The restrictiveness of state tax and expenditure limitations and state debt.

Author:Deller, Steven

    While the debt crisis in Greece, Spain and Ireland and its implications for Europe have received the greatest attention recently, many state and local governments in the U.S. are also struggling with debt problems. The economic recovery has been slow for most state and local governments throughout the U.S. High unemployment rates, rising poverty rates and falling property values have had significant effects on governments' abilities to balance their budgets. The latest report by state budget officers (NASBO, 2011) suggests that states began moving out of economic paralysis in 2011, but that the recovery will be slow. According to a recent report issued by the National League of Cities, the recovery of sub-state governments will lag behind the states (Hoene and Pagano, 2011). The most visible local debt problems include Harrisburg, Pennsylvania, Jefferson County, Alabama, Vallejo, California and Detroit, Michigan where bankruptcy has occurred or is being considered. As such, it is not surprising that a number of states have renewed calls for stricter fiscal limitations in response to current state and local fiscal crises (Merrifield and Monson, 2011).

    Most U.S. states have imposed some form of restraint on state and/or local governments' ability to raise revenues, spend funds and/or incur debt. Widely referred to as tax and expenditure limitations (TELs) the most commonly known are California's Proposition 13, Massachusetts' Proposition 21/2 and Colorado's Taxpayers Bill of Rights (TABOR). As noted by Joyce and Mullins (1991), Mullins and Wallin (2004) and Stallmann (2007) TELs have been justified for a multitude reasons but the most common is to impose discipline to restrain Niskanen-Buchanan-Tullock or Leviathan type government inefficiencies and waste. Regardless of the motivation, an increasing number of state and local government officials are finding themselves forced to operate under stricter budgeting rules.

    The literature on government borrowing and tax and/or expenditure imposed restrictions is modest, but expanding. Much of this literature can be broken down into a handful of categories: those supporting, or encouraging, the use of TELs to limit borrowing (e.g., Ratchford, 1936; Wagner, 1971) and those assessing the impact of TELs on debt policies (e.g., Bahl and Duncombe, 1993). The latter category of literature has a particular focus on methods of TEL evasion through either creation of special purpose districts (e.g., Stephens and Wikstrom, 1998 and McCabe, 2000), reliance on different debt instruments that do not fall under the restrictions (e.g., special-revenue bonds--Bahl and Duncombe, 1993) or use of fees and charges (Bennet and DiLorenzo, 1982; Schwartz, 1997; Thompson and Green, 2004). The question this study addresses is, if TELs limit the ability to generate revenues can the TEL be effectively by-passed by incurring debt? If this is the case, are TELs creating a fiscally unsustainable position in the long-term?

    One of the limitations to the literature on the relationship between TELs and fiscal policy responses is that the heterogeneity of TELs is generally over looked. In essence, no two state TELs are alike and states change their TEL policies over time. The same is true of state restrictions on debt. The problem with much of the available literature is that limits tend to be captured by simple dummy variables. For example, is a TEL of a certain type present or not present? This approach does not capture the heterogeneity of TELs and debt limits. In addition, a TEL may include whether or not it limits revenues for debt repayment. For example, in the study of debt limits on debt levels, Bunch (1991) uses a dummy variable for the presence of any type of debt limit policy. Similarly, Ellis and Schansburg (1999) incorporate three dummy variables in their modeling of state debt: prohibitions on guaranteed debt, referendum requirements for additional debt and a super-majority requirement to increase debt ceilings. Clingermayer and Wood (1995) use two dummy variables in their modeling of TELs; does the state have either a revenue or spending limit, and does the state have a debt limit? Bahl and Duncombe (1993) use a six point scale to measure the restrictiveness of debt limits but they use a dummy variable to capture the presence of a TEL.

    The central hypothesis of this study is that more restrictive state TELs increase state use of debt. The analysis moves beyond the use of dummy variables to indicate the presence of a TEL by using indices of state-level TEL restrictiveness, which can change over time, and examining their impact on state-level total debt. Beyond these simple introductory comments the study is divided into the following sections: a discussion of the current state of the literature, a discussion of the three indices of TEL restrictiveness, an outline of the empirical models and estimation methods and a discussion of the empirical results. The study concludes with a review of key findings, policy implications and potential future work.


    Some of the earliest academic literature on state-level tax and expenditure limitations, TELs, was prescriptive, specifically endorsing their use (Ratchford, 1936). The argument has consistently been Leviathan focused; political and bureaucratic pressures create an environment where state and local governments are unable to restrain their fiscal behavior, leading to unsustainable levels of taxation and debt. As a result, legal constraints, particularly with respect to state and local government debt, are needed to force fiscal restraint (Wagner, 1971). Part of the early motivation for imposing constraints was based on historically poor fiscal decisions on the part of many states. For example, in 1841 and 1842 Florida, Mississippi, Arkansas, Indiana, Illinois, Maryland, Michigan and Pennsylvania defaulted on their interest payments (Wallis, 2005; Oates, 2008). Other states, including Alabama, New York, Ohio and Tennessee narrowly avoided default. As a result several states rewrote their constitutions and included restrictions on debt levels (i.e., debt limits) and/or how debt can be assumed (i.e., debt restrictions) (Wallis, 2005). Indeed, constitutional limits on state debt are the oldest form of an explicit TEL dating from the 19th century (ACIR, 1987).

    Today, the Leviathan typology of government and lack of fiscal discipline justifying the need for constraints apparently has become a priori fact. Cabases, Pascual and Valles (2007: 293) note that "[t]he need for restrictions on borrowing by subnational governments is a generally accepted notion that is justified both by public choice theory and by the fact that such restrictions are in force in the majority of decentralized countries." Their research finds that TELs have been effective in constraining borrowing behaviors of local governments in Spain. While not nearly as explicit in their call for a TEL, Merrifield and Monson (2011) design an "optimal" TEL for Utah and contend that had the TEL been in place, the state's current fiscal and economic picture would be much brighter.

    The majority of the tax and expenditure limitations literature has focused on one basic question: have TELs altered how state and local governments conduct business and if so, in what way? While one should take care in drawing broad generalizations from a complex literature, researchers generally conclude that tax and expenditure limitations alter state and local government behavior but not necessarily in the ways envisioned by TEL proponents. Depending on how the TEL is structured, state and local officials have found ways to circumvent the restrictions (Kiewet and Szokaty, 1996; Gerber et. al., 2001; McCubbins and Moule, 2010). TELs limiting the ability of local governments to raise revenues, generally the property tax, have resulted in a shift to increased reliance on state aids (Joyce and Mullins, 1991; Skidmore, 1999) and income inelastic revenues such as fees and charges (Bennet and DiLorenzo, 1982; Schwartz, 1997; Thompson and Green, 2004).

    Consistent with the "circumvention" argument, there is evidence to suggest that TEL restrictions, particularly limits on debt, result in a greater number of special purpose districts (MacManus, 1981; Mullins, 2004). Both Stephens and Wikstrom (1998) and McCabe (2000) find that if financial constraints are imposed on general purpose local governments the formation of special districts can add financial options; if TELs are a binding constraint on local governments, then an increase in special district activity can circumvent the intent of the TEL. The research on special purpose district formation caused by TELs is, however, far from conclusive. Bowler and Donovan (2004) estimate pooled models with panel data from the Census of Governments and find that adoption of a TEL did not affect the formation of special districts; the interaction of TEL adoption and states with ballot initiatives, however, increases the number of municipalities and special districts. They concluded that the ability of citizens to put tax limitations on the ballot is an incentive for states to allow a range of fiscal options. Carr (2006) follows Bowler and Donovan's work but finds that the role of restrictions on local governments in the formation of special districts is much more limited than the previous literature suggests.

    More specific to our research question is the relationship between TELs and debt issuance. Sharp and Elkins (1987) examined the impact of Missouri's Hancock Amendment (the state's TEL) on seven Missouri cities. Following adoption of the Hancock Amendment they find patterns in Kansas City and St. Louis debt trends consistent with the argument that these cities incurred a greater proportion of non-guaranteed debt. In essence, the two largest cities in Missouri pursued policies that in effect circumvented the intent of the Hancock...

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