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An Introduction to State and Local Public Finance
Thomas A. Garrett and John C. Leatherman

PART 1 - GOVERNMENT GROWTH, TAXES AND TAX THEORY

I. The Growth of State and Local Governments - Revenues and Expenditures

A. Evidence on the Growth of State and Local Governments

Historically, state governments have produced higher education, welfare, public health and state-wide highway maintenance and improvements, whereas local governments produced elementary and secondary education, local infrastructure, parks, and police and fire protection. While the roles of both levels of government have remained the same over time, the past forty years have seen a dramatic increase in state and local government expenditures. Per capita state and local expenditures from 1960 to 1996, in real 1993 dollars, are shown in Figure 1.

In 1960 state governments were spending roughly $740 per person while local governments spent about $670 per person. As seen in Figure 1, both state and local expenditures per capita have increased dramatically. Per capita state expenditures topped $2,600 in 1996, nearly a 350 percent increase from 1960. Local expenditures per capita increased 250 percent between 1960 and 1996, with 1996 local expenditures per capita reaching $1,600.

The growth in state and local governments can also be shown by considering state and local government expenditures and revenues as a percent of Gross Domestic Product (GDP) of the United States. Expenditures and revenues as a percent of GDP highlights the growing role of state and local governments in producing a higher percentage of the country’s total output. The measure also reveals the percentage of total income that is used by state and local governments. State and local government revenues and expenditures as a percent of GDP from 1960 to 1996 are provided in Table 1.

Local expenditures and revenues as a percent of GDP increased nearly 50 percent over the past forty years, while state expenditures and revenues as a percent of GDP nearly doubled between 1960 and 1996. It is interesting to compare this increase in state and local government expenditures with expenditures of the federal government. Local, state, and federal government expenditures as a percent of GDP are shown in Figure 2.

Historically, federal expenditures as a percent of GDP have been higher than both state and local governments combined, but Figure 2 shows the gap between federal and state and local government expenditures has decreased in recent years. In 1960, state and local government expenditures totaled about 10 percent of GDP, whereas federal government expenditures reached 18 percent of GDP, nearly 80 percent greater than state and local governments. As of 1996, however, state and local government expenditures reached 17 percent of GDP, whereas federal government expenditures only increased to roughly 21 percent of GDP.

B. Explaining the Growth of State and Local Governments

There are several factors that explain the dramatic growth of state and local governments over the past four decades. Individual income rose significantly during this period. With higher incomes, individuals demand more goods and services, including those traditionally provided by state and local governments. An important point, however, is that while incomes and government expenditures experienced an overall increase during this period, the growth in state and local expenditures slowed and even decreased during the recessionary periods of the mid 1970s and early 1980s and 1990s. Growth in income slowed during these periods, and as a result state and local governments received relatively less revenues, thereby reducing expenditures. This marked decrease in the growth of state and local government expenditures during recessionary periods can be seen in Figure 1.

Another factor that explains the overall growth of state and local governments is that the population of the United States increased during this period, in part due to the baby-boom occurring after World War II. State and local expenditures rose during this period to meet the increasing demands for state and local government services created by the growing population. Life expectancies also increased during this period. As individuals continued to live longer, there was an increase in demand for government goods and services such as health care and public welfare.

The initial increase in state expenditures during the 1960s was in part due to states’ rapid introduction of new taxes during the 1950s, 1960s, and early part of the 1970s. New taxes led to an increase in revenues to state governments and thus an increase in state government expenditures. Between 1951 and 1969, sixteen states adopted sales taxes. Since 1969, no state has adopted a sales tax. Ten states adopted personal income taxes between 1961 to 1976, and eleven adopted a corporate income tax between 1957 and 1971. Only two states adopted a personal income tax since 1971, and no state has adopted a corporate income tax since 1971 (ACIR, Significant Features of Fiscal Federalism, various years).

A final explanation for the growth of state and local governments is devolution - the transfer of responsibilities from higher levels of government to lower levels of government. Recently, state governments have taken a more active role in providing services such as education and public welfare, activities traditionally funded by the federal government. Although there has been much research and debate on devolution, one of the primary explanations for increased state and local responsibilities is the public’s decreasing confidence in the federal government’s ability to effectively provide goods and services, along with the growing desire for decentralization and competition that is part of the capitalistic mentality (Tannenwald, 1998). As long as state and local governments gain greater responsibility in providing goods and services, increases in state and local government expenditures can be expected.

C. The Changing Responsibilities of State Governments

While there has been an overall increase in state expenditures in recent history, this does not imply that expenditures on each function of state government have increased. To the contrary, state expenditures on certain functional areas have decreased over time, while others, as expected, have increased. State expenditures can be categorized into five functional areas: higher education, highways, public welfare, health care, and correctional facilities. Expenditures on each functional category as a percent of total state expenditures are shown in Table 2.

i. Education

Education expenditures, specifically on higher education, comprise the greatest percentage of total state expenditures, although this percentage has decreased slightly in the past two decades. In the 1960s and early 1970s there was a significant increase in the public’s demand for higher education over earlier years, increasing from 21 percent of state expenditures in 1950 to nearly 40 percent of state expenditures in the late 1960s and early 1970s. This increase in demand resulted from two factors: 1) society began to place a greater weight on the importance of higher education beginning in the 1960s, and 2) the baby-boomers reached college age. The combination of these two factors raised the demand for higher education, thus forcing states to spend an increasing percentage of their total budget on education during this time period. Although states are currently spending a smaller percentage of their total budget on higher education expenditures than in the past, higher education still remains the greatest priority of state governments as roughly 35 percent of state expenditures are currently allocated to higher education.

ii. Highways

Unlike education expenditures, states have spent a declining portion of their total budget on highways. From over 25 percent of total expenditures in 1960, expenditures on highways have decreased to only about eight percent of total expenditures in recent years. This decrease is due to several factors. First, the 1950s and 1960s saw a dramatic increase in the number of highways constructed, in part due to the creation of the Federal Interstate System. Although highways require periodic maintenance, highways are durable goods lasting for many years. Once the initial cost of new highway construction is met, states require relatively less funds to maintain roadways. Second, highway construction and maintenance are financed through motor fuels taxes which are usually levied as a certain number of cents per gallon. Motor fuel taxes are thus not indexed by inflation, meaning that as the price of fuel increases the tax collected does not increase because it is not linked to the price of fuel, just the quantity of fuel purchased. As the price level increases, states receive a higher percentage of their funds from inflation-linked taxes like the sales tax and income tax rather than gasoline taxes. As a result expenditures on non-inflation indexed items decrease relative to other expenditure categories. A continual increase in tax rates on non-indexed items would increase tax revenues, however this option is not frequently considered by officials given the probable public opposition.

iii. Public Welfare

Since the early 1960s, public welfare has been an increasing portion of total state expenditures. Totaling roughly 14 percent of state expenditures in 1970, welfare expenditures as a percent of total state expenditures reached over 26 percent in 1996. The Medicaid program, which began in 1965, has been the predominant cause of the increase in state welfare expenditures (Holcombe and Sobel, 1997, 29). Although Medicaid is typically viewed as health care rather than welfare, a state makes a payment to an individual for health care rather than directly spending the money on health care for the individual. Thus, Medicaid is considered a welfare expenditure in terms of state budgeting. In 1970, less than one-half of all welfare expenditures consisted of public medical payments. By the 1990s, however, nearly three-quarters of all public welfare expenditures could be attributed to the Medicaid program.

iv. Health Care

Health care expenditures include those expenditures on hospitals, contributions to local clinics and public health programs. Medicaid payments are not included in health care since they are considered a public welfare expenditure rather than a health care expenditure. Unlike other categories of state government expenditures, health care expenditures have remained a relatively constant percentage of total state expenditures. While health care costs have consistently increased over time, state health care expenditures have hovered between seven and eight percent of total state expenditures over the past several decades.

v. Corrections

Correctional expenditures predominately consist of expenditures on state prisons. Although current correctional expenditures consist of only four percent of total state expenditures, this amount has nearly tripled since the 1950s when correctional expenditures accounted for only 1.5 percent of total state expenditures. States’ increased responsibility for correctional facilities can be attributed to: 1) the ‘war on drugs’ beginning in the early 1980s, which led to an increase in the number of convicted drug offenders, 2) an increase in the violent crime rate, which, according to the U.S. Bureau of the Census, has increased from 571 incidents per 100,000 population to over 750 incidents per 100,000 population in the mid 1990s, and 3) an increase in the overall state and federal prison population, increasing from 100 per 100,000 population in 1970 to over 400 per 100,000 population in 1997.

vi. Other Expenditures

Although higher education, welfare, health care, highways and correctional facilities are the five main expenditure categories, states do provide funding for other functional areas as well.

Some of the areas include library services, veteran’s services, parks and recreation and public utilities. Expenditure on these categories has averaged about 20 percent of total state expenditures.

D. Conclusion

This section provided evidence on the rapid growth in state and local governments over the past forty years. Attention was given to explaining those factors responsible for the dramatic increase in state and local government size. These factors include increases in income, an increase in the overall population, an increase in life expectancies, the introduction of new taxes, and the transfer of fiscal responsibility from the federal government to state and local governments. The section then addressed the main categories of state government expenditures and discussed the major historical trends for each of these five expenditure categories.

Although the future cannot be predicted with certainty, a growing, older population along with the decentralization of government decision making all suggest that the current trends in the growth of state and local governments will continue. State and local governments will be asked to provide more goods and services for the populations they represent. Only in the unlikely event that populations decide the free-market can better provide the goods and services once provided by local governments, there is little doubt the 21st century will see an increase in the size of state and local governments.

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