Federal, State, and Local Linkages

From Taxes: Where Does the Money Go? by Scott Loveridge, Liz Templin, Carole  Yoho, and Nancy Lenhart

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This section looks at the flow of tax dollars between different levels of government. Because of these transfers, some units of government spend more than they collect, while others spend less than they collect. These transfers, in turn, affect the public's perception regarding how much they receive in government services for the taxes they pay.

Payments to State and Local Governments

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The federal government returns part of its tax receipts to state and local governments. States transfer part of their tax receipts and funds from the federal government to local governments. These shared funds are called intergovernmental aid .² Why does intergovernmental aid occur? Why not simply tax everyone less at the federal and state levels and let the local governments collect their own revenues from their own citizens?

As noted in the "A World Without Taxes" discussion, life would be very different without government services. Similarly, life could be very different without intergovernmental aid. Intergovernmental aid is a way of assuring minimal levels of services that would likely be underprovided (from the viewpoint of mainstream society) if local governments had to pay all the costs directly. Why would local governments "underprovide" certain services? The three basic reasons are:

1. Poor districts may not be able to pay. Most Americans believe that all citizens of this country are entitled to have certain basic human needs met regardless of their ability to pay. Examples are food, shelter, and to some extent, education and health care. Since local governments vary in their ability or willingness to ensure the level of services that society feels appropriate, the federal and state governments have enacted programs and provided funding from their own sources to share in local costs. Intergovernmental aid helps local governments that do not have the resources (tax capacity) to pay for basic services.
   
   
2. Benefits of the service may be reaped by persons outside the district. An example of this is pollution control. If Minnesota puts less pollutants into the Mississippi, then residents of nine other states benefit from the clean water. Isn't it reasonable that people in all ten states pay something for the benefit? Similarly, a well educated child often moves away from the home town. That well educated person then makes contributions to a different community from the one that provided the education. The well educated person who does stay in his or her home town may make a discovery or develop a new invention that helps everyone in the nation (for example, someone who breeds a new variety of wheat with improved yields that ultimately cuts everyone's grocery bills). So people benefit from educational services provided to children in communities in other parts of the state or nation. Most people feel that because some of the benefits of educational expenditures go to people outside the school district, local costs of education should be partially paid for by everyone in the state and nation. Similar arguments can be made for law enforcement, roads, bridges, and income maintenance programs. Intergovernmental aid is one way to make sure that everyone who benefits from local expenditures pays part of the costs.
   
   
3. Intergovernmental aid provides a method of matching people's taxing preferences to their preferred method of delivering services. Both the federal government and Minnesota state government rely heavily on income taxes. Most people feel that income taxes are fairer than property taxes, because income taxes are more closely based on a person's ability to pay. Property taxes are the mainstay of local governments (and virtually the only tax source available to local governments in Minnesota). The income tax is more efficiently administered at the federal and state levels because of the specialized personnel required and because people cannot easily escape it by moving. On the other hand, people generally seem to prefer to have services provided or managed by governments close to them and by people they can easily access.

How Big Is Intergovernmental Aid In Minnesota?

Considerable public policy debate concerns the level of services to provide, who should pay, how to provide services, and what level of government should be responsible. The debate has as much or more to do with personal beliefs and values than it does with facts. Therefore we don't discuss here whether the level, financing, and mode of service provision in Minnesota is appropriate or not. Instead, this section is intended to show you the importance of intergovernmental aid flows in Minnesota.

The federal government supplied roughly 16 percent of the total general revenue of Minnesota state and local governments in 1990-91. See Figure 3. The largest portion of federal aid was for public welfare (mainly Medicaid), with smaller percentages for education, highways, housing, and other programs. Federal funds are provided to the state or directly to local governments under a variety of conditions and arrangements-formulas set out in federal laws, funding for federally mandated activities, through application and competition, etc.

Figure 3. Flow of General Revenue Funds for Minnesota
State and Local Governments 1990-91 by Level of Government

Minnesota is close to the U.S. average of 16.1 percent in the percentage of its state and local general revenue it receives from the federal government. Twenty-eight states receive higher percentages and 21 states receive lower percentages (high of 24.6 percent for Mississippi and low of 11.5 percent for Alaska). On the basis of per capita intergovernmental revenue received by Minnesota's state and local governments, Minnesota's $643 per capita puts it above the U.S. average of $550 per capita. Ten states receive higher amounts on a per capita basis; 38 receive lower amounts; and one (Massachusetts) receives the same per capita amount from the federal government.³

To provide state and local government services in Minnesota in 1990-91, $18.8 billion was spent by state and local governments. This expenditure amounted to $4,250 per person, placing Minnesota in seventh place in state and local government general expenditure per capita in the nation.⁴ Figure 3 shows revenue sources for state and local government. As you can see, the state raises roughly one-half of all state and local government revenue. Local governments generate only a little over one-third of state and local government funds. However, as Figure 3 also shows, local governments wound up with nearly two-thirds of the funds raised from federal, state, and local sources combined.

Which Minnesota Local Governments Receive Aid?

Figure 4 shows how significant intergovernmental aid is to each type of local government, as compared to property taxes and other local sources. Note that school districts rely most heavily on intergovernmental aid.

Figure 4. Local Government General Revenue Sources — Minnesota, 1990-91

Since federal aid to state and local governments and state aid to local units are important in determining one's property tax bill, a review of federal and state policies and practices is crucial. We will begin with some basic information on the roles of the federal, state, and local governments. It should be noted that the various government levels share responsibility for administering a number of programs and services through a variety of arrangements. In other words, the roles of the federal, state, or local government are often not as exclusive to that one level as might appear from the description that follows.

Federal Government

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Many federal government activities flow out of its constitutional responsibilities to:

• Provide for national defense.
• Conduct foreign policy.
• Maintain law and order.
• Regulate interstate commerce.
• Create court and monetary systems.
• Provide services that cannot be efficiently provided by state and local governments.

The federal government has assumed the lead role in income maintenance programs — in financing some of them, and administering others. It also sets policies and rules for state and local administration of many social service programs.

Transfers to state and local governments accounted for 10.8 percent of total federal spending of $1.48 trillion in 1990-91—down from roughly 16 percent in the mid-70s. The proportion of state and local government revenue coming from federal aid has been declining since its high point in 1977-78, when it accounted for 22 percent of state and local general revenue. In 1990-91, it provided 17.1 percent of state and local general revenue.⁵ Federal program cutbacks and elimination of the federal general revenue sharing program (the State and Local Fiscal Assistance Act of 1972) have had a significant impact on state and local finances and programs. The recent policies of passing more responsibilities (sometimes with funding, but often without) down to the states have influenced state policy making. Given the federal deficit and political difficulties inherent in raising federal taxes, it appears unlikely that states and local units can expect much additional help from the federal government.

State Government

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State and local governments are generally responsible for functions such as:

• Education
• Transportation
• Social services
• Health, safety, and environment

States often share responsibility with the federal and local governments. For example, in Minnesota, the state provides much of the funding for K-12 education, while the local school district delivers the service. The key point is that revenue does not have to be generated by the same level of government that delivers the service. In Minnesota, the state government provides more state-raised funds to local units than most other states.

Unfortunately for Minnesota, cutbacks in federal government aid in the early 1980s came while the state was dealing with inflation, a recession, and the farm crisis. Unlike the federal government, state and local governments must balance their budgets. As a result, there was an increase in state and local taxes while budgets and services were cut. The state also cut aid to local governments in some areas. State aid accounted for roughly 43 percent of local government general revenue in 1980-81. During 1985-90, this figure dropped to about 38 or 39 percent, although total dollar aids did increase. The percentage for 1990-91 was 40.

In the 1989 session, the legislature made changes in Minnesota's tax system, especially the property tax system and in the way intergovernmental aid was distributed to school districts and local governments. Basically the state began to increase its responsibility for programs controlled at the state level (K-12 education, and certain parts of human services and the criminal justice system) and to decrease its responsibility for programs deemed local, such as municipal services. The changes were made in such a way as to minimize the effects on property taxes in 1990 when the provisions became effective. These shifts meant that the school districts had to raise less money from property taxes while the cities had to raise more. Most property tax levy limits were eliminated — effective for property taxes payable in 1993. Levy limits for schools are still set by the state.

At the beginning of 1991, Minnesota, like the rest of the nation, was in an economic downturn. Recessions reduce tax collections, while adding to burdens in the social service area. A projected state budget shortfall for the biennium resulted in a combination of spending cuts, tax changes, and local government aid reductions in the 1991 and 1992 sessions of the legislature.

In the slow-growth economy of 1993, Minnesota again found itself confronted with the prospect of insufficient revenues to meet increasing demands on the spending side, especially in K-12 education where enrollments are growing and other costs are rising; and in the human services area. Property tax increases prompted calls from both taxpayers and local governments for state relief. Changes were made in the 1993 legislative session to address the immediate problems and to correct some perceived inequities in the property tax and local aid systems. Meanwhile there is growing pressure from a variety of sources to reexamine the roles, responsibilities, and organization of state and local governments, including the way in which they raise their revenues. All of these kinds of changes, whether sweeping or piecemeal, have implications for taxpayers and for those who use public services.

Local Government

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The Minnesota state constitution states: "The legislature may provide by law for the creation, organization, administration, consolidation, division and dissolution of local government units and their functions . . ."⁶ In other words, the state created local governments and defines their powers . For some levels of government, like school districts and county governments, roles are very clearly outlined by the state and they must administer certain programs as directed by the state. These required activities are often called mandates.

The state has the authority to set minimum acceptable levels of services (i.e., pollution standards, educational levels, etc.). The state also has the constitutional authority to delegate to local units of government the responsibility for meeting these standards. Of course, local units of government can choose to provide levels of service higher than the minimum and can provide additional services the community desires. Cities, unlike counties and school districts, are established by local initiatives to provide services that are local in nature, such as sewage systems and local police and fire protection. Table 4 provides a snapshot of the major functions by type of local government.

Summary

• The federal government is involved in the provision of a number of basic public services. It provides dollars to state and local governments in the form of intergovernmental aid. Often intergovernmental aid formulas are structured to: (a) lessen differences in the ability of states and localities to provide basic services and (b) provide incentives for state and local governments to provide services that are seen as underprovided.
  
  
• Federal aid as a percentage of state and local revenues has been declining.
  
  
• The state has the authority to mandate that services be provided by local government.
  
  
• Minnesota state government directs a large share of its state-raised revenue to local governments as intergovernmental aid to lessen inequalities between areas, to ensure provision of basic services, and to hold down local property taxes.
  
  
• Increasing budget pressures on the state government have led the state to reduce or change some of its aid programs for local governments.
  
  

² Technically, this is classified as intergovernmental revenue, but since it is largely in the form of aid, we use "intergovernmental aid." Back

³ Advisory Commission on Intergovernmental Relations, Significant Features of Fiscal Federalism, Vol. 2, Revenues and Expenditures, pp. 156-159, September 1992. Back

⁴ Government Finances, 1990-91, tables 29 and 33. Forthcoming. Back

⁵ Government Finances, 1977-78, table 3, p. 16, and Government Finances, 1990-91, table 19. Back

⁶ Article XII, Section 3. Back

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