. Its effect on the labor costs of the State-local sector was delayed and partially ameliorated by legislation enacted in the 99th Congress. Chapter V summarizes the effect of these disparate Federal policy changes on the fiscal health of the State-local sector. CRS-5 I. FEDERAL BUDGET POLICIES Changes in Federal expenditures policy can have profound effects on the fis- cal health of the State-local sector. This section traces changes in Federal grant expenditures from FY1980 to FY1985, identifies the policy changes in the major Federal grant programs, and discusses the State-local response to these changes. A. Federal Grants to State and Local Governments As has been noted elsewhere, the growth in Federal grants to the State-local sector was arrested in 1978. 2/ This change in Federal priorities was strength- ened beginning in 1981 by an increased commitment to national defense spending and a desire to enact tax reduction. These changed priorities caused the alloca- tion of Federal spending to tilt dramatically toward national defense and inter- est on the national debt. Spending on national defense rose from $144.8 billion in 1980 to $266.9 billion in 1985, while interest on the national debt rose from $52.5 billion In) $129.1 billion (see Appendix: table A for current dollar amounts). As shown in table 1, this growth represents an inflation-adjusted in- crease of 33.9 percent in national defense, and an 86.6 percent increase in in- terest payments. 2/ Ladd, Helen. Federal Aid to State and Local Governments. In Mills, Gregory B., and John L. Palmer, eds. Federal Budget Policy in the 1980s. 6Wash- ington, The Urban Institute, 1984. p. 165-202. CRS-6 TABLE 1. U.S. Budget Outlays by Selected Categories of Expenditure In Constant Dollars (1980=100) Fiscal Years 1980-1985 (S billions) Percent 1980 1981 1982 3 1983 1984 1985 Change Total U.S. Budget Outlays _a_/ $576.7 $597.5 $617.8 $649.2 $661.8 $710.8 523.37., National Defense and International Affairs 144.8 153.4 164.0 178.5 189.1 202.5 39.9% Direct Payments to Individuals 245.5 260.4 270.4 288.5 279.5 278.4 13.4% Net Interest bf 52.5 62.5 72.1 73.3 87.3 98.0 86.6% Grants to State and Local Governments 91.5 86.1 74.8 75.4 76.7 83.9 -8.3% For Individuals 31.9 33.5 32.1 34.0 34.8 38.4 20.4% For States 59.5 52.6 42.7 41.5 41.9 45.5 -23.5% All Other Federal Outlays 42.4 35.1 34.8 33.5 29.2 48.06 13.1% .3] Totals exclude "off-budget" outlays which are included in the total fig- ures of the Budget of the United States Government. bf These totals have not been revised from those included in the initial presentation of the Fiscal Year 1986 Budget. Source: Constant dollar totals were computed from Appendix table A using the gross national product deflators based on the calendar 1972 prices as de- veloped by the U.S. Department of Commerce, Bureau of Economic Analysis and detailed in Appendix table C. Appendix tables 2 and 4 show the index of change for outlays in current and constant dollars, respectively, for each fiscal period from 1980 through 1985. CRS-7 Consistent with these changed priorities, grants to State and local govern- ments increased very slowly in current dollars from 1980 to 1985, from $91.5 bil- lion to $110.6 billion. In constant dollars, this represented an 8.3 percent de- crease. This decrease is the more notable because the change in spending priori- ties did not occur in the context of a stable Federal budget. Total Federal bud- get expenditures Igrgw; 23.3 percent in. constant dollars from. 1980 txn 1985. The decrease in Federal spending on grants was not uniform for all types of grants. The Office of Management and Budget divides grants into two types: grants to State-local governments, and grants to individuals. This distinction emphasizes that some grants provide cash or in-kind benefits to identifiable in- dividuals -- such as Medicaid and Aid to Families with Dependent Children. Other grants provide funding for State-local programs which in a sense benefit all State-local taxpayers -- such as General Revenue Sharing. Federal funding for grants for individuals increased from $31.9 billion in 1980 to $50.6 billion in 1985. This represents a 20.4 percent increase in con- stant dollars. In contrast, grants for State-local programs remained virtually unchanged in current dollars, from $59.5 billion in 1980 to $59.9 billion in 1985, representing an inflation-adjusted decrease of 23.5 percent. 9 Thus, the Federal reduction in State-local financial support was targeted primarily upon grants for State-local programs. Funding for grants to individu- als continued to grow. B. Federal Policies Causing Grants to Decline An inventory of Federal grant-in-aid programs for fiscal year 1984 listed 392 categorical grant programs, a decrease of 27 percent from the 534 in fis- cal year 1981. Block grants increased from 4 to 12 in number over this CRS-8 period. §/ Most of these program consolidations were implemented by the Omnibus Reconciliation Act of 1981, which caused outlays to State and local governments to decline by 6.9 percent in 1982. Since then program changes have moderated, but outlays still have grown at less than the rate of inflation. This section discusses these policy changes. Turning first to grants for individuals, table 2, column 4 shows that 61 percent of the constant dollar increase is attributable to payments for Medi- caid. fif This growth can be expected to moderate if the Congress enacts the current proposal to reduce Medicaid outlays by $1.0 billion below the current services outlay for fiscal year 1986 and to limit increases for medical costs to the rise in the consumer price index. Subsidized housing and the "other" category are the other two programs for which increased outlays are important factors in the increase in grants to indi- viduals. The primary reason for the increase in the "other" category is the in- teraction of the Department of Agriculture price support and economic stabiliza- tion policies with the growth in the farm surplus. If adopted, proposals now in conference would restrict access to agricultural credit programs, increase exports of surplus commodities, and tighten food stamp eligibility and adminis- tration, thereby generating savings equal to almost one-third of fiscal year 1985 outlays. The growth in subsidized housing outlays stems from the enactment of grants for housing development and rental rehabilitation programs in areas of substantial need. Outlays were made for the first time in 1985; however, these 2/ See Golonka, Susan. Whatever Happened to Federalism? Intergovern- mental Perspective. Vol. II, no. 1, Winter 1985. 9 p. '3] In addition to the Congressional Budget Office data cited in table 1, the comments in this section also draw on data from Federal Funds Information for States, the Congressional Quarterly, and the Congressional Record. CRS-9 TABLE 2. Grants to State and Local Governments Which Are Also Payments to Individuals, by Function and Selected Program In Constant Dollars (1980 = 100), Fiscal Years 1980-85 ($ millions) Percent Share Change of 1980 1985 1980-1985 increase_g/ Payments for individuals $31,927 $38,389 20.4% 100.0% Health 14,827 18,562 25.2 -- Medical assistance (Medicaid) 13,232 17,889 29.9 61.2 Other 3/ 1,595 1,373 -13.9 -3.4 Income security 16,973 19,706 16.1 Assistance payments (AFDC) 6,888 6,544 -5.0 -5.3 Child nutrition 3,233 2,781 -14.0 -7.0 Subsidized housing 2,610 3,955 51.5 20.8 Low income home energy assistance 1,180 1,624 37.6 6.9 Other_b/ 3,062 4,800 56.7 26.9 Student financial assistance and veterans‘ benefits 127 121 =4.8 * * Less than 0.05 percent. _a/ Includes health resources and services and alcohol, drug abuse, and men- tal health grants. bj Consists of programs related to nutrition and food services, refugee as- sistance and low-income housing. 2/ Calculated as change in each program's 1985 and 1980 outlays between 1980 and 1985, divided by change for all programs combined. Source: See table 1. CRS-10 programs are included in the Administration proposals for a two-year moratorium on new subsidized housing commitments beginning in fiscal year 1986. The two major programs undergoing decline when adjusted for inflation were Aid to Families with Dependent Children (AFDC) and Child Nutrition. Tightening of eligibility requirements and commencement of work requirement programs ac- count for the decrease in AFDC outlays. Current legislative proposals would fur- ther tighten eligibility requirements and reduce administrative costs, thereby further reducing future outlays. Reduced outlays for Child Nutrition.would con- tinue if current proposals to limit eligibility for school lunches should pass. Outlays for Federal grants to State and local programs show a very differ- ent pattern in table 3. with the exception of Federal aid for highways and urban development action grants (UDAG), all programs suffered a decrease in outlays in constant dollars during the 1980-85 period. Three pieces of information are critical to understanding the 10 percent constant dollar increase in highway outlays and whether this growth can be ex- pected to continue. First, this increase was funded by an increased tax on gasoline sales. Second, outlays would have been even higher had the Federal Government not introduced additional administrative requirements on the alloca- tion of these funds, thereby slowing their‘ disbursement. Third, post-1985 authorizations for disbursement of these funds is below the level of accumulated revenues, and the tax is scheduled to expire in 1988. Thus, growth in this program can be expected to moderate. The other transportation programs have already experienced substantial cuts in constant dollars. Current proposals for Urban Mass Transit grants would fur- ther reduce outlays by eliminating operating subsidies for mass transit and lim- iting grants for capital outlays to the amount generated by the revenue from 1 cent of the 9-cent Federal motor fuel tax. CRS-13 Outlays increased substantially for UDAG, which, although relatively small in dollar value, is considered a very important financing tool for attracting private funds for economic development. This increase is not expected to per- sist; current proposals would eliminate or severely reduce UDAG outlays, extend- ing to UDAG the budget reductions already implemented in other Federal develop- ment programs. This is readiily apparent in the other programs included under the Community and Regional Development function in table 3, which declined on average in real terms by about 40 percent from 1980 to 1985. The education, training, employment, and social services function experi- enced a 33.4 percent decrease in outlays in constant dollars. This reduction is attributable to several factors. First, many grants have been consolidated into larger block grants. With consolidation comes a 3 percent reduction in outlays to compensate for an alleged administrative savings. Second, the reduction also reflects the Federal decision to turn back responsibility for some services to the State-local sector and the business community. For example, reduced Federal assistance to local schools located in communities with substantial Federal em- ployment, but where children of Federal employees do not pose a burden to the lo- cal community.’ And the Federal employment training program (CETA) was replaced with the Job Training Partnership Act block grant which emphasizes the involve- ment of the business community. Finally, the Federal Government reduced its general purpose fiscal assist- ance by 45.1 percent in constant dollars. The elimination of the States‘ share of General Revenue Sharing was a primary reason for this decrease, as was the fixed dollar appropriation for the local government share. The current legisla- tive proposal would continue this decline by reducing the final quarter 1986 pay- ment such that GRS outlays decrease by 8.5 percent in 1986. Authorization for the program expires at the conclusion of fiscal year 1986. CRS-14 C. The State-Local Response The decline in Federal financial assistance to the State-local sector has been identified -- an 8.3 percent decrease in the real value of grants, and a 23.5 percent decrease in the real value of grants for State-local programs. The Federal policies which produced these changes have also been identified. An im- portant issue is how the State-local sector reacted to this withdrawal of Federal support. This section compares the reduction in Federal grants to the change in State-local tax revenues, which requires the use of Cbnsus data. These data cover 1980 to 1984 and refer to State fiscal years. Data are not yet available for 1985. The extent to which State and local Governments substitute their own fiscal efforts for Federal financial support is difficult to determine. The data pre- sented here can indicate only whether the sector was increasing its own tax ef- forts sufficiently Ix) provide revenues adequate to replace withdrawn Federal revenues. State-local budgets are, however, dynamic in nature and reflect con- stant reallocation among functions competing for scarce funds. lIt would be ne- cessary to evaluate expenditure changes on a functional basis within the context of long-term State and local budgetary plans in order to determine whether these State-local taxes were substituting for the Federal funding of the specific pro- grams identified in table 2._§/ The first two rows of table 4 present the actual dollars of Federal grants and State-local tax revenues from 1980 to 1984 (based on Census data). The third row calculates what Federal grants relative to State-local tax revenues would _§/ For an attempt to determine the extent to which State-local governments replaced funding for specific programs, see selected papers presented in Nathan, Richard P., Fred C. Doolittle and Associates. The Consequences of Cuts: The Ef-A fects of the Reagan Domestic Program on State and Local Governments. Princeton, Princeton Urban and Regional Research Center, 1983. CRS-ll TABLE 3. Grants to State and Local Governments by Function and Selected Programs, Excluding Grants Which are Also Payments to Individuals In Constant Dollars (1980 = 100), Fiscal Years 1980-85 Total all functions Transportation Highways Urban mass transit Airports and other transport Community & regional devlpmt. Economic devlpmt. assistance Local public works and regional devlpmt. Community devlpmt. grants Urban devlpmt. action grants Urban renewal & related grants Education, training, employment and social services Compensatory education for the disadvantaged Social services block grant Human development services Community services program Temporary employment asst. Training & employment services Other 3/ General purpose fiscal asst. General revenue sharing Shared revenues Other_b/ All other functions 5/ 1980 59,524 13,087 8,676 3,129 1,282 6,486 452 860 3,902 225 1,047 21,783 3,370 2,763 1,548 547 1,797 6,924 4,834 8,478 6,829 673 976 9,690 1985 45,513 13,027 9,548 2,547 932 3,905 275 6 2,896 377 351 14,503 3,192 2,081 1,449 285 3,729 3,767 4,658 3,478 516 664 9,420 Percent Change 1980-85 (footnotes on next page) CRS-12 TABLE 3. Grants to State and Local Governments by Function and Selected Programs, Excluding Grants Which Are Also Payments to Individuals In Constant Dollars (1980 = 100), Fiscal Years 1980-85 3/ The most significant increase in constant dollars is in the family so- cial service block grant established in 1981 and amounting to $560 million in fiscal 1985. For six programs with higher nominal amounts in 1985 the increases in real sums were as follows (in millions of dollars): impact aid +19, special programs (education) +2, education for the handicapped +19, older Americans employment +11, National Endowment for the Arts +5, and Institute of Museum Services +4. Decreases occurred for ten programs (in millions of dollars): bilingual education -46, rehabilitation and handicapped research -172, voca- tional and adult education -157, higher education -15, libraries -30, work incentives -83, public broadcasting -1, Indian education -11, and the Depart- ment of Commerce grants for telecommunication information and job opportunities programs -5. b] Includes payments to the District of Columbia, Puerto Rico, the trust territories of the Pacific, and other outlays in the administration of U.S. territories. Detail is not available for fiscal year 1985. _<_:_/ The U.S. Department of Agriculture grant programs related to price support and economic stabilization policies increased by $2.175 billion from fiscal 1980 to 1985. Grants for administration of the income security pro- grams rose by 610 million, and for the health programs by $397 million. Other increases were (in ‘millions of dollars): energy’ +263, general government +37, and national defense (i.e., construction of National Guard Armories and disaster relief) +18. The largest decrease amounting to $1.1 billion occurred in the natural resources and environment function as a result of the reduction in funds for construction grants administered by the Environmental Protection Agency. The elimination of law enforcement grants and grants for health man- power training programs resulted in cuts of $34 million and $25 million, re- spectively. Source: See table 1. CRS-15 have been if State-local tax revenues had increased at the rate of inflation from 1980 to 1984. In other words, this row illustrates how the relative Federal con- tribution would have declined if the State-local sector had raised revenues suf- ficiently to maintain its share of the cost of State-local services. The ratio declines from 0.371 in 1980 to 0.325 in 1983, reflecting the decrease in Federal grants which occurred during this time. The ratio rises slightly in 1984, re- flecting the stability in Federal funding which occurred beginning in 1984 (see table 1). The fourth row calculates what actually happened -- Federal grants (row one) divided by actual State-local tax collections (row two). As the State-local sector had time to adjust, its real tax collections began to rise such that the actual ratio fell much more in 1983 than did the hypothetical ratio in row 3. The actual ratio continued to decline in 1984 relative to the ratio in row 3. This suggests that by 1983 the State-local sector had enacted discretionary tax changes to generate the revenue which could be used to assume some of the former Federal responsibility for financing State-local services. This State-local effort to substitute State-local tax effort for decreased Federal grants occurred even though the Federal Government was encroaching on a traditional State-local revenue source -- excise taxes on motor fuels, ciga- rettes, and alcoholic beverages. In 1980, the Federal Government levied a 4 cents per gallon gasoline taxg while State governments levied a gasoline tax av- eraging 9.1 cents per gallon. As of 1985, the Federal rate was 9 cents per gal- lon; the State rate was 9.8 cents. This higher Federal tax rate made it more difficult for the States to raise their own motor fuel taxes. Although it is true that about 95 percent of total Federal motor fuel taxes are distributed to the States, the Federal fund apportionment restricts the States’ discretion in spending. TABLE CRS-16 4. The FY1980-FY1984 State-Local Response to The Loss of Federal Grants ($ billions) Percent Change 1980 1981 1982 1983 1984 1980-1984 Federal Grants $83.0 $90.3 $87.0 $90.0 $97.1 17.0% State-local 1 Tax Revenues 223.5 244.5 266.3 284.6 320.2 43.3% Grants -- Tax Revenues Growing at Inflation Rate 0.371 0.367 0.328 0.325 0.335 Grants -- Actual Tax Revenues 0.371 0.369 0.327 0.316 0.303 Source: Calculated by CRS from U.S. Bureau of the Census. Governmental Finances in 1982-83 (annual series). date within the previous 12 months. Fiscal years ending June IN) or at some CRS-17 The same basic pattern occurred with tobacco product taxes and is expected to occur with alcoholic beverage taxes._§/ The Federal share of tobacco product tax revenues increased substantially between 1980 and 1985, rising from 42.4 per- cent of total tobacco tax revenues to 53.6 percent. Z] The Federal share of al- coholic beverage tax revenues is expected to increase from 63.8 percent in 1985 to 68.4 percent in fiscal 1986. Q] For further discussion of Federal use of selective excise taxes, see Advisory Commission on Intergovernmental Relations. Federal Use of Selective Excise Taxes -- Implications for State and Local Governments. In: Strength- ening the Federal Revenue System. Report A-9. 1984. 10 p. Z] Eight cents of the Federal cigarette tax was scheduled to expire on September 30, but has been extended through December 16. Should this extension not be continued beyound December 16, at least twelve States have contingency plans for increasing their rates by that amount without additional legislative action. ’ CRS-19 II. GENERAL REVENUE SHARING As discussed in Chapter I, existing statutory provisions would terminate General Revenue Sharing (GRS) after September 30, 1986. In the aggregate, elimi- nation would be a serious but not crippling blow to local governments, for GRS fell from 5.3 percent of total local tax revenues in 1980 to 3.7 percent in 1984. There is some concern, however, that the variation among local governments is very substantial._§/ This variation can be assessed in several ways. Table 5 presents GRS pay- ments as a percent of total tax revenue by size of city. Cities over one million in population have a percentage of 3.6, whereas cities below 100,000 have a per- centage of 8.2. Table 6 looks at the distribution of GRS payments among counties. The same degree of variation is observed here. The smallest counties have GRS payments equal to 8.7 percent of total tax revenues, and the largest counties have a per- centage of 4.7 percent. Although it is clear that GRS payments are generally a more important source of funding to smaller units of government, the range of the measure is only a magnitude of 2 or 3 to 1. One could also look for variation across States, and compare GRS payments for all local governments in.a State to total local tax revenues in the State._2/ §/ This is illustrated in table VII.5 of Department of Treasury. Office of State and Local Finance. Federal-State-Local Fiscal Relations, which contrasts GRS allocations to adjusted (non-education) taxes. p. VII 60-61. _?_/ Municipalities and counties account for 92 percent of GRS payments. State totals also include general-purpose township governments not classified as "municipalities" by the Census. CRS-20 TABLE 5. General Revenue Sharing Payments to Cities as a Percentage of Total Tax Revenues by Population Size of Cities Fiscal Years 1983-84 ($ millions) General Revenue Sharing as a General Revenue Percentage of Population Size Sharing Total Taxes Total Tax Revenues Total all municipalities $2,463 $43,719 5.63% 100,000 or more 499 13,795 3.62 500,000 to 999,999 250 5,353 4.67 300,000 to 499,999 194 b 3,196 6.07 200,000 to 299,999 108 1,693 6.38‘ 100,000 to 199,999 249 4,003 9.89 50,000 to 99,999 288 5,038 8.68 Less than 50,000 875 10,641 8.22 Source: Adapted by CRS from U.S. Bureau of the Census. City Government Finances in 1983-84. The variation by State for fiscal years 1983-84 is somewhat greater, ranging from 2.3 percent of tax revenues in New Hampshire (the lowest of eight States less than 3.0 percent) to 12.0 percent in Mississippi (the highest of seven States greater than 9.0 percent). The effect on some local governments could be worsened depending upon State payments to local governments for general local support. For all States come bined, these grants exceeded Federal GRS by $6.2 billion in fiscal years.1983-84. While the Federal GRS payment remained virtually unchanged in actual dollars from 1980 to 1985, the State total increased by 30 percent from 1979 to 1984. How- ever, State support declined in five States during this period -é California, TABLE 6. CRS-21 General Revenue Sharing Payments to Counties as a Percentage of Total Tax Revenues by Population Size of Counties Fiscal Years 1983-84 ($ millions) General Revenue Sharing General Revenue Total as a Percentage of Population Size Sharing Taxes Total Tax Revenues Total all countries $1,723 $27,902 6.18% 500,000 or more 583 12,462 4.68 300,000 to 499,999 155 2,863 5.41 200,000 to 299,999 127 1,851 6.86 150,000 to 199,999 78 1,418 5.55 100,000 to 149,999 110 1,592 6.91 Less than 100,000 670 7,715 8.68 Source: Finances in 1983-84. Connecticut, Georgia, Hawaii, and Idaho. stantial -- from $1.8 billion in 1979 to $1.1 billion in 1984. ceeds the $525 million 1984 GRS payment Adapted by CRS from U.S. Bureau of the Census. County Government The decrease in California was sub- This decrease exv to California local governments. CRS-23 III. FEDERAL TAX POLICIES The Federal Government also provides financial support to the State-local sector through the Federal tax system. The two major Federal tax subsidies are the deductibility of nonbusiness State and local taxes from Federal taxable in- come and the exclusion from Federal taxable income of interest income on tax- exempt State-local bonds. Of much less importance is the tax credit for reha- bilitation expenditures. In addition, forty-six States and the District of Columbia use an income tax, and most of these are "coupled" in some manner to the Federal income tax system. This coupling causes State income tax revenues to change automatically in response to changes in Federal tax law. Thus, no assess- ment of the effect of Federal policy on State-local fiscal conditions is complete without considering the tax side of the Federal budget. A related tax issue af- fecting the fiscal health of the State-local sector is also discussed in this section -- Federal laws which exclude certain tax bases from State-local taxation and provide benefits to the Federal Government. A. Deductibility of Nonbusiness State and Local Taxes During the FY1980-85 period when Federal grants to the State-local sector declined by 8.3 percent in constant dollars, the Federal revenue loss from State- local tax deductions (shown in table 7) increased by 19 percent in constant dol- lars. Financial support from deductibility assumed greater importance as a source of Federal assistance. CRS-24 TABLE 7. Federal Revenue Losses from Income Tax Provisions Affecting the State-Local Sector, FY1980-85 ($ billions) Rehabilitation Tax-Exempt Bonds Deductible Taxes Tax Credit Current $ Constant $ Current $ Constant $ Current $ Constant $ 1980 $10.7 $10.7 $20.5 $20.5 0 A 0 1981 13.4 12.2 25.5 23.2 0 0 1982 12.1 10.3 27.6 23.4 0.2 0.24 1983 13.1 10.7 28.9 23.6 0.3 0.2 1984 16.4 12.9 29.7 23.3 0.3 0.2 1985 18.5 14.0 32.2 24.4 0.3 0.2 Percent Change 1980-85 72.9% 30.8% 57.1% 19.0% NA NA Source: Special Analyses, Budget of the United States Government. FYs 1982, 1984, 1986. Not all of this Federal revenue loss translates into State-local financial assistance. The way in which deductibility can affect State-local tax revenues is indirect._1Q/ Deductibility reduces the after-Federal-tax price (cost) of a State-local taxpayer's tax dollar auui increases his after-Federal-tax;income.A Both the lower price and higher income cause the taxpayer to desire a higher 19] For a detailed explanation, see Noto, Nonna A. and Dennis Zimmerman. Limiting State-Local Tax Deductibility: Effects Among the States. National Tax Journal, December 1984. p. 539-549; and Kenyon, Daphne A. Federal Income Tax Deductibility of State and Local Taxes: What Are Its Effects? Should It Be Mod- ified or Eliminated? In: Strengthening the Federal Revenue System. Advisory Commission on Intergovernmental Relations. Washington, October 1984. p. 37-66. CRS-25 level of State-local services, and to increase his willingness to pay higher State-local taxes. The extent of this increase in State-local taxes and spending depends upon the sensitivity of the itemizer's demand for public services to these changes in his tax price and income, and on the success of the itemizer in making the poli- tical process reflect his changes in demand. Since there is a range of estimates for these critical aspects of State-local taxpayer behavior, it is not surprising that estimates of the magnitude of the State-local tax and spending response also vary. Using estimates of price and income sensitivity and itemizer political control that are relatively favorable to a positive effect on State-local taxes and spending produces estimates of increases in the 14 to 20 percent range. _l/ Using lower estimates of price and income sensitivity and itemizer political con- trol produces State-local tax and spending increases around 5 or 6 percent. lg] Whatever the magnitude of the tax and spending increase induced by deducti- bility is, the elimination of deductibility as proposed by the Administration could be expected to generate a symmetric, equivalent reduction in State-local taxes and spending. Thus, elimination of deductibility can be expected to worsen the State-local sector's fiscal condition. ll] For example, see U.S. Congress. Senate. Committee on Governmental Affairs. Subcommittee on Intergovernmental Relations. Limiting State-local Tax Deductibility in Exchange for Increased General Revenue Sharing: An Analysis of the Economic Effects. Committee Print. 8. Prt. 98-77, 98th Cong., 1st sess. Washington, U.S. Govt. Print Off., 1983; and Ladd, Helen. Federal Aid to State and Local Governments. In: Federal Budget Policy in the 1980s. Mills, Gregory B., and John L. Palmer, eds. Washington, The Urban Institute, 1984. p. 165-202. 12/ See Dennis Zimmerman. Testimony before the Subcommittee on Intergov- ernmental Relations of the Senate Committee on Governmental Affairs. The Treat- ment of State-Local Nonbusiness Tax Deductions in.Tax‘ReformflProposals. June 26, 1985; and Department of Treasury. Office of State and Local Finance. Federal- State-Local Fiscal Relations: Report to the President and the Congress. Sep- tember 1985. Chapter IX. CRS-26 As this report is written, the latest version of tax reform as produced by the House Committee on.Ways and Means would restore full deductibility to State- local taxes. Any effect on State-local taxes would be attributable solely to lower marginal tax rates and the relatively small tax price increase that would result. But, the tax legislative process is far from complete, and efforts may still be made to adopt a compromise position between full deductibility and com- plete elimination of deductibility. One of the compromises is the Rostenkowski proposal to limit deductibility. It is particularly interesting because it illustrates how sensitive different States‘ tax revenues can be to the structure of Federal tax treatment of State- local taxes. The Rostenkowski proposal would eliminate deductibility of sales sales and personal property taxes. It would restrict deductions to income and real property taxes and would permit the itemizer to choose between deducting these taxes in excess of 5 percent of adjusted gross income or deducting these taxes up to $1000 (married) or $500 (single). For any State, the difference in these two proposals‘ effect on State-local taxes and spending depends primarily upon the effect on itemizers' tax price. The proposal that increases the tax price the most would generate the biggest de- crease in taxes and spending. These differences are summarized in table 8.0 We do not have 1985 data. In fact, the latest year for which we have State-by-State data is 1980. Thus, the differences in the proposals are illustrated assuming the changes had been imposed in 1980. The 1980 marginal tax price based on 1980 tax law appears in column 1. This This is the net cost to the taxpayer of an additional dollar of State or local taxes after the offsetting effect of Federal deductibility has been taken into account. For example, in Wyoming the average itemizer marginal tax rate was 30 percent, creating a 0.70 marginal tax price. In calculating the average itemizer CRS-27 TABLE 8. The Effect of the Administration and Rostenkowski State-Local Tax Deductibility Proposals on the Average State-local Itemizer's Marginal Tax Price Assuming the Changes were Imposed in 1980 STATE MARGINAL MARGINAL % INCREASE % ITEMIZERS MARGINAL % INCREASE TAX PRICE: TAX PRICE: IN TAX PRICE: NOT AFFECTED: TAX PRICE: IN TAX PRICE: 1980 LAW ADMINISTRATION ADMINISTRATION ROSTENKOWSKI ROSTENKOWSKI ROSTENKOWSKI Wyoming 0.70 1.00 42.8 97.5 0.71 1.1 Massachusetts 0.71 1.00 40.8 95.9 0.72 1.7 Louisiana 0.71 1.00 40.9 94.9 0.72 2.1 Texas 0.69 1.00 45.7 81.4 0.74 8.5 Washington 0.70 1.00 42.8 86.7 0.74 5.7 Tennessee 0.71 1.00 40.0 89.3 0.74 4.3 Florida 0.71 1.00 40.1 85.4 0.76 5.9 New York 0.70 1.00 41.9 80.7 0.76 8.1 Nevada 0.73 1.00 37.8 88.8 0.76 4.2 Dist. of Columbia 0.68 1.00 47.7 62.5 0.80 17.9 Mississippi 0.72 1.00 38.3 70.8 0.80 11.2 South Dakota 0.74 1.00 35.7 71.6 0.81 10.1 Indiana 0.71 1.00 40.9 62.1 0.82 15.5 Maryland 0.69 1.00 44.2 52.8 0.84 20.9 Wisconsin 0.72 1.00 38.8 59.0 0.83 15.9 Arkansas 0.73 1.00 36.1 61.3 0.84 14.0 Oklahoma 0.71 1.00 39.9 54.9 0.84 18.0 New Mexico 0.73 1.00 37.5 54.7 0.85 17.0 North Dakota 0.72 1.00 38.8 51.0 0.86 19.0 Alabama 0.73 1.00 37.5 48.2 0.87 19.4 Oregon 0.72 1.00 38.4 45.2 0.87 21.0 Michigan 0.70 1.00 42.7 40.3 0.88 25.5 Minnesota 0.71 1.00 41.0 39.7 0.88 24.7 Arizona 0.73 1.00 37.0 43.0 0.88 21.1 Delaware 0.69 1.00 44.3 35.6 0.89 28.5 West Virginia 0.69 1.00 45.0 34.2 0.89 29.6 California 0.72 1.00 39.6 36.4 0.90 25.2 Missouri 0.72 1.00 39.7 32.5 0.91 26.8 Ohio 0.70 1.00 42.5 30.3 0.91 29.6 Alaska 0.64 1.00 55.8 21.3 0.92 4 .9 Vermont 0.71 1.00 41.0 26.3 0.92 30.2 Maine 0.73 1.00 37.9 26.6 0.93 27.8 Hawaii 0.71 1.00 41.8 22.3 0.93 32.5 Georgia 0.71 1.00 40.5 23.0 0.93 31.2 Kansas 0.71 1.00 41.6 22.3 0.93 32.3 Connecticut 0.68 1.00 46.1 19.4 0.94 37.1 South Carolina 0.73 1.00 37.5 23.8 0.94 28.6 New Jersey 0.69 1.00 45.1 19.6 0.94 36.2 Montana 0.73 1.00 37.2 23.5 0.94 28.5 Idaho 0.74 1.00 35.1 22.2 0.94 27.4 North Carolina 0.72 1.00 39.7 18.8 0.95 32.3 Utah 0.75 1.00 32.9 21.1 0.95 26.0 Colorado 0.72 1.00 39.3 14.5 0.96 33.6 Virginia 0.70 1.00 43.7 12.7 0.96 38.2 Iowa 0.71 1.00 40.4 13.2 0.96 35.1 Rhode Island 0.71 1.00 40.5 12.8 0.96 35.3 Kentucky 0.71 1.00 40.4 12.8 0.96 35.3 Nebraska 0.72 1.00 39.8 12.0 0.97 35.0 Illinois 0.69 1.00 44.3 6.4 0.98 41.5 Pennsylvania 0.71 1.00 41.7 5.7 0.98 39.4 New Hampshire 0.71 1.00 41.2 1.4 1.00 40.6 CRS-28 tax price for each State, joint returns are counted twice, single returns once. The itemizer's marginal tax price under the Administration proposal is presented in the second column. Under this proposal, every dollar of tax which is deducti- ble under current law would no longer be deductible. Every itemizer's after- Federal-tax cost of his last dollar of State-local tax rises from a value of one minus his marginal tax rate to a value of one. Thus, the marginal tax price for itemizers in.every State under the Administration proposal would be one, as indi- cated in column 2. The percentage increase in itemizer tax price that would be produced by this proposal (compared to 1980 law) appears in column 3. The interesting thing about the Rostenkowski proposal is that it would not increase every itemizer's tax price to one. The itemizer would choose the floor or ceiling option which minimizes his tax liability. The last dollar of State- local tax would still be deductible for itemizers who choose the floor and have income taxes plus real property taxes in excess of five percent of AGI, or who choose the ceiling and have income taxes plus real property taxes less than $1000 (married) or $500 (single). These itemizers would not experience an increase in their marginal tax price. But the last dollar of State-local tax would not be deductible for itemizers who choose the floor and whose income plus real property taxes are less than 5 percent of AGI, or who choose the ceiling and whose income plus real property taxes exceed $1000 (married) or $500 (single). These item- izers would experience an increase in their marginal tax price to.a value of one. 0 The percent of itemizers under Rostenkowski whose tax price would remain equal to the 1980 law tax price appears in column 4._l§/ For example, 97.5 _l§/ The average itemized married and single deduction for income plus real property taxes in 14 AGI classes is tested against the floor and ceiling. The itemizer is assumed to choose the option which minimizes Federal tax liability. If the average married (single) return is determined to retain deductibility for its marginal tax dollar, all married (single) returns are considered (continued) CRS-29 percent of Wyoming itemizers would experience no increase in marginal tax price, because the ceiling is larger than the average itemizer's deductible income and property taxes (for 1980). The marginal tax price for itemizers under the Rostenkowski proposal is presented in column 5. It is calculated as a weighted average of the two tax prices -- the 1980 tax price and 14. For example, in Wyoming a 1980 tax price of .70 times .975 (for the 97.5 percent of itemizers not affected) plus a new tax price of 1 times 0.25 (for the 2.5 percent of item- izers affected) yields a marginal tax price of .71. lfij The percentage tax price increase under Rostenkowksi from 1980 law appears in column 6. The States are ranked in table 8 in descending order of the difference be- tween the percentage tax price increase for the Administration and Rostenkowski proposals (column 3 minus column 6). The increase is always higher for the Ad- ministration proposal because gi;_itemizers experience a price increase. The Rostenkowski proposal would provide Wyoming and Massachusetts with the most re- lief and Pennsylvania and New Hampshire with the least relief from the expected decrease in State-local taxes and spending caused by enactment of the Administra- tion proposal. For example, the percentage increase in the marginal tax price for Massachusetts itemizers would be 1.7 percent under Rostenkowski (because 96 percent of itemizers‘ deductible income and property taxes exceed the 5 percent floor) and 40.8 percent under Administration. In contrast, New Hampshire's per- centage increase would be about the same under the two plans, falling to 40.6 (continued) not to be affected by the proposal. It was not possible with these data to identify those taxpayers who would switch from itemizing to the standard deduction. The procedure, therefore, overestimates the number of taxpayers whose tax price is not affected by Rostenkowski. lg] This somewhat underestimates the Rostenkowski price change, because the lower Rostenkowski tax rates (and higher tax price) are not included in the calculation for itemizers whose marginal tax dollar is still deductible. CRS-30 percent for Rostenkowski (because deductible income and property taxes exceed the ceiling for over 98 percent of itemizers) and 41.2 percent for Administra- tion. The primary reason for the difference in the two proposals‘ tax price in- creases is the percent of itemizers whose tax price is not affected under Rostenkowski, shown in column 4. In summary, eliminating deductibility would raise itemizers‘ tax prices and lower after-tax incomes, and would have an adverse effect on State-local taxes and spending. The magnitude of the decrease depends critically upon the extent of itemizers‘ political control and their sensitivity’ to price and. income changes, factors about which opinions differ. All States would be affected by the Administration's proposal to eliminate deductibility. The Rostenkowski pro- posal to partially limit deductibility would affect the States very differently, reducing the Administration proposa1's adverse effect substantially for some States and very little for others. It is important to remember that even should full deductibility be retained, a substantial reduction in tax rates would raise the tax price of itemizers and might generate substantial interest among State- local itemizers in reducing their State-local tax burdens. TB. Exclusion of Interest Income from Tax-exempt Bonds As was true with State-local taxes, the Federal revenue loss from exclusion of interest income on tax-exempt bonds increased from 1980 to 1985, in this case by 30.8 percent in constant dollars. Federal financial support to the State- local sector through tax-exempt bonds was also becoming an increasingly impor- tant source of financial assistance. The value of this Federal assistance to the State-local sector is the dif- ference between the interest income on taxable bonds which State-local govern- ments would have to pay in the absence of tax exemption, and the interest they CRS-31 income they actually pay. Since many purchasers of tax-exempt bonds receive in- terest income in excess of the income required to induce them to choose tax- exempt rather than taxable bonds, some portion of the Federal revenue loss goes to purchasers of the bonds rather than to State-local governments. Tax-exempt bonds have historically been used to finance traditional State- local functions, such as roads, sewers, and schools. Over the past 20 years, they have, however, been used for an ever-expanding variety of purposes. State and local governments have issued bonds and used the proceeds on behalf of such entities as private business for fast-food restaurants and heavy industries; private non-profit institutions for education and medical care; individuals for student loans and owner-occupied housing; and «communities for’ airports and sports stadiums. Congress has made repeated efforts to restrict the growth of "private- purpose" tax-exempt bonds. Major legislative action began with the Revenue and Expenditure Control Act of 1968, which placed restrictions on the issuance of industrial development bonds (IDBs). Subsequent legislation has addressed bond use for such purposes as student loans and mortgage subsidies. The most recent effort to restrict the growth of private-purpose bonds was the State per capita volume cap on IDBs enacted in the Deficit Reduction Act of 1984. In spite of these efforts, the share of long-term tax-exempt bond volume classified as pri- vate purpose has continued to rise. The Congress is of two minds on the merits of the non-traditional activities financed with tax-exempt bonds. On the one hand, many of these "private-purpose" bonds generate benefits for particular State-local areas, but generate zero (or even negative) net benefits for the Nation. lg] On the other hand, many of the _l§/ For a more complete discussion of these issues, see U.S. Library of Congress. Congressional Research Service. Limiting the Growth of (continued) CRS-32 activities financed with these bonds, such as economic development, student loans, and owner-occupied housing, also receive Federal support from the expend- iture side of the budget or from.other tax subsidies. How can these other forms of Federal subsidy for these activities be justified if the activities do not serve a public purpose? The Administration proposal to deal with the growth of "private-purpose" tax-exempt bonds would disallow tax exemption if more than one percent of bond proceeds is used directly or indirectly by a person other than a State or local government. Non-governmental use of a facility financed with proceeds of State- local bonds would be considered to be use of those proceeds, making the bonds taxable. The bonds would, however, be tax exempt when the facilities are used by a nongovernmental person provided the facilities are available for use by the general public on the same basis. This "on the same basis" exception would ap- parently be dependent upon the absence of a formal or informal use agreement with the nongovernmental person and by the accessibility of the facility to the gener- al public. In addition, a facility financed with bonds must be owned by a governmental unit to qualify for tax exemption. Public/private partnership would be allowed only to the extent of a private management contract not exceeding one year. Al- p location rules would permit tax-exempt financing for a proportionate share of the cost of a facility used in part for governmental and in part for nongovernmental purposes. The Administration's proposal attempts to impose a governmental use-of- proceeds rule that virtually requires direct government provision of goods and (continued) Tax-Exempt Industrial Development Bonds: An Economic Evaluation. Report No. 84-37 E, by Dennis Zimmerman. Washington, 1984. 37 p. ‘ CRS-33 services as a proxy for a definition of public purpose. The rule is much more restrictive than the use of proceeds rule now in effect, and would allow for no exceptions. This rule would eliminate the use of tax-exempt bonds for activities frequently characterized as private purpose (e.g., student loans, IDBs, and pol- lution control), because these purposes require nongovernmental use of bond pro- ceeds. But this rule would also eliminate activities providing public benefits through nongovernmental use of bond proceeds. Subsidizing nongovernmental enti- ties in order to provide student loans, airport facilities, and economic develop- ment may be a desirable way to satisfy public purpose. Such activities often re- ceive other types of Federal subsidies, so it is not clear why the use of tax- exempt bonds for these activities is said to serve no public purpose. The Treasury Department estimates that 61 percent of all long-term tax- exempt bonds issued in 1983 would have been taxable under its proposed rules._L§/ Although others may estimate the percent to be somewhat higher, all agree that the Treasury’ proposal would. substantially ‘reduce Federal. assistance: to the State-local sector. Any disagreement which exists concerns (1) the extent to which the activities being denied financial assistance are serving a public pur- pose, l1] and (2) how much the interest subsidy for traditional public-purpose bonds would be increased by the reduction in supply of other tax-exempt bonds. .l§/ U.S. Department of Treasury. The President's Tax Proposals to the Con- gress for Fairness, Growth, and Simplicity. May 1985. p. 283. ll] This issue is discussed more completely in U.S. Library of Congress. Congressional Research Service. lTax Reform and Tax-Exempt Bonds: Separating Public and Private Purpose. Report No. 85-1009 E, by Dennis Zimmerman. Washing- ton, 1985. 16 p. CRS-34 The major alternative to the Administration proposal is the Rostenkowski proposal. It would disallow exemption if more than 5 percent or $5 million of the bond proceeds, whichever is less, were used by a person other than a State or local government. Thus, this proposal follows essentially the same path to reform as the Administration proposal -- restriction based upon the user of the proceeds. Unlike the Administration proposal, this proposal would make some excep- tions which permit some flexibility in who uses bond proceeds. Exceptions would be made for tax-exempt organizations (not-for-profit hospitals and universi- ties), and for specific categories of projects, much in the manner of current law. These include multi-family housing, some airport facilities, some dock and wharf facilities, some facilities for the furnishing of water, and sewage and solid waste facilities. These exceptions are nonetheless more restrictive than current law because of various special conditions that would have to be met to merit tax exemption. Long-term management contracts would be permitted. In summary, the proposals to restrict the supply of tax-exempt bonds would reduce Federal financial support to the State-local sector. However, it is not clear how important the loss is to the essential functions of the State-local sector. C. Tax Credit for Rehabilitation Expenditures Current law allows a tax credit for rehabilitation expenditures on older buildings, 15 percent for nonresidential buildings at least 30 years old and 20 percent for nonresidential buildings at least 40 years old. The depreciable ba- sis of the building is reduced by the amount of the credit earned, and straight line depreciation must be used with respect to the rehabilitation expenditures. CRS-35 If the building is a certified historic structure, the credit is 25 percent and the depreciable basis is reduced by 50 percent of the amount of the credit earned. Table 7 indicates that the Federal revenue loss from this provision is very small relative to tax deductibility and tax-exempt bonds. (The provision was not enacted until 1981, effective for 1982.) Furthermore, the subsidy is not pro- vided for a State-local fiscal instrument like taxes or bonds, but rather to in- dividuals and businesses engaging in rehabilitation of buildings. Any benefits to the State-local sector are even more indirect than is the case for the tax and bond subsidies, and accrue from the increased property values and economic activ- ity associated with such expenditures. The State-local sector is probably interested in this provision because the locations of the structures being rehabilitated may be concentrated in older, and most likely urban areas. It is precisely these areas which have been most con- cerned about their deteriorating tax bases and loss of economic activity to sur- rounding suburban and exurban areas. Thus, it is possible that loss of this pro- vision could have a significant dampening effect on the economic revitalization of some urban areas. However, some of these rehabilitated buildings displace new construction that would otherwise have occurred, and some displace non-real estate investment expenditures that also contribute to the State-local tax base. The overall net effect on the State-local sector is probably not very great from this provi- sion. l§/ l§/ For a discussion of the likely economic effects of the provision, see Gensheimer, Cynthia Francis. Rehabilitation Tax Credits: A Real Estate Tax Shelter of the 1980s. The Journal of Real Estate Taxation, summer 1982. p. 299- 318. CRS-36 The Administration proposal would completely eliminate the tax credit for rehabilitation expenditures. The Rostenkowski proposal would restrict the cred- it to buildings constructed before 1935 and reduce the credit to 10 percent; the credit for certified historic structures would be reduced to 20 percent and re- quire a full basis adjustment for depreciation. In summary, elimination of the tax credit for rehabilitation expenditures would probably not have a substantial effect on the fiscal health of the State- local sector as a whole. A few jurisdictions might be affected much more than the average due to their age and concentration of older and historic buildings. D. State-Local Income Tax Linkage to the Federal Income Tax Thirty-eight States and the District of Columbia levy both an individual income and corporate net income tax, while eight States levy either an individual "cou- or a corporate net income tax. Most of these State-local income taxes are pled" or linked to the Federal income tax. la] The State-local definition of its adjusted gross income, taxable income, deductions, exemptions, or credits is often in some way dependent upon the Federal income tax definition of these con- cepts. Thus, when Federal tax policy changes the definition and measurement of these concepts, State-local income tax revenues respond automatically. The Economic Recovery Tax Act of 1981 offers an excellent case study of these effects. Among many other changes, the Act accelerated expenses for de- preciation of capital assets. States with corporate income and individual in- come taxes soon discovered these Federal changes had significantly increased lg] This is particularly true in three States -- Nebraska, Rhode Island, and Vermont -- where individual income tax liability is stated as a fixed per- centage of Federal taxes paid. CRS-37 depreciation deductions and thereby reduced corporate and individual income tax collections..gQ/ Some efforts have been made to estimate the automatic effects of Federal tax reform on State-local tax revenues, assuming no offsetting changes are made in State-local tax policies. One study evaluated the effect of three possible Fed- eral tax:changes based on 1981 data -- elimination.of all itemized deductions (a 14 percent increase in State tax liability), taxation of employer contributions to employees (a 30 percent increase), and taxation of currently nontaxable trans- fer payments (a 12 percent increase)._gl/ The potential effects on State-local revenue of Federal base broadening are substantial. The Advisory Commission on Intergovernmental Relations (ACIR) has been evaluating the effect (H? current tax reform efforts (H1 State-local tax reve- nues. ‘ggf Table 9 presents presents the ACIR staff's qualitative estimates of the relative effects among the States. These changes are short-term effects. It is possible that these automatic changes in State-local revenues would create a desire for adjustments in State- local income tax provisions. The discussion in section A of this chapter sug- gests that taxpayers‘ willingness to pay taxes and provide services is influ- enced by their after-Federal-tax income and the net price of a dollar of State- local tax. Federal tax reform is likely to affect State-local taxpayers‘ _gg/ Kweit, Catherine, and Marilyn M. Rubin. Impact of the Economic Recov- ery Tax Act on State and Local Revenues: A Case Study of New York City Corporate Tax Revenues. National Tax Journal, September 1982. p. 295-306. 21/ deSeve, Charles W., and Thomas E. Vasquez. The Impact of Changes in the Federal Tax Code (H1 State Tax Revenues. National Tax Journal, September 19840 pa 33/ Advisory Commission on Intergovernmental Relations. A Progress Report on the Study of the State-by-State Effects of a Comprehensive Federal Tax Reform. August 1985. Memorandum. CRS-38 The Potential Short-term Impact of Comprehensive Tax Reform on State Revenues, from "Coupling" Moderate to Large Small or Negative No Effect gj Colorado Alabama Alaska Delaware Arizona Arkansas Illinois California District of Columbia Kansas Connecticut Florida Louisiana Georgia Hawaii Maryland Iowa Idaho Mississippi Kentucky Indiana Missouri Maine Nevada Montana Massachusetts New Hampshire New Mexico Michigan New Jersey New York Minnesota North Carolina Ohio Nebraska Pennsylvania Oklahoma North Dakota South Carolina Utah Oregon South Dakota Virginia Rhode Island Tennessee Vermont Texas West Virginia Washington Wisconsin Wyoming a/ Nevada, Texas, Washington, and Wyoming do not levy any income taxes. Connecticut, New Hampshire, and Tennessee have corporation net income taxes, but very limited individual income taxes. Source: ACIR. A Progress Report on the Study of the State-by State Effects of a Comprehensive Federal Tax Reform. August 1985. Unpublished memorandum. Based on deSeve Economic Associates preliminary description of the linkages be- tween State tax codes and the Federal income tax structure. after-Federal-tax income and tax price. In the long run, that is, over some per- iod of years, State-local tax revenues are likely to be adjusted to a level con- sistent with these new levels of income and tax price. Thus, assuming other fac- tors do not change, a higher State-local tax price produced by lower Federal tax rates and the restriction of State-local tax deductibility may generate a desire to reduce State-local taxes by an amount which exceeds the revenue increase from "coupling." Thus, any short-term automatic increase in State-local tax revenues may simply be a temporary waystation on the path to State-local tax reduction. CRS-39 E. Tax Bases Exempt from State-Local Taxation by Federal Law Any exclusion or other special taxation of certain tax bases from State- local taxation affects the ability of the State-local sector to raise revenue. Special treatment of four tax bases is mandated by Federal law. 23/ The exemption of Federal real property from State-local taxation was esti- mated to cost the State-local sector about $4 billion in tax revenue in 1982. The exemption of interest paid on Federal securities from State-local taxation was estimated to cost about $2 billion in State-local revenues. Given the rapid growth in the national debt which has occurred since 1982, this exemption is costing State-local governments ever larger amounts of revenue. Federal law also precludes property taxes on the asset value of, as well as the interest paid on, Federal securities owned by national banks. This exclusion was estimated to cost State-local governments a maximum of $225 million in 1982. And, finally, the inability of State-local governments to levy sales taxes on goods sold on military bases was estimated to cost State-local governments about $541 million in 1982. The maximum revenue loss from all four provisions in 1982 amounted to about $6.8 billion. 23/ This section relies on Chapter X of the Treasury Department's study, Federal-State-Local Fiscal Relations. Office of State and Local Finance. Sep- tember 1985. See particularly table X.4. CRS-41 IV. FISCAL IMPLICATION OF SUPREME COURT'S GARCIA DECISION* As a result of the Supreme Court's February 19, 1985, decision in Garcia v. San Antonio Metropolitan Transit Authority, most State and local government workers became covered by the Fair Labor Standards Act (FLSA). One primary ef- fect of this decision was that these workers would now have to receive cash com-. pensation at the rate of one and one-half times their regular rate of pay for FLSA overtime hours worked. Previous to the Garcia decision, many State and lo- cal workers received compensatory time on an hour per hour basis for overtime hours worked instead of cash at the penalty rate. Almost immediately, represen- tatives of State and local governments estimated that the decision would cost them, and ultimately the taxpayer, billions of dollars. Representatives of State and local government workers, on the other hand, argued that such estimates were grossly overstated since they were based on "worst case" analyses. As the "dust" settled, it became clear that an accurate measurement of the total cost resulting from the Garcia decision would be very difficult to perform. At the heart of the issue was how many FLSA overtime hours State and local gov- ernment employees worked. The answer to this question varies significantly from one political jurisdiction to another. Furthermore, many employers already meet the provisions of the FLSA as the result of a collective bargaining contract. Another factor overlooked in the initial calculations was the opportunity for State and local governments to restructure their work periods so that the effect of the Garcia decision could be minimized. Several jurisdictions that took this * Prepared by Dennis M. Roth, Specialist in Labor Economics. CRS-42 route found they could significantly reduce the costs that resulted from the ex- tension of FLSA coverage. For these and other reasons, analysts realized that accurate cost estimates could not be performed in the immediate future. Nevertheless, the threat of an additional fiscal burden on State and local governments prompted the Congress to explore ways to minimize any additional costs that might result. Consequently, both the House and Senate met with repre- sentatives from public employers and organized labor and reached a compromise agreement. In summary, the compromise allows State and local governments to pay FLSA covered overtime in the form of compensatory time (comp time) as long as comp time is awarded on the basis of one and one-half hours for every FLSA over- time hour worked. Law enforcement, fire protection, and seasonal workers could accrue 480 hours of comp time before cash would need to be paid, and all other covered workers could accrue 240 hours before cash would need to be paid. Sever- al other issues were also addressed in the legislation. Eff The question now becomesf what will the fiscal impact on State and local governments be as a result of the amendments to the FLSA to counter the Garcia decision? Once again the answer must be that it will be extremely difficult, if not impossible, to estimate the fiscal impact of these amendments. A preliminary estimate on the economic effect of the Garcia decision prepared by the Congres- sional Budget Office (CBO) indicated that if the Garcia decision were to take ef- fect immediately (without any changes in union contracts and adjustments to work schedules), State and local governments would pay between $0.5 billion and $1.5 billion. As noted earlier, this assumption is a "worst case" one. With changes _gfl/ The Fair Labor Standard Amendments of 1985 became law on November 13, 1985 (P.L. 99-150)- For further information, see U.S. Library of Congress. Congressional Research Service. Issue Brief No. IB85195, by Dennis M. Roth and Vincent E. Treacy. (Updated November 27, 1985) CRS-45 V. SUMMARY AND CONCLUSIONS This report indicates that Federal intergovernmental policy in the 1980s reflects a serious reevaluation of the Federal responsibility to provide finan- cial assistance to the State-local sector. All forms of Federal financial as- sistance have either been reduced or have been threatened with reduction. Real outlays for grants for State-local programs have been substantially reduced. Current legislative proposals would also reduce outlays for grants for individu- als. And Federal tax subsidies to the State-local sector have been coveted as a primary revenue source to pay for reduction of Federal income tax rates. It is important to consider the Federal budget environment in which these reductions have occurred. They have not occurred at a time when Federal spending ing was declining in real terms, so that one could rationalize the reductions as the State-local sector accepting its proportionate share of an austerity plan. Rather, the reductions have occurred at a time when Federal spending increased by 23 percent in real terms. The conclusion seems clear that these accumulated pol- icies reflect, at the least, a willingness by Congress and the Administration to question the desirability or usefulness of the goods and services the State-local sector provides with Federal funds. This is not a new story, and this is certainly not the first report to com- ment on what appears to be an ongoing reassessment of the relative roles of the Federal and State-local governments in our federal system. But the report does point out that the withdrawal of Federal support is proceeding on virtually all fronts. CRS-46 In this environment, the State-local sector is reassessing its past prac- tices. Some sorting-out process is occurring whereby demands for Federal sup- port are relinquished in those areas lacking substantial national or regional in- terest, and instead concentrated in those areas where the State-local sector is the logical or efficient unit of government to provide services possessing sub- stantial national or regional interest. No clear-cut solution is available, but recent budget and tax policies indicate strong desires at the Federal level to get on with the process, with or Without active cooperation at the State-local level. dg/cjw/agf/jw/mls/jw TABLE A. CRS-47 APPENDIX In Current Dollars, Fiscal Years 1980-1985 (S billions) U.S. Budget Outlays by Selected Categories of Expenditures 1980 1981 1982 1983 1984 1985 Total U.S. Budget Outlays 3/ $576.7 $657.2 $728.4 $796.0 $841.8 $936.8 National Defense and International Affairs 144.8 168.7 195.3 218.9 240.5 266.9 National Defense 134.0 157.5 185.3 209.9 227.4 251.5 Direct payments to Individuals 245.5 286.4 318.8 353.7 355.5 367.0 Social Security and Medicare 151.0 179.1 202.1 224.0 237.0 239.1 Income security 67.1 77.2 84.4 96.6 85.1 93.0 Veterans benefits and services 20.9 22.5 23.6 24.6 25.0 25.9 All Other 6.5 7.6 8.7 8.5 8.4 9.0 Interest (net)_b/ 52.5 68.7 85.0 89.8 111.1 129.1 Grants to State and Local Governments 91.5 94.8 88.2 92.5 97.6 110.6 Payments to individuals 31.9 36.9 37.9 41.6 44.3 50.6 Health 14.8 17.5 17.7 19.0 20.5 22.6 Income security 17.0 19.3 20.1 22.5 23.6 27.8 Other 0.1 0.1 0.1 0.1 0.2 0.2 Other grants-in-aid 59.5 57.9 50.3 50.9 53.3 60.0 Natural resources and environment 5.4 5.0 4.9 4.0 3.8 4.0 Agriculture 0.6 0.8 1.0 1.8 1.8 3.4 Transportation 13.1 13.5 12.2 13.2 15.0 17.2 Community and regional development 6.5 6.1 5.4 5.0 5.1 5.1 Education, training, employment social services 21.8 21.4 16.5 16.0 16.6 19.1 Health and income security 2.4 3.1 3.0 3.6 3.4 3.8 General purpose fiscal assistance 8.5 6.7 6.3 6.3 6.7 6.1 All Other 1.2 1.3 1.0 1.0 0.9 1.3 All Other Federal Outlays 42.4 38.6 41.1 41.1 37.2 63.2 3/ Totals exclude "off-budget" outlays which are included in the total figures of the Budget of the United States Government in the following amounts ($ billions): years 1980-85. 14.2, 21.0, 17.3, 12.4, 10.0, and 9.1, respectively, for fiscal (continued) CRS-48 TABLE A. U.S. Budget Outlays by Selected Categories of Expenditures In Current Dollars, Fiscal Years 1980-1985 -- continued ($ billions) bf These totals have not been revised from those included in the initial presentation of the Fiscal Year 1986 Budget. £/ Tables 3.1, 3.3, and 11.2 in the Historical Tables. Budget of the United States Government. Fiscal Year 1986. Fiscal year 1985 totals and detail by function are from the Final Monthly Treasury Statement of Receipts and Out- lays of the U.S. Government (p. 29). Remaining figures for fiscal year 1985 are CRS estimates based on the Congressional Budget Office Analysis Division compi- lation showing grant components in the House and Senate baseline data compared to House and Senate baseline data compared to House conference actions. TABLE B. CRS-49 Index of Change. Fiscal Year 1980=100 U.S. Budget Outlays by Selected Categories of Expenditures in Current Dollars Fiscal Years 1980-85 1980 1981 1982 1983 1984 1985 Total U.S. Budget Outlays 3/ 100.0 114.0 126.3 138.0 146.0 162.4 National Defense and International Affairs 100.0 116.5 134.9 151.2 166.1 184.3 National Defense 100.0 117.5 138.3 156.6 169.7 187.7 Direct payments to Individuals 100.0 100.4 129.9 144.1 144.8 149.5 Social Security and Medicare 100.0 118.6 133.8 148.3 157.0 158.3 Income security 100.0 115.1 125.8 144.0 126.8 138.6 Veterans benefits and services 100.0 107.7 112.9 117.7 119.6 123.9 All Other 100.0 116.9 118.5 130.8 129.2 138.5 Interest (net) b/ 100.0 130.9 161.9 171.0 211.6 245.9 Grants to State and Local Governments 100.0 103.6 96.4 101.1 106.7 120.9 Payments to individuals 100.0 115.7 118.8 130.4 138.9 158.6 Health 100.0 118.2 119.6 128.4 138.5 152.7 Income security 100.0 113.5 118.2 132.4 138.8 163.5 Other 100.0 N.C. N.C. N.C. N.C. N.C. Other grants-in-aid 100.0 97.3 84.5 85.5 89.6 100.8 Natural resources and environment 100.0 92.6 90.7 74.1 70.4 74.1 Agriculture 100.0 133.3 166.7 300.0 300.0 566.7 Transportation 100.0 103.1 93.1 100.8 114.5 131.3 Community and regional development 100.0 93.8 83.1 76.9 78.5 78.5 Education, training, employ- ment and social services 100.0 98.2 75.7 73.4 76.1 87.6 Health and income security 100.0 129.2 125.0 150.0 141.7 158.3 General purpose fiscal assistance 100.0 78.8 74.1 74.1 78.8 71.8 All Other 100.0 108.3 83.3 83.3 75.0 108.3 All Other Federal Outlays 100.0 91.0 96.9 96.9 87.7 149.1 N.C. = Not Computed 2/ Totals exclude "off-budget" outlays which are included in the total figures of the Budget of the United States Government for fiscal years 1980-85. bf These totals have not been revised from those included in the initial presentation of the Fiscal Year 1986 Budget. Source: Computed by CRS from Appendix table A. CRS-50 TABLE C. U.S. Budget Outlays by Selected Categories of Expenditures In Constant Dollars (1980=100), Fiscal Years 1980-85 ($ billions) 1980 1981 1982 1983 1984 1985 Total U.S. Budget Outlays_§/ $576.7 $597.5 $617.8 $649.2 $661.8 $710.8 National Defense and International Affairs 144.8 153.4 165.6 178.5 189.1 202.5 National Defense 134.0 143.2 157.2 171.2 178.8 190.8 Direct payments to Individuals 245.5 260.4 270.4 288.5 279.5 278.4 Social Security and Medicare 151.0 162.8 171.4 182.7 186.3 181.4 Income security 67.1 70.2 71.6 78.8 66.9 70.6 Veterans benefits and services 20.9 20.5 20.0 20.1 19.7 19.6 All Other 6.5 6.9 7.4 6.9 6.6 6.8 Interest (net) b/ 52.5 62.5 72.1 73.3 87.3 98.0 Grants to State and Local Governments 91.5 86.2 74.8 75.4 76.7 83.9 Payments to individuals 31.9 33.5 32.1 33.9 34.8 38.4 Health 14.8 15.9 15.0 15.5 16.1 18.6 Income security 17.0 17.5 17.0 18.3 18.6 19.7 Other 0.1 0.1 0.1 0.1 0.1 0.1 Other grants-in-aid 59.5 52.6 42.7 41.5 41.9 45.5 Natural resources and environment 5.4 4.5 4.2 3.3 3.0 3.0 Agriculture 0.6 0.7 0.9 1.5 1.4 2.6 Transportation 13.1 12.3 10.3 10.8 11.8 13.0 Community and regional development 6.5 5.5 4.6 4.1 4.0 3.9 Education, training, employ- ment and social services 21.8 19.5 14.0 13.1 13.0 14.5 Health and income security 2.4 2.8 2.5 2.9 2.7 2.9 General purpose fiscal assistance 8.5 6.1 5.3 5.1 5.3 4.6 All Other 1.2 1.2 0.9 0.8 0.7 1.0 All Other Federal Outlays 42.4 35.0 34.9 33.5 29.2 48.0 3/7 Totals exclude "off-budget" outlays which are included in the total figures of the Budget of the United States Government for fiscal years 1980-85. bf These totals have not been revised from those included in the initial presentation of the Fiscal Year 1986 Budget. Source: Computed by CRS from Appendix table A. The following deflators were used: 110.0, 117.9, 122.6, 127.2 and 131.8 for FYs 1981-85, respectively. TABLE D. CRS-51 Index of Change. Fiscal Year 1980=100. U.S. Budget Outlays by Selected Categories of Expenditures In Constant Dollars. Fiscal Years 1980-85 1980 1981 1982 1983 1984 1985 Total U.S. Budget Outlays_a/ 100.0 103.6 107.1 112.6 114.8 123.3 National Defense and International Affairs 100.0 105.9 114.4 123.3 130.6 139.9 National Defense 100.0 106.9 117.3 127.8 133.4 142.4 Direct payments to Individuals 100.0 106.1 110.1 117.5 113.8 113.4 Social Security and Medicare 100.0 107.8 113.5 121.0 123.4 120.1 Income security 100.0 104.6 106.7 117.4 99.7 105.2 Veterans benefits and services 100.0 98.1 95.7 96.2 94.3 93.8 All Other 100.0 106.2 113.8 106.2 101.5 104.6 Interest (net)_b/ 100.0 119.0 137.3 139.6 166.3 186.7 Grants to State and Local Governments 100.0 94.2 81.7 82.4 83.8 91.7 Payments to individuals 100.0 105.0 100.6 106.3 109.1 120.4 Health 100.0 107.4 101.4 104.7 108.8 125.2 Income security 100.0 102.9 100.0 107.6 109.4 116.1 Other 100.0 N.C. N.C. N.C. N.C. N.C. Other grants-in-aid 100.0 88.4 71.8 69.7 70.4 76.5 Natural resources and environment 100.0 83.3 77.8 61.1 55.6 55.6 Agriculture 100.0 116.7 150.0 250.0 233.3 433.3 Transportation 100.0 93.9 78.6 82.4 90.1 99.2 Community and regional development 100.0 84.6 66.2 63.1 61.5 60.0 Education, training, employ- ment and social services 100.0 89.4 64.2 60.1 59.6 66.5 Health and income security 100.0 116.7 104.2 120.8 112.5 120.8 General purpose fiscal assistance 100.0 71.8 62.4 60.0 62.4 54.1 All Other 100.0 100.0 75.0 66.7 58.3 83.3 All Other Federal Outlays 100.0 82.5 82.3 79.0 68.9 113.2 N.C. = Not Computed 3/ Totals exclude "off-budget” outlays which are included in the total figures of the Budget of the United States Government for fiscal years 1980-85. bf These totals have not been revised from those included in the initial presentation of the Fiscal Year 1986 Budget. 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