CRS REPORTS ON FEDERAL RETRENCHMENT IN INTERGOVERNMENTAL FISCAL RELATIONS DURING 1980s.

FEDERAL BUDGET AND TAX POLICY AND THE STATE-LOCAL SECTOR: RETRENCHMENT IN THE 1980s

This report discusses Federal budget and tax policies from fiscal years 1980 to 1989 as they affect the State and local sector. The focus here is on those Federal spending programs and tax provisions designed specifically to affect the State and local sector, such as grants-in-aid, General Revenue Sharing, and tax- exempt bonds, rather than on fiscal policy in general.

FEDERAL BUDGET AND TAX POLICY AND THE STATE-LOCAL SECTOR: RETRENCHMENT IN THE 1980s

SUMMARY

Federal spending and tax policy in the 1980s affected intergovernmental fiscal relations in several ways. First, Federal grants-in-aid and tax subsidies for State and local services decreased during the 1980s. For example, Federal grants for State and local programs (in constant dollars) declined at a 5.3 percent annual rate between 1980 and 1989; the allowable volume of tax-exempt bonds for what the Congress (but not State and local officials) has defined as private activities decreased by 57.0 percent between 1983 and 1988; and the ability of State and local taxpayers to deduct their nonbusiness sales taxes from the Federal income tax base w as eliminated. These changes are consistent with Presddent Reagan's effort to reassess the Federal taxpayer's responsibility for supporting State and local services and, eventually, to return more responsibility for some public services to the State and local sector.

Second, the Federal Government moved substantially toward reducing its direct financial relationships with local governments. An increased share of remaining Federal grants-in-aid is funneled to the States, where some of it is repackaged and sent on to local governments. The proportion of grants paid initially to local governments accounted for 25 percent of total Federal grants during the 1979-80 fiscal years and 15 percent in fiscal years 1985-86. In addition, local governments, which previously had independent access to the tax-exempt bond market to issue what the Congress terms private-activity bonds, now must go to their State governments to receive an allocation of the State's capped private-activity bond volume before they may issue such bonds.

Finally, both States and local governments responded to this reduced Federal aid by raising their own-source revenues at a rate substantially in excess of inflation. This increase is reflected in the ratio of Federal spending to own-source revenue. At the State level, this ratio decreased by $9.21 per $100 of own-source revenue between fiscal years 1980 and 1986; at the local level, this ratio decreased by $1.92 per $100 of own-source revenue. These changes reflect an effort by the State and local sector to assume some of these former Federal responsibilities.

                              CONTENTS

As was true in the 1986 report, the focus here is on those Federal spending programs and tax provisions designed specifically to affect the State and local sector, such as grants-in-aid, General Revenue Sharing, and tax-exempt bonds, rather than on fiscal policy in general. It can be said, of course, that Federal fiscal policy often has a greater impact on State and local fiscal health than do changes in Federal programs specific to the State and 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 specific to the State and local sector to evaluate the evolving Federal view of the appropriate Federal and State-local roles in providing public services.

The report begins with a brief discussion of the justification for Federal financial support of State and local service provision. Although there is general agreement that a Federal role exists, the definition of that role is sufficiently subjective to allow for a wide range in the level of Federal financial support.

The report then turns to changes in Federal grants to State and local governments. The policies that led to the reduction in these grants (in constant dollars) are discussed in some detail, and the State and local effort to substitute their own tax effort for Federal grant dollars is investigated.

The report next identifies the major aspects of the various tax acts in the 1980s that affected Federal financial support to the State and local sector. The discussion focuses on tax-exempt bonds, the deductibility of State and local taxes, and the linkage of the Federal and State income tax bases.

A concluding section summarizes the overall effect of these Federal spending and tax policies on the State and local sector.

JUSTIFYING FEDERAL FINANCIAL SUPPORT OF STATE-LOCAL SERVICES

Two reasons are often cited for Federal financial support of the State and local sector. First, it is argued by some analysts that the State and 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 public education system are received by nonresidents, a community may provide less than the desirable amount of public education. It may be necessary for the Federal Government to provide a financial incentive to State and local governments in order to increase the level of such public services.

Second, fiscal disparities exist 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. The desire to reduce this unequal tax-base wealth due to its potential effect on the provision of basic services in different States has often been used to justify Federal subsidy of the State and local sector.

These rationales are generally acceptable to most people as a motivating force for Federal action. But they provide little guidance on the magnitudes of geographic spillovers or fiscal disparities that are socially or politically acceptable. Subjective judgments are required, and this subjectivity means that for all practical purposes a wide range of Federal support for the State and local sector is acceptable. No "correct" level of support is discernible.

FEDERAL BUDGET POLICIES

Changes in Federal expenditure policy can have profound effects on the fiscal health of the State and local sector. This section traces changes in Federal grant expenditures from FY1980 to FY1989, identifies the policy changes in the major Federal grant programs, and quantifies the response of both State and local governments to these changes.

FEDERAL GRANTS TO STATE AND LOCAL GOVERNMENTS

Total U.S. budget outlays rose from $590.9 billion in FY1980 to $1094.2 billion in FY1989, an annual growth rate of 6.8 percent. When corrected for inflation, this annual growth rate is reduced to 2.4 percent (see Appendix Table A for current dollar figures, Appendix Table B for constant dollar figures).

The allocation of this growing public budget was unevenly distributed among the major budget functions listed in Table 1. The most rapidly growing portion of the budget during this period was the Net Interest category. The burgeoning deficit caused net interest payments to grow at an inflation-adjusted rate of 7.4 percent. The other major budget categories that exhibited real growth over this period were National Defense/International Affairs (3.8 percent) and Direct Payments for Individuals (2.7 percent).

In contrast to these three categories, outlays for the other two major budget functions decreased in real terms. Grants to State and Local Governments increased in current dollars from $91.5 billion in 1980 to $119.0 billion in 1989, while All Other Federal Outlays actually declined in current dollars over this period from $54.6 to $48.5 billion. When adjusted for inflation, these figures represent negative rates of decline of 1.5 percent for Grants to State and Local Governments and 5.8 percent for All Other Outlays. These differences are highlighted in the first panel of Figure l, which displays the real growth rates of these major budget categories. The Grants to State and Local Governments category is labelled as Grants to States in Figure 1.

In order to appreciate fully the change in Federal policy toward the State and local sector, the Grants to State and Local Governments category must be broken down further. The Office of Management and Budget divides Grants to State and Local Governments into two types: payments for State and local programs, and payments for individuals. This distinction emphasizes that some grants provide cash or in-kind benefits to identifiable individuals -- through the Medicaid and Aid to Families with Dependent Children programs, for example. Other grants provide funding for State and local programs which in a sense benefit all State and local taxpayers -- such as highway construction and environmental clean-up programs or General Revenue Sharing.

The component of Grants to State and Local Governments that is channeled to individuals contains transfer-type activities of the Federal Government that are similar to the non-grants category in Table 1 called Direct Payments for Individuals. The primary difference between the transfer-type activities included in the Grants category and those in the Direct Payments category is that, for one reason or another, the degree of financial and administrative responsibility varies between the levels of government. ²

These two categories have, in fact, fared just about the same in the 1980s. Table 1 shows that the component of Grants going to individuals grew at an inflation-adjusted rate of 3.3 percent compated to 2.7 percent for Direct Payments for Individuals. Thus, in a sense, the effort to evaluate changes in Federal responsibility to provide financial support for the State and local service provision should be based upon the payments for State and local programs component (labelled For States) of the Grants to State and Local Governments category in Table 1.

  TABLE 1. U.S. BUDGET OUTLAYS BY SELECTED CATEGORIES OF EXPENDITURE

Figure 1 also separates the Payments to States category into payments for physical capital and payments for current expenditures, a breakdown that is useful in assessing recent concerns with infrastructure financing. It appears that reductions have focused more on current expenditures than on capital expenditures. Constant dollar payments for Physical Capital decreased at a 3.3 percent rate while those for current expenditures (labelled Other Grants) decreased at a 6.7 percent rate.

FIGURE 1. ANNUAL GROWTH RATE OF FEDERAL OUTLAYS FOR SELECTED BUDGET FUNCTIONS AND VARIOUS TYPES OF GRANTS-IN-AID: IN CONSTANT DOLLARS (1982=100), 1980-1989 [FIGURE OMITTED]

Additional detail on the physical capital/current expenditures (Other Grants) breakdown is provided in Table B in the Appendix. Large reductions occurred in the physical capital grants for Natural Resource/Environment and for Community and Regional Development, while grants for Transportation were almost constant in real terms. In the Other Grants category, the largest reductions occurred in Transportation, Community and Regional Development, and General Government.

FEDERAL POLICIES CAUSING GRANTS TO DECLINE

The present period of retrenchment (FY1979-1988) in Federal grants to State and local governments follows two decades of the most extensive increases in U.S. Government responsibilities for national domestic programs since the depression years of the 1930s. A brief review of the earlier period is helpful to understanding current policy. ³

Approximately 160 grant programs were authorized in 1962, and another 379 in 1966. They included what is today the largest grant program, Medicaid, which was enacted in 1966 as an addition to the entitlement programs created by the Social Security Act of 1935. The 1960s also witnessed the first funding for compensatory education of the disadvantaged. In the 1970s, large increases were made primarily in grants to local governments for economic development, local public works, public service employment, and anti-recession fiscal assistance.

Efforts were made in the 1970s to simplify the grant structure by replacing numerous categorical grants (for specified programs) with a general revenue sharing grant and six special revenue sharing programs. The General Revenue Sharing program and three of the special revenue sharing programs (community development, comprehensive employment and training, and law enforcement assistance) were enacted as block grants. Nonetheless, authorization continued for many of the categorical programs that were supposed to be replaced by these block grants.

The Nixon Administration's efforts to reduce expenditures included an attempt to impound funds for some categorical programs, primarily for wastewater treatment and highway construction grants. The Congressional Budget and Impoundment Control Act of 1974, however, required the executive branch to obtain approval from Congress to withhold appropriated funds, which in a number of instances was denied.

By 1979 both the Carter Administration and the Congress came to question the national benefits from the proliferation of grant programs. As a result, the first large cutbacks occurred that year: the elimination of the anti-recession fiscal assistance and local public works programs; a reduction in wastewater treatment and public service employment grants; and discontinuance of the State portion of General Revenue Sharing (GRS) and a refusal to adjust the nominal dollars in the local government portion of GRS for inflation. These cuts were followed in 1981 by the Reagan Administration's New Federalism proposal to rely more heavily on States, local governments, and the private sector for the financing of domestic programs.

Although much of this proposed realignment of responsibilities between the States and the Federal Government did not take place, other aspects of the Reagan proposal moved forward. Smaller categorical programs were merged into block grants. ⁴ Direct payment of grant monies to local governments was largely eliminated, although some of the funding was rechanneled to the States. A Federal commitment was made to provide a "safety net" (income maintenance and social services) and support for elementary and secondary education, but with increasing State participation. And transportation grants were increased while funds for other programs were reduced. ⁵ As a result of all this activity, grant programs decreased from 534 in 1981 to 422 in 1987 with a corresponding increase in block grants from four to thirteen. ⁶

Table 2 provides detail on specific categories of grant programs. The major programs for State-administered health and income security functions paid to individuals enjoyed positive real growth rates during the decade, although they may have had ups and downs during the decade. Part of the explanation for this growth is their exemption from the Gramm-Rudman-Hollings sequestration. The Medicaid program not only was exempt from cuts, but had its coverage extended to the elderly poor and to spouses whose partner's medical bills threaten their impoverishment. Both the health and income security programs will increase even more with the enactment of catastrophic health insurance legislation (P.L. 100-360), and possible adoption of welfare reform and home health care by the 100th Congress.

    TABLE 2. GRANTS TO STATE AND LOCAL GOVERNMENTS BY FUNCTION AND

/a/ The total includes other payments to individuals not shown separately and administered by States (e.g. health resources and services, alcohol and drug abuse, and mental health).

/b/ This is a new program designation beginning with the Fiscal Year 1988 Historical Tables of the U.S. Budget which combines "Aid to Families with Dependent Children" and "Child Support Enforcement." Totals include administrative costs as indicated by fiscal year 1987 detail shown in the Justification of Appropriation Estimates for Committee on Appropriations, Fiscal Year 1989 by the Family Support Administration of the Department of Health and Human Services. Administrative costs account for 10.5 percent of the total budget authority for AFDC.

/c/ Includes child nutrition, special milk and other programs related to nutrition and food service, housing assistance, low income energy assistance, and aid to refugees.

/d/ The total includes grants for airport development, recreational boating safety, and other programs related to transportation which are not shown separately.

/e/ Consists of economic development assistance, local public works and regional development programs, and grants related to urban renewal.

/f/ Consists of grants for impacted school aids, special education programs for the handicapped and other groups requiring assistance, and for public broadcasting, promotion of arts and humanities, and the development of job opportunities programs.

/g/ Not shown separately are the payments to the District of Columbia, the shared tax revenues, and outlays to U.S. territories and possessions.

/h/ Includes grants for the administration of Federal programs such as employment services and unemployment compensation as well as the Federal shares of other jointly financed programs. Other activities include the U.S. Department of Agriculture economic stabilization programs and those of the Environmental Protection Agency.

Some have suggested that Medicaid's charmed budgetary life is attributable to the political strength of its constituency groups: the elderly who become poor because of need for long-term nursing home care (and their offspring who are relieved of the burden); the medical provider groups -- hospital administrators and medical practitioners; and State administrators who wanted to transfer fully State-financed services into the Federally-matched Medicaid program.

Only two categories of State functions enjoyed positive real growth rates -- Highway Construction (0.3 percent) and the All Other category under Education, Training, etc. (primarily Office of Education programs, 1.2 percent). The increase in the highway category was funded in 1983 by a five-year five-cent increase in the Federal gasoline tax (through September 30, 1988, now extended through September 30, 1993). This tax has created surpluses in the Highway Trust Fund because of an unwillingness of the Reagan Administration to allow increased obligations. Similar efforts by Congress to increase the obligations for airport construction and renovation to the level of revenue from user charges earmarked for that purpose have failed, as have efforts to increase the authorization level for mass transit grants.

The near-level funding during this period for programs such as impact aid and vocational and adult education has been offset by increased emphasis on education for the handicapped and on vocational rehabilitation. The recently enacted Hawkins-Stafford Elementary and Secondary School Improvement Amendments of 1988 (P.L. 100-297) has added new grants for school dropout prevention, joint education of disadvantaged preschool children and their parents (Even Start), foreign language education, comprehensive child development centers, educational telecommunications partnerships, a Fund for the Improvement and Reform of Schools, and teaching and education for native Hawaiians.

The decreases in the programs grouped under the General Government and the Community and Regional Development categories are particularly noteworthy. Most payments for these programs had been made directly to local governments, and these decreases were instrumental in implementing the Reagan Administration's desire to refocus the Federal intergovernmental effort to State governmental units. ⁷ As a result, the proportion of grants paid initially to local governments accounted for 25 percent of total Federal grants during the 1979-80 fiscal years but only 15 percent in fiscal years 1985-86 (after netting out General Revenue Sharing from the '85-'86 figures to reflect the elimination of GRS in 1987).

The success of this policy to deal primarily with the States is further borne out by comparison of the decrease in total Federal grants as a percent of total general governmental revenue for States and local governments between fiscal years 1980 and 1986. The data indicate the magnitude of the decrease to be smallest for States and largest for county governments. The ratio fell 11 percent, from 26.5 to 23.6, for States; 28 percent, from 20.8 to 15.0, for special districts; 31 percent, from 8.9 to 6.1, for school districts; 57 percent, from 14.3 to 6.2, for cities; 72 percent, from 7.4 to 2.1, for townships; and 73 percent, from 9.1 to 2.5, for counties. ⁸

THE STATE AND LOCAL RESPONSE TO FEDERAL GRANT POLICY

The decline in Federal financial assistance to the State and local sector has been identified -- a 1.5 percent decrease in the real growth rate of Grants to State and Local Governments, and within this category a 5.3 percent decrease in the real growth rate of grants for State and local programs. The Federal policies that produced these changes have also been identified.

Two issues are raised. First, how important are cutbacks in Federal grants to the State and local sector's ability to provide services? Second, how did the State and local sector react to this reduction of Federal support? Did they pick up the slack and substitute their own revenue effort, or did they simply reduce services proportionately? This section addresses these issues by comparing changes in Federal grants to changes in State and local governments' own-source general revenue, based upon Census data. Unfortunately, these data are available only through State fiscal year 1986, so we cannot trace the response through to 1989.

The first columns in Tables 3 and 4 present the ratio of FY1980 Federal grants to State own source general revenue (Table 3) and local own-source general revenue (Table 4), multiplied by 100. The numbers show that Federal support was much more important for States than for localities. The State ratio of $39.84 suggests that $39.84 of services were financed with Federal revenue for every $100 financed with State-raised revenue. The ratio varied from a high of $63.30 in Montana to a low of $14.37 in Alaska. The local ratio of $18.53 suggests that $18.53 of services were financed with Federal revenue for every $100 financed with local-raised revenue. The ratio varied from a high of $104.36 in the District of Columbia to a low of $7.17 for local governments in Wyoming.

      TABLE 3. FY1980-86 STATE RESPONSE TO FEDERAL GRANT CHANGES:

Column 2 -- Actual Federal grants divided by own-source general revenue adjusted for 1980-86 inflation, times 100, minus column 1.

Column 3 -- Same as column 2 using actual 1986 own-source general revenue.

Column 4 -- Column 3 minus column 2.

Source: CRS calculations based upon U.S. Bureau of the Census. Governmental Finances in 1979-80 and 1985-86. GF-80 No. 5 and GF-86 No. 5.

      TABLE 4. FY1980-86 LOCAL RESPONSE TO FEDERAL GRANT CHANGES:

Column 1 -- Actual Federal grants divided by own-source general revenue, times 100.

Column 2 -- Actual Federal grants divided by own-source general revenue adjusted for 1980-86 inflation, times 100, minus column 1.

Column 3 -- Same as column 2 using actual 1986 own-source general revenue.

Column 4 -- Column 3 minus column 2.

Source: CRS calculations based upon U.S. Bureau of the Census. Governmental Finances in 1979-80 and 1985-86. GF-80 No. 5 and GF-86 No. 5.

Answering the question of how State and local governments responded to changes in Federal grants is difficult because it requires some judgment about what State and local revenue would have been if no policy changes had been made. Column 2 of Tables 3 and 4 illustrates how relative Federal effort would have changed by 1986 if the States and the local governments had raised their own-source general revenue sufficiently to maintain their share of the cost of services being provided in 1980, which we assume requires own-source revenue to grow at the rate of inflation.

The ratio in column 2 is calculated as FY1986 Federal grants (in current dollars) divided by FY1980 own-source revenue adjusted for the 1980-86 rate of inflation, multiplied by 100, and minus the 1980 ratio from column 1. The ratio in Table 3 indicates that grants increased more rapidly than inflation for State governments, while the ratio in Table 4 indicates the opposite is true for local governments. States on the average enjoyed an increased Federal contribution of $2.10 per $100 of own revenue (only 14 States had the relative Federal contribution decline), while local governments in every State suffered a decreased Federal contribution; the average decrease was $8.28 per $100 of own revenue. It is important to note that the local ratios use Federal grants net of payments for General Revenue Sharing (GRS). This is done in order to more closely approximate the Federal grant levels that prevailed after the demise of GRS in fiscal 1987.

Column 3 in both tables repeats the calculation of the change in Federal effort made in column 2 except it uses the actual own-source general revenue raised by States and local governments. If the decrease in column 3 (using actual revenues) exceeds the decrease in column 2 (using inflation-adjusted revenues), then the State or the local governments within a State have made an effort to pick up some of the spending responsibility turned back by the Federal Government. In effect, their own-source revenues grew faster than the rate of inflation, either because of discretionary revenue policy changes or because responsive revenue structures were in place.

In Table 3 the States are ranked in column 4 in descending order of the difference between columns 3 and 2, what one might call the State substitution effort. On average State own-source revenue increased more than the rate of inflation such that the Federal contribution ratio declined by $9.21 per $100 of own revenue. Wyoming led the way, increasing own-source revenue such that the Federal contribution declined by $24.21 per $100 of own revenue. Oregon seems to have made the smallest effort, increasing revenue only enough to decrease the Federal contribution ratio by $2.41 per $100 of own revenue. In column 4 of Table 4 local own-source revenue increased such that the Federal contribution ratio declined by $1.92 per $100 of own revenue. The District of Columbia led the way among local governments, increasing own-source revenue enough to decrease the Federal contribution ratio by $22.52 per $100 of own revenue. Massachusetts is the only State in which local governments appear not to have picked up any of the slack (it has a positive number in column 4), allowing own-source revenue to decline such that the Federal contribution ratio increased by $0.95 per $100 of own revenue.

FEDERAL TAX POLICIES

No assessment of the effect of Federal policy on State and local fiscal conditions is complete without considering the tax side of the Federal budget. The Federal income tax provides two instances of preferential treatment directed specifically to State and local governments -- the exemption of interest income from State and local bonds, and the deductibility of some State and local taxes from Federal taxable income. Both of these provisions have been altered substantial1y in the 1980s. In addition, many of the non State-local provisions of the major Federal income tax reform passed in 1986 had implications for the revenues collected by those States whose income tax is coupled in some way to the Federal income tax.

TAX-EXEMPT BONDS

The tax exemption privilege allows the State and local sector to raise capital at a considerably lower interest cost than would be incurred if the bonds were taxable. As a consequence, these bonds long have been a very important part of the sector's financial landscape. Access to these bonds has been subject to an increasing assortment of restrictions that has reduced the financial benefits to the sector. This section describes the growth of tax-exempt bond volume over the last two decades, assesses the impact of restrictions imposed in the 1980s on the use of bonds for private activities, and discusses the Federal and State-local perspective on the wisdom of these restrictions.

THE GROWTH OF BOND VOLUME

State and local use of tax-exempt bonds grew rapidly from the mid 1960s through the first half of this decade. The first panel of Figure 2 traces the growth in long-term tax-exempt bond volume from 1965 to 1987. Volume rose from $11.1 billion in 1965 to a peak of $204.3 billion in 1985, before falling to $98.7 billion by 1987. The annual growth rate between 1965 and 1985 was a remarkable 14.6 percent.

FIGURE 2. LONG-TERM TAX-EXEMPT BOND VOLUME, 1965-1987: ACTUAL AND ADJUSTED FOR INFLATION AND STATE-LOCAL SIZE [FIGURE OMITTED]

This rapid growth caught the attention of the Congress and Treasury officials. Two aspects of this growth were bothersome. First, the Federal revenue loss from the tax-free interest income on these bonds is tied directly to bond volume. By 1980 the revenue loss on the outstanding stock of bonds had reached the level of $10.7 billion, and by 1985 the revenue loss was $18.5 billion. The estimated revenue loss for fiscal 1988 is $21.0 billion.

Second, concern was expressed that this Federal financial assistance was being used for private rather than public purposes. Policymakers suspected that an increasing proportion of this volume seemed to be conduit financing, in which a State or local governmental entity issued bonds and passed the proceeds through to businesses and individuals for their private use. Activities being financed included: student loans and mortgages for owner-occupied and multifamily rental housing; facilities for sports events, convention centers, trade shows, airports, docks, wharves, parking, sewage and solid waste disposal, utility services, air and water pollution control, and industrial parks; and virtually any activity using a bond issue of less than $1 million for the acquisition, construction, or improvement of land or depreciable property.

The growth of private-use bonds is difficult to document because data on bond volume by private use were not collected until 1983. One way to get a rough approximation is to divide bond volume between its general obligation (GO) and revenue components. Bonds issued as general obligations of the issuing government pledge to pay the debt service on the bonds with the taxing power of the governmental entity. Almost all GO bonds are issued to support what has come to be termed public purposes. ⁹ Revenue bonds, in contrast, pledge to pay off the debt service with the revenues collected from the users of the capital facility being constructed with the bond proceeds. Almost all bonds issued to finance what have come to be called private activities are issued in the revenue bond form, although many activities considered to satisfy public purposes are also financed with revenue bonds. ¹⁰

The first panel of Figure 2 also provides a rough idea of the growing importance of revenue bonds, and thus to some extent of bonds issued for private activities. Those bond issues (both GO and revenue) that represent refundings of pre-existing bond issues (usually to take advantage of lower interest rates) are subtracted from total volume, and the remaining bond volume used to finance new capital facilities is divided between GOs and revenue bonds. These original-issue revenue bonds (the checkered area in the diagram) grew at an annual rate of 17.9 percent from 1965 to 1985, while original- issue GOs (the lined area in the diagram) grew at a much more modest 7.8 percent rate. Thus, the type of bond (revenue) issued for private activities was growing much more rapidly than the type (GO) normal1y used to finance traditional public-purpose activities. It must, however, be reiterated that some activities considered to be public purpose are financed with revenue rather than GO bonds.

Of course, one would expect tax-exempt bond volume to grow in order to accommodate growth in the size of the State and local sector and the effect of inflation. For that reason, the second panel of Figure 2 adjusts the bond volume data for the effects of inflation and growth in the size of the State and local sector (as measured by population growth). These adjustments cut the annual growth rate of total volume by more than half, to a rate of 6.6 percent. Decomposing this growth rate by type of bond shows that revenue bonds grew in real terms at a 9.9 percent annual rate while GOs actually had a very small negative growth rate over the 20-year period of 0.2 percent. Clearly, these data indicate that revenue bonds were responsible for the expanding municipal debt market. And private activities are invariably financed with revenue bonds.

THE IMPACT OF RESTRICTIONS ON PRIVATE-ACTIVITY BOND VOLUME

Congress reacted to this growth by imposing a series of limitations on the issuance of bonds for private activities beginning with the Revenue and Expenditure Control Act of 1968 and culminating in the Tax Reform Act of 1986. ¹¹ These limitations included attempts to define what constituted a private-activity bond that would be taxable (based upon governmental/nongovernmental use of the proceeds and the presence of trade or business property as security backing for the bonds); a string of exceptions that allowed private- activity bonds issued for certain activities to remain tax exempt (refer back to the list of private activities enumerated at the beginning of this section); requirements for registration of bond ownership; restrictions on arbitrage profits; and volume caps on those private-activity bonds that were favored with continued tax exemption.

The Deficit Reduction Act of 1984 introduced the concept of a volume cap by limiting the volume of private-activity bonds issued by all governmental entities in a State to the greater of $150 per person or $200 million. The cap was not very restrictive -- most private-activity bonds were not subject to the cap and the effective dates of the limitations allowed the issuance of bonds for projects already in the pipeline. The 1986 Act reduced the cap for 1987 to the greater of $75 per person or $250 million, and for 1988 and subsequent years to the greater of $50 per person or $150 million; reduced the number of private-activity bonds that retained a tax exemption; and subjected most of the remaining tax-exempt private- activity bonds to the cap. It is these restrictions which are primarily responsible for the marked drop in the volume of non- refunding revenue bonds shown in Figure 2, from $109.8 billion in 1985 to $35.4 billion in 1987. ¹²

The impact of these volume caps and other restrictions on private-activity bond volume can be determined more precisely than is possible with the data used in Figure 2. The year 1983 was the last year in which State and local governments could issue private- activity bonds without restriction. Fortunately, 1983 was the first year that the Tax Equity and Fiscal Responsibility Act of 1982 required that private-activity bond issues be reported to the Treasury. ¹³ Figure 3 compares the 1988 volume cap to actual 1983 private-activity volume, with the States ranked in descending order of their percentage reduction in bond volume. ¹⁴ The average reduction for all States is 57.0 percent. Arizona suffers the largest reduction, some 89.1 percent. Idaho and Delaware are the only States for which the 1988 volume cap exceeds actual 1983 private-activity bond volume, in Idaho by 8.7 percent.

FIGURE 3. PERCENTAGE REDUCTION IN ANNUAL VOLUME OF PRIVATE-ACTIVITY BONDS, 1988 VOLUME CAP COMPARED TO 1983 ACTUAL VOLUME [FIGURE OMITTED]

Bond volume data by "new capital category" from the public Securities Association can be used to get a good idea of private- activity bond use in 1987. These data divide the $51.7 billion of tax-exempt long-term borrowing into 50 "new capital categories." Fourteen of the categories amounting to $24.7 billion, or 48 percent of the total, contain what might be called traditional public purposes. Ten categories amounting to $11.7 billion, or 23 percent of the total, contain what might be called private activities. And 26 categories amounting to $15.3 billion, or 30 percent of the total, contain what might be called commercial-type enterprises generally operated by local governmental authorities, some of which might be considered private activities by some observer. ¹⁵

FEDERAL AND STATE-LOCAL PERSPECTIVES ON RESTRICTIONS

Views on the desirability of these restrictions depend to a large extent on one's perspective. The State and local sector by and large considers the restrictions to be an unwarranted infringement on their right to conduct their financial affairs free from Federal interference. This is not surprising since these revenue bonds generate benefits to the issuing jurisdiction and entail almost no cost to State and local taxpayers.

The issuing jurisdiction benefits in the sense that economic activity and jobs are either induced to remain within the jurisdiction or to move into the jurisdiction from some other location. The State and local calculation of benefits does not encompass consideration of whether the economic activity and jobs represent increments for the nation as a whole.

The issuing jurisdiction incurs few costs because debt service is paid by user charges or revenues generated by the project being built. If these project revenues are inadequate to cover the debt service, the issuing government is under no obligation to use tax revenue to cover the shortfall. So the cost of an unsuccessful project falls upon bondholders in the form of defaulted or delayed payments. And the other major cost of the subsidy, the foregone tax revenue from nontaxable interest income, falls upon Federal taxpayers.

The Federal policymaker has exactly the opposite concerns. The bonds are seen as simply redistributing the geographic location of economic activity and jobs, a result that is an unproductive use of scarce savings. And the bonds do impose costs on Federal taxpayers in the form of foregone income tax revenue.

Disagreement between the Federal and State-local governments has raged for years as to the legality of these restrictions, in the sense that bonds issued in violation of these provisions are taxable. The issue has been settled in the Federal Government's favor by a recent Supreme Court ruling, South Carolina v. Baker (56 USLW 4311 (April 20, 1988)). The Court held that there is no constitutional barrier to the imposition of Federal income taxes on interest income received by holders of State and local government obligations. ¹⁶ It is now clear that bonds that do not meet the requirements of the recent tax acts are subject to the taxation of their interest income, and will undoubtedly remain so, at least while the Federal Government is running large deficits.

DEDUCTIBILITY OF NONBUSINESS STATE AND LOCAL TAXES

The other major Federal tax change in the 1980s that directly affected the State and local sector is the treatment of nonbusiness State and local taxes in the calculation of Federal taxable income. Prior to the Tax Reform Act of 1986, State and local income, general sales, real property, and personal property taxes were all deductible in the calculation of an individual's taxable income. The Federal revenue loss from deductibility was substantial, rising from $20.5 billion in 1980 to $32.5 billion in 1986.

The effect of this subsidy on the fiscal health of State and local governments is considerably less than these figures might suggest, since not all of the revenue loss translates into financial assistance. Deductibility reduces the after-Federal-tax price (cost) of a State and local taxpayer's tax dollar and increases his after- Federal-tax income. Both the lower price and higher income cause the taxpayer to desire a higher level of State and local services, and to increase his willingness to pay higher State and local taxes. The extent of this increase in State and 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 political process reflect his changes in demand. ¹⁷

The Tax Reform Act of 1986 made three changes in Federal tax law which increased the cost of State and local taxes: (1) statutory tax rates were lowered; (2) the percentage of taxpayers who itemize was reduced; and (3) the deductibility of the sales tax was eliminated. This increased State and local tax made taxpayers desire a lower level of public spending and taxation. However, the magnitude of the desired reduction was probably small in most States.

To elaborate, for a taxpayer who itemizes deductions, the after- Federal-tax cost of a deductible State and local tax dollar equals one minus his Federal marginal tax rate. Prior to 1987, a taxpayer with the top Federal marginal tax rate of 50 percent had a cost of $.50 for his State and local tax dollar because his Federal tax bill was reduced by $.50. When the Tax Reform Act's 28 percent top tax rate is fully phased in, the same taxpayer will have an after- Federal-tax cost of $.72 for his State and local tax dollar. Thus, the reduction of Federal statutory tax rates has the effect of raising the cost to the State and local taxpayer of financing public services.

In any political jurisdiction, decisions about spending levels are made collectively with varying degrees of citizen input. Only those taxpayers who itemize on their Federal tax returns experience a cost reduction from State and local tax deductibility. The average tax price for a jurisdiction's citizens is also dependent on those taxpayers who itemize on their Federal tax returns. The Tax Reform Act had the effect of increasing the percentage of taxpayers who do not itemize, which effectively raised the percentage of taxpayers whose State and local tax cost is one dollar. (The top-rate taxpayer referred to above, were he to become a nonitemizer, would have his tax cost raised from $.50 to $1.00 instead of from $.50 to $.72). As the percentage of nonitemizers increases, the average tax price for the community as a whole increases, and the desire for a lower level of public spending increases.

Finally, the elimination of the deductibility of sales taxes raised the sales tax cost to $1.00 for all State and local taxpayers, whether or not they are itemizers. This change also had the effect of causing State and local taxpayers to want to decrease the level of public spending in those States that levy sales taxes.

Rough estimates of the effect of these three tax reform changes on the level of State and local spending by State have been made. ¹⁸ The reduction in tax cost from deductibility was estimated to have raised State and local spending an average of three percent in 1982 above what it would otherwise have been. This increase above what spending would otherwise be was expected to decline to about one percent in 1987. This suggests a small reduction in State and local spending from the Tax Reform Act of about two percent. In only two States (Utah and Colorado) was the decline estimated to be as high as three percent.

Some concern has also been expressed that the elimination of sales tax deductibility would cause States to restructure their tax systems to lessen reliance on the sales tax. Five of the ten States which do not have a general tax on personal income (see Table 5) raised more than half of their fiscal 1987 tax revenue from the general sales tax, and Mississippi, which has a low-rate income tax, also depends on the general sales tax for more than half of its taxes. But restructuring does not appear likely to occur soon, because it would require constitutional amendments to levy an income tax in most of these States. ¹⁹

LINKAGE BETWEEN FEDERAL AND STATE INCOME TAX BASES

The Tax Reform Act of 1986 also affected the level of State and local taxation via the linkage between State and Federal income tax bases. A major theme of tax reform was the broadening of the Federal income tax base. Those States with income tax bases linked (coupled) to the Federal base definition stood to experience a windfall increase in revenues if the State income tax structure was not adjusted. Those few States experiencing a windfall loss automatically bestowed a tax decrease and a smaller public sector on their citizens if the State income tax structure was not adjusted. The information presented in this section suggests the potential increase in State spending from the linkage of income tax bases was relatively small, exceeding three percent for only four States, and that the actual increases were even smaller because most States adjusted their tax structures to return much of the windfall to taxpayers.

The Advisory Commission on Intergovernmental Relations has made estimates of the percentage increase or decrease in each State's individual income tax revenues due to its coupling with the Federal income tax system. ²⁰ These estimates are presented in table 5, column 1. The importance of these changes in income tax revenue for State spending (in contrast to the importance for any individual's tax liabilities) depends upon how important income tax revenue is as a State revenue source. Accordingly, each State's individual income tax revenue as a percentage of general revenue is presented in column 2. Column 3 gives the percentage change in GENERAL REVENUE from the linkage of the two income tax systems (column l times column 2 divided by 100). Put in this context, the change in income tax revenue is not nearly as substantial. The change exceeds 3 percent of general revenue in only four States. Thus, even if a State decided to spend the additional income tax revenue, the size of the public sector would not grow very much.

A report by the National Conference of State Legislatures (NCSL) suggests most States did not spend the additional revenue, but rather returned it to taxpayers. ²¹ According to the NCSL survey, more than 80 percent of the $6.3 billion of automatic personal income tax increase from linkage was avoided by State action. Of the 34 States with expected automatic increases in income tax revenue, 15 will keep the entire amount, 13 will avoid it entirely, and 5 will keep part of it. The States keeping the revenue increase tend to be those expecting a relatively small increase.

Actions taken in 1987 to deal with the windfall revenue gains resulted in a permanent restructuring of State individual income taxes in 16 States. For example, the personal exemption and standard deduction was increased and the number of tax brackets were compressed (with lower rates at the lower and upper ends) in California, Minnesota, New York, West Virginia, and Wisconsin. ²² Nine States that either took no action in 1987 or provided one-year relief have enacted similar changes in their tax structures in the first half of 1988: Georgia, Hawaii, Idaho, Iowa, Utah, Maine, Nebraska, Oklahoma, and Vermont. Massachusetts, whose State income tax was not coupled to the Internal Revenue Code, voted to conform its provisions to those of the Tax Reform Act in 1988. ²³

  TABLE 5. PERCENTAGE CHANGE IN STATE INCOME TAX AND GENERAL REVENUE

/b/ Taxes only dividend or interest income above specified levels.

Sources:

Column 1--Advisory Commission on Intergovernmental Relations. The Tax Reform Act of 1986--Its Effect on Both Federal and State Personal Income Tax Liabilities. Staff Information Report SR-8. January 1988. Table 7b.

Column 2--Advisory Commission on Intergovernmental Relations. Significant Features of Fiscal Federalism, 1985-86 Edition. Report M-146. Table 34.

Column 3--CRS calculation, column l times column 2 divided by 100.

CONCLUSIONS

The Reagan Administration said it was going to reduce the Federal Government's role in the economy. If the Federal financial commitment to the State and local sector is a measure of its role, the promise has been kept. Both grants-in-aid (in constant dollars) and tax subsidies have been reduced during the 1980s. In addition, the remaining financial assistance available to the State and local sector has increasingly been funneled to the States and away from the local governments.

Attention might now turn to whether these trends are likely to continue. To this point, the effect on services has been cushioned because both the States and local governments have responded by increasing their own-source revenues sufficiently to assume some of the responsibility for services abandoned by the Federal Government. But suppose this reduction in Federal aid has not run its course and represents the beginning of a continued reevaluation of Federal intergovernmental responsibilities. One must ask whether the States and local governments will continue to fill the revenue gap and whether local governments will become increasingly dependent on State government for their intergovernmental assistance. The answers to these questions are of vital importance to State and local taxpayers and officials.

² For example, Food Stamp benefit levels are set and financed by the Federal Government, and the program is classified in the Direct Payments for Individuals category. Aid to Families with Dependent Children benefit levels are set and partially financed with State funds, and the program is classified in the Grants to States category. The Federal share of benefit levels in 1987 ranged from 50 percent in 11 States to 78.5 percent in 1 State.

³ For a more detailed discussion of this background, see Federal Funds Information for States (FFIS). Special Analysis. A History of Federal Grants-in-Aid to State and Local Governments. (by Victor J. Miller). National Conference of State Legislatures and the National Governors' Association Center for Policy Research. June 1988.

⁴ The Reagan Administration proposed a 25 percent cut in these programs. Funding for the merged programs as approved by Congress averaged about 12 percent below the total for the prior year for all programs placed in the block. These cuts ranged from zero for the energy assistance block grant to a 34 percent cut in the community services block grant. See Nathan, Richard P., Fred.C. Doolittle, et. al. Reagan and the States. Princeton, New Jersey, Princeton University Press. 1987. p. 57-59.

⁵ This summary is based upon FFIS, Special Analysis and Nathan and Doolittle, Reagan and the States, p. 358-361.

⁶ An additional five proposals for block grants were defeated during this period. Even though block grants were replacing categoricals, the proportion of funds distributed through categorical programs continued to increase, accounting for 87 percent of total grants in 1988 compared to 79 percent in 1980. See Advisory Commission on Intergovernmental Relations. A Catalog of Federal Grant-In-Aid Programs to State and Local Governments. No. 153, August 1987. p. 1-2.

⁷ Cutbacks in Federal programs to assist economic development in depressed areas or regions are credited with the expanded State role in attracting private sector investment during the 1980s. One list includes: 100 public investment funds providing loans to and investments in business; 25 States with public venture capital funds; 40 States with grants to stimulate technological innovation; and a few States which developed cooperative arrangements with management and labor to revitalize regional industries. Osborne, David. Laboratories of Democracy. Cambridge, Mass., Harvard University Press. 1988. p. 1.

⁸ Computations by CRS from figures in the several reports in the Census Bureau series on governmental finances. Fiscal year 1986 data were adjusted to exclude general revenue sharing in county, city, and township figures. School districts and special districts were not eligible to receive general revenue sharing.

⁹ The exceptions to this conclusion are veterans' housing bonds issued primarily in California, Oregon, and Texas, and some industrial development bonds issued by the State of Maine. The 1986 volume for veterans' housing bonds was $0.34 billion in California, $1.053 billion in Oregon, and $0.967 billion in Texas.

¹⁰ Some revenue bonds are actually retired from earmarked tax revenues, such as motor fuel taxes used to finance highway construction, or lease payments financed by annual appropriations, which are equivalent to interest and debt redemption payments for public buildings and jails constructed by State agencies and leased to the State.

¹¹ For a detailed accounting of these limitations, see U.S. Library of Congress, Congressional Research Service. Tax-Exempt Bonds and Twenty Years of Tax Reform: Controlling Public Subsidy of Private Activities. Report No. 87-922 E, by Dennis Zimmerman. November 23, 1987.

¹² As the volume of tax-exempt bonds has fallen, the volume of taxable bonds issued by States and local governments has risen from $0.3 billion in 1985 to $3.6 billion in 1986 and $2.5 billion in 1987.

¹³ The 1983 estimates in this report are based upon the figures for new issue private-activity bonds published in U.S. Department of Treasury. Statistics of Income. SOI Bulletin. v. 4, no. 1, September 1984. The Treasury data have been adjusted by CRS to: include the volume issued for single-family mortgage subsidy bonds and veterans' home and farm loan program; and exclude the volume of exempt-entity bonds. Some data for these adjustments were compiled from the 1983 Statistical Supplement. The Bond Buyer. p. 15-22.

¹⁴ The volume cap estimates are based upon estimates provided by FFIS. Issue Brief 88-1. January 11, 1988.

¹⁵ The traditional public-purpose categories include schools, roads, bridges and streets, fire stations, libraries, public buildings, and other general improvement projects. The private- activities category includes single-family mortgage holders, industrial development and pollution control, student loans, and retirement and nursing home operators. The commercial enterprise category includes such activities as water and sewer, public utilities, mass transit, and airports.

¹⁶ For a discussion of this issue, see Davie, Bruce and Dennis Zimmerman. Tax-Exempt Bonds After the South Carolina Decision. Tax Notes, v. 39, no. 13, June 27, 1988. pp. 1573-80.

¹⁷ 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 Modified or Eliminated? In: Strengthening the Federal Revenue System. Advisory Commission on Intergovernmental Relations. Washington, October 1984. p. 37-66.

¹⁸ Kenyon, Daphne A., Implicit Aid to State and Local Governments through Federal Tax Deductibility. In: Bell, Michael, ed. State and Local Finance in an Era of New Federalism. JAI Press. 1988.

¹⁹ Manvel, Allen D., The Tax Reform Act and General Sales Taxes. Tax Notes, April 25, 1988. p. 525-527.

²⁰ Advisory Commission on Intergovernmental Relations. The Tax Reform Act of 1986 -- Its Effect on Both Federal and State Personal Income Tax Liabilities. SR-8. January 1988. The estimates presented here are based on the assumption that States linked to Federal law as of a specified date update their references to Federal law by maintaining the same conformity structure to the new Federal provisions.

²¹ Gold Steven D., Corina L. Eckl, and Brenda M. Erickson. State Budget Actions in 1987. Legislative Finance Paper No. 58. National Conference of State Legislatures. July 1987.

²² Fiscal Survey of the States. National Governors' Association, National Association of State Budget Officers. September 1987. p. 13-15, and March 1988, p. 13-15.

²³ Commerce Clearing House Inc. All States Tax Guide.

                               APPENDIX

/b/ Figures include outlays for lesser unspecified functions.

/c/ Total outlays for general operations of most U.S. non- defense agencies are included in this category net of "undistributed offsetting receipts." The offsets consist of employers' shares of contributions to on-budget and off-budget employee retirement systems, revenues from rents and royalties from the Outer Continental Shelf, and (for fiscal 1987) proceeds from the sale of major assets. For fiscal years 1980-89 these are as follows (in billions of dollars): 19.9, 28.0, 26.1, 34.0, 32.0, 32.7, 33.0, 36.5, 36.1, and 41.0 respectively.

Source: Adapted by CRS from Tables 3.1, 3.3, 9.5, 11.2, and 12.2 in the Historical Tables. Budget of the U.S. Government. Fiscal Year 1989.

  TABLE B. U.S. BUDGET OUTLAYS BY SELECTED CATEGORIES OF EXPENDITURES