Note: I attach an article I wrote for Practical Law about municipal finances. The kind people there have given me permission to share the article in my personal writing, and in exchange I will encourage you to take a look at the resources offered by Practical Law. Their existing content is probably the most useful resource of which I am aware, and they are diligently building new content for the state and local government lawyer. It’s a great tool and I hope you will explore it.

If you are interested in the topic, please refer to the attached article for a much more detailed treatment.

There is an enormous variation among the states on the specific laws applicable to municipal finances, but so far I’ve seen nothing to disabuse me of the notion that cities don’t have much latitude in how they raise, spend, and borrow money. There are probably lots of good reasons to narrow the options available to city government, from low voter turnout in city elections to (arguably) greater incidence of corruption at the city level to the possibility of disruptive urban economic protectionism. But I remain convinced that cities need more local flexibility in fiscal matters.

In my experience, the most meaningful restrictions govern how cities can raise money. Perhaps in future notes I’ll talk about spending and borrowing money, but for now let’s consider only the restrictions applicable to raising money. The first big split in raising money for cities is between taxes and fees.

Taxes, of course, implicate a core governmental power and are theoretically subject to the greatest abuse. On the other hand, whenever my city gets into a fiscal disagreement with the state, we remind them that our elected officials are subject to democratic pressures no less than state legislators. That argument is seldom persuasive, and as a result our only major option with respect to taxes is local, ad valorem property taxes with assessment rates set by state constitution and millage rates subject to a mandatory cap. The result, which is surprising to the people who actually believe us when we tell them, is that our property taxes are essentially flat year over year, serve no purpose other than to raise revenues, and are actually not the main driver of our fiscal policy. To drive the point home: the total amount of taxes collected in my city is less than the annual cost of police and fire service. Everything else we do (water, sewer, sanitation, roads, sidewalks, parks, gardens, community development, economic development, housing, transit, and on and on) is paid for by something other than taxes.

Cities in other states have different options. Some states allow local governments to use sales taxes, and some states even allow local income taxes. That taxonomy exhausts the major Linnaean classification of tax genera (property, sales, income). But there are further species of taxes, like real estate transfer taxes, hospitality taxes (on prepared foods), accommodations taxes (on overnight stays), excise taxes, and so on, and somewhere in America, some local government has the right to use such taxes.

To the casual observer, it might not matter what kind of tax a city uses, just so long as the tax raises enough money to pay for whatever it might be that the city wants to do. There are two flaws with this casual observation, however, one of which is economic and the other of which is regulatory.

The economic flaw is that each city is a micro-economy in which activities that might be taxed are more or less elastic with respect to the tax. Elasticity is simply a concept that weighs how responsive an activity is with respect to changes in the cost of that activity. The classic example: smoking cigarettes is a relatively inelastic activity, in that a smoker is not going to change consumption much based on increases in excise taxes. Real estate transfers are going to be relatively inelastic in a booming real estate economy, whereas retail consumption might by highly elastic in a city (especially if consumers can simply make purchases in the county or an adjoining city). I’m not suggesting that cities should always tax the inelastic activity; I am instead suggesting that cities should always consider the elasticity of an activity in setting tax policy. Otherwise, the tax might suffocate the very activity that makes the city work. But because cities have essentially no choice at all in designing the type of taxes they can impose, the point is (at least for now) moot.

The regulatory flaw is that federal and state governments routinely use taxes not only to raise revenues but also to drive behavior, but cities can’t do that. In a prior note I have already given examples of federal tax policies that are about shaping behavior rather than raising revenue. I admit: When I get frustrated at work, I daydream about how much more effective our policies would be if we could use fiscal tools to drive behavior. For example, we have identified something like 1,400 problem vacant houses in our city. The absent owner of a vacant house doesn’t have much incentive to do anything much with the house. Taxes are low (because, perversely, disuse and lack of maintenance leads to lower assessed values, which leads to lower taxes). Codes enforcement activities are difficult because we can’t get personal jurisdiction over the owner. And so on, in a litany of problems that are familiar to any professional working in just about any city just about anywhere. And thus I think, how about an excise tax on the disfavored activity of vacancy? If such a tax were simply enough to drive behavior – i.e., to tip the decisional analysis of the vacant property owner in favor of rehab or sale instead of simply letting the property sit – that would be a huge victory. I could give dozens of other examples, all of which are denied to us.

Enough about taxes. The other major option is fees, and cities everywhere are increasingly moving to a fee-for-service model. On the face of it, this is not a bad direction. It surely seems fair to make consumers of service pay for the services they use. My main objections to financing government by fees are that fees are inherently regressive and that fees cannot be used effectively to drive behavior (because of cost-of-service methodologies and because of general prohibitions on cross-subsidization).

Fees are regressive because the amount of the fee cannot be calculated by reference to the payer’s ability to pay. In most states, that is an element of the definition of a fee: the amount of the fee is based on the cost of the service and not ability to pay. A simple illustration can be applied to the longest-established user fee, water and sewer charges. The owner of a million-dollar home pays the same for 6,000 gallons of water as does a tenant in low-income housing. Given the massive challenges that cities face in inclusive growth, turning to a regressive tool as at the primary way to raise revenues cannot be the best solution.

And fees have the same regulatory problem discussed above because most states restrict the cost-of-service calculation to the discrete service being provided. In theory a building inspection costs a city the same amount of time and money whether the home is a $1 million new construction or a $100 thousand rehabilitation job, but a city might nonetheless prefer to charge significantly more for the first example.

Enough for now, I have already laid this groundwork in my prior note. Let me suggest two, concrete policies that could be adopted at the state level that would seriously improve the ability of cities to design successful fiscal policy:

  1. Allow cities to construct a uniquely local tax structure. This structure would remain subject to state-level anti-discrimination, uniformity, and due process protections. Such a structure might even remain subject to an overall cap. The important point is that cities should be able to choose from the full range of revenue-raising measures in response to local economic conditions.
  2. Allow cities to adapt fees to favor social justice and to create behavioral incentives. For example, a building department should not be allowed to charge more for fees than its total budget, but it should be allowed to design a fee structure that is progressive and that charges meaningfully less for favored activities (such as infill and rehabilitation).

Of course, some states may already allow such latitude to city governments. That is not the case, however, in my home state of South Carolina, and it is not the case in a number of other states that I have studied. I therefore concede that my recommendations need to be tailored to local laws and circumstances, but the point remains.

A final note. Obviously, the reason that states routinely restrict city fiscal autonomy is because the most efficient lobbying strategy is to focus on the highest-level, relevant government. When a regional or national homebuilder is unhappy with a city’s fee structure, it is far easier to seek redress at a single state house than in a host of individual cities. More to the point, state-level officials don’t have to answer to the peculiarly retail politics at the city level.

That being the case, a reader might object that all my suggestions would accomplish would be to drive lobbying pressure down to the local level. That’s a fair point, but city elected officials would be in a much better position to resist heavy-handed lobbying pressure from the regional and national players. Or, said differently, city elected officials are more engaged with local sentiment, and perhaps would be better situated to design fiscal strategies that are more responsive to specific community needs.

I therefore encourage my readers who work for (or in the interests) of city government to proactively pursue more fiscal latitude.

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