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IS LOCALGOVERNMENT REVENUE RESPONSE TO FEDERAL AID SYMMETRICAL? EVIDENCE FROM PENNSYLVANIA COUNTY GOVERNMENTS INAN ERAOFRETRENCHMENT WILLIAM F. STINE*

Abstract - Previous empirical studies have made little attempt to test whether the fiscal response to intergovernmental aid is asymmetric. This paper tests the asymmetric response hypothesis for 66 Pennsylva- nia county governments over the 1978-88 period. This marked a period of retrenchment in which counties experienced fre- quent annual reductions in federal aid. The local government revenue response to federal aid was found to be asymmetric. The reduction in federal aid induced a reduction in own-source revenue. The results support the notion that taxpayers prefer fiscal restraint when permanent loss of aid occurs.

INTRODUCTION

Local governments in the United States have faced increasing fiscal pressure in recent years because of a substantial reduction in federal aid. Federal aid re-

*Clarion University of Pennsylvanta, Clanon, PA 16214

ceipts peaked in 1978 after steady growth throughout the 1960s and 1970s. They declined from 22 percent of total United States state and local government general revenue in 1978 to 16.6 percent in 1987 (Bahl, 1990, p. 62). Retrenchment has been even more severe on county government general revenue in many states. For instance, federal aid receipts as a percentage of Pennsylvania counties’ total general revenue fell from 25 percent in 1978 to 8 percent in 1988. The adjustment was particularly difficult since Pennsylvania counties receive most of their tax revenue from the real estate tax.’ They faced the alternative of increasing own- source revenue, acquiring more state aid, or reducing expenditures and costs.

The estimated revenue response of Pennsylvania county governments to declining federal aid is the focus of this paper. Estimating responsiveness raises an interesting empirical question that has been largely ignored in the grants literature. The question is whether the

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revenue response to changes in ald is symmetrical. In other words, is its mag- nitude the same for declining aid as it is for increasing aid? Previous empirical studies have not ulistinguished whether grants were increasing or decreasing over time.* However, one would expect to find aid increasing in some years and decreasing in others. Whether the revenue response differs essentially depends upon how voters and politicians view changes in aid. This paper hypothesizes that it is asymmetric.

Asymmetric own-source revenue response may occur for a number of rea- sons. One possibilllty is that local taxpayers have a fiscal illusion about the true cost of raising own-source revenue. That is, they systematically underestimate the amount of revenue they have to pay in order to finance local public services.3 Thus, if a greater amount of own-source revenue is required to support local public services, fiscal illusion implies it will be less difficult to raise additional revenue. A number of studies have explored the various reasonis for understating revenue burden. A good review of these studies can be found in Oates (1988). In general, fiscal illusion is more likely the greater the complexity of the revenue structure, the less visible the revenue sources, and the rnore Iincome elastic the revenue system .4

Another source of fiscaJ illusion is the flypaper effect. The flypaper effect refers to understatlng the benefit of aid rather than the cost of raising local revenue. It usually is associated with the receipt of unconditional nonmatching aid. The unconditional nonmatching grant, like an increase in income, is independent of the local budget process. No change in local taxes or expenditures is required in order to receive it. Theoretically, it follows from this that a change in community income and an unconditional nonmatching grant should have identical

effects on local revenue. Empirical studies by Gramlich and Gqlper (1973), In- man (1979), Stine (198i5), and Islam and Choudhury (1990), however, have found that this is not the case. Apparently, elecled officials do not view the receipt of a nonmatching granp in the same light as additional incottne available to the community. Rather, they tend to view this, type of grant,as found money that belongs to the public sector. None of the previous estimates of the flypaper effect distinguish betw$en increasing and declining aid. If thk flypaper effect also holds vvhen aid is declining, then it implies a smaller increase in own-source revenue than if taxpayqrs view it as lost personal income. Howqver, if taxpayers are more likely to notice the loss of intergovernmental revenye than its receipt, they will attempt to replace it by increasing own-source rdvenue. In this case, the response may be similar to the loss of community income. Thus, if the flypaper effect holds oply when aid is increasing, this may acccjunt for some of the asymmetric respon$.e.

Finally, own-source revenue response also may be asymmetrical if revenue- maximizing agencies oft special interest groups resist program reductions. Reve- nue will be less respon

F ive if the institu- tional features of reprqsentatlve government lead to excess sppnding.5 Niskanen (1971) slJpplies many cif the arguments for the revenue-maxim/zation hypothesis, while Becker (1983) prbvides a careful analysis Iof the effect o If special interest groups on political equ~ilibriurn.

The existence of fiscal Illusion and insti- tutional bias suggests sponse to aid may 4 hat revenue re-

not be symmetrical. They imply a larger increase in own- source revenue to offsqt the loss of aid than would be predicted if response were symmetrical. Ano;ther possibility, still, is that asymmetric/al response may occur even in the absepce of fiscal illu-

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I REVENUE RESPONSE TO FEDERAL AID

sion. Well-informed voters and public officials may desire greater fiscal restraint when aid is declining because they be- lieve local government spending is too high. This would predict a smaller increase in own-source revenue than if revenue response was symmetrical.

The 1978-88 period offers a good op- portunity to test the asymmetric response hypothesis for Pennsylvania county governments. Although a substantial reduction in federal aid was experienced by most counties between 1978 and 1988, enough annual variation was found to test for symmetry. Federal aid receipts fluctuated annually rather than declining continuously. Of the 66 Pennsylvania counties, 57 counties experienced a decline of federal aid from the previous year in six or more years. The average number of years for declining federal aid was 7.27, while the average number of years for declining state aid to the 66 county governments was 4.71 .6

The next section provides descriptive statistics on the revenue trends across Pennsylvania counties in the observed time period. Then, an empirical model of asymmetric response is posited and tested. Finally, some concluding comments are offered.

PENNSYLVANIA COUNTY GOVERNMENT REVENUE AND EXPENDITURE TRENDS

Pennsylvania has a diverse group of counties, many of which are small and rural.7 The 66 counties included in this study range in population size from less than 10,000 to approximately 1.5 million.* It had 36 counties with a population less than 100,000 in 1980. Alle- gheny was the only county with a population greater than one million and Delaware and Montgomery were the only other counties with a population greater than 500,000.’ The remaining

27 counties were in the 100,000 to 500,000 population range.

This section offers summary statistics on the revenues and expenditures of 66 Pennsylvania counties over the 1978-88 period. It reports two types of descriptive statistics to illustrate the different trends experienced during this period of declining federal aid: (1) aggregate statewide revenue and expenditure statistics describe the nature of composi- tional changes in selected years; and (2) aggregate statewide growth rates of different revenue and expenditure components indicate how fiscal variables were, on average, changing over the entire period.

Level of Aggregate County Government Revenue and Expenditure Components

Act 511 of 1965 allows all Pennsylvania local governments except counties to raise revenues from such taxes as those on earned income, mercantile transac- tions, real estate, real estate transfer, business privilege taxes, amusement, me- chanical devices, and persons. Con- versely, Pennsylvania counties are more constrained in their use of tax revenue, relying heavily upon the real estate tax. They derive own-source revenue from three non-real-estate sources: other local taxes, departmental revenues, and other nontax revenues. Other local tax receipts primarily are generated from the personal property tax and the per capita tax.” While most tax revenue is received from the real estate tax, departmental revenues and other nontax revenues also play a significant role in county government revenue structures. For instance, 38.6 percent and 21.8 percent of own- source revenue was received from departmental revenues and other nontax revenues, respectively, in 1988. Depart- mental revenues are fees received by various departments for general government service, judicial service, public

safety, public works, human services, and other services. Nontax revenues include fees from a variety of sources including licenses and permits, fines and forfeits, investment income, and other miscellaneous income.

intergovernmental aid IS broadly classified as federal, state, and other miscellaneous intergovernmental receipts.” Other aid consists of liquid fuel taxes transferred to the county and combined federal and state aid.‘*

Table 1 summarizes the amount of deflated dollar revenue received from various own-source revenue and aid components for selected years in the 1978-- 88 period. The numbers in parentheses give the percentage share of total revenue or total expenditure. Departmental revenue and other nontax revenue are combined into a single component (nontax revenue), since Pennsylvania began reporting revenue received from other local governments separately in 1984 while previously it was included in either departmental revenue or other nontax revenue.

Table 1 shows that federal aid receipts declined steadily throughout the 1978-- 88 period. Federal aid received by Penn- sylvania counties apparently reached its peak by 1978. It was approximately 74 percent ($385.4 million) of its 1978 amount in 1977. Federal aid was lower than the previous year in every year in the 1978-83 period. It showed more annual fluctuation in the 1984-88 period but continued to trend downward falling to about 35 percent of its 1978 amount in 1988. Lore significantly, federal aid as a percentage of total revenue declined in almost every year. It fell from 24.9 percent in 1978 to 8.1 percent in 1988.

Receipts from most revenue components initially declined with the loss of federal aid. Both own-source revenue and total

revenue were lower in 1980 than in 1978. Further, receipts from the individual revenue components were either lower or about the same. The most significant decline occurred in the real estate tax. However, by li982, federal aid was $183.9 million below its 1978 level while total revenue was only $129 million below its 1978 level. Consequently, even in this period of falling revenue, county governments had to find alternative sourIces to make up for the loss of federal aid. Own-source revenue was higher in 1982 than in 1978. This also was reflected by the increase in own- source revenue share flom 49.6 percent to 57.1 percent between 1978 and 1982. Most of the increase in local reve-. nue came from nontax revenue. Real estate taxes and state aid receipts were approximately the same as they were in 1978, although both shares were higher.

Total revenue increased steadily in the post-l 982 period and exceeded its 1978 level by 1986. All revenue components except federal aid were higher than they were in 1982. The 1982-88 period was one in which counties found alternative revenue sources to replace federal aid. However, state aid receipts became in- creasingly significant. Tiheir share of total revenue increased from 26.1 percent in 1982 to 30.9 percent ih 1988. During the same time period, the own-source revenue share of total revenue was relatively stable. Declining federal aid apparently was one of the factors contributing to changes in the size and composltion of county government revenues over the 1978-88 period. The initial period saw receipts decline, but eventually, the lost federal aid was made up from alternative sources and the growth of total revenue continued.

Table 1 also shows various aggregate real expenditure components. Total expenditures showed a pattern similar to total revenues.13 They declined initially

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TABLE 1 RECEIPTS FROM SELECTED REVENUE COMPONENTS

66 PENNSYLVANIA COUNTY GOVERNMENTS SELECTED YEARS: 1978-1988a

(PERCENTAGE SHARE OF TOTAL REVENUE/TOTAL EXPENDITURE IN PARENTHESES)

1978 1980 1982 1984 1986 1988

Revenue Components Real estate tax .$ 553.5 $ 501.4 $ 555.2 B 545.9 B 592.7 $ 634.6

(30.5) (29.8) (33.0) (31.6) (30.9) (32.3) Other taxes 36.8 33.1 32.0 39.2 48.3 48.2

(2.0) (2.0) (1.9) (2.3 (2.5) (2.5) Non-tax revenue 310.1 308.7 374.7 398.1 407.5 428.9

(17.1) (18.4) (22.2) (23.0) (21.3) (21.8) Own-source revenue 900.4 843.2 961.9 983.2 1048.5 1111.7

(49.6) (50.1) (57.1) (56.9) (54.7) (56.6) Federal aid 451.1 381.4 267.2 238.4 201.5 158.1

(24.9) (22.7) (15.9) (13.8) (10.5) (8.1) State aid 441.3 440.6 439.8 464.1 556.8 606.6

(24.3) (26.2) (26.1) (26.9) (29.1) (30.9) Other aid 20.9 17.0 15.8 41.3 108.3 87.3

(1 ..a (1 .a (0.9) (2.4 (5.7) (4.5) Total revenue $1,813.7 $1.682.1 $1,684.7 81,727.l $1,915.2 $1,963.6

Expenditure Components Health and welfare $ 606.3 $ 651.3 $ 697.4 B 753.7 $ 853.8 $ 945.6

(34.1) (37.7) (40.7) (43.0) (45.3) (47.5) General administration 204.9 171.5 161.5 184.7 199.2 214.8

(11.5) (9.9) (9.4) (10.6) (10.6) (10.8) Judicial 155.3 152.9 165.7 165.8 171.9 179.9

(8.7) (8.9) (9.7) (9.5) (9.1) (9.0) Library 13.6 14.1 13.1 12.8 14.3 16.0

(0.8) (0.8) (0.8) (0.7) (0.8) (0.8) Corrections 115.0 130.5 144.9 131.1 143.2 152.1

(6.5) (7.6) (8.5) (7.5) (7.6) (7.6) Highways 34.8 49.0 46.5 47.8 27.1 31.6

(2.0) (2.8) 0.7) (2.7) (1.4) (1.6) Parks and recreation 27.6 32.2 25.2 20.1 21.5 20.9

(1.6) (1.9) (1.5) (1.1) (1.1) (1.1) Interest 47.6 49.5 62.2 40.2 66.2 52.7

(2.7) (2.9) (3.6) (2.3) (3.5) (2.6) Other 571.7 475.8 397.3 394.8 390.5 376.9

(32.2) (27.6) (23.2) (22.5) (20.7) (18.9) Total expenditures 91,777.o $1,726.7 $1,713.8 81,751.O $1,887.7 $1,990.6

Source: Commonwealth of Pennsylvania, Department of Community Affairs, Local Government Financial Statistics, annual editions, 1978-1988. “Figures are in millions of 1982 dollars. Current dollar amounts were deflated by the U.S. Bureau of Economic Analy- sis‘s State and Local Government Price Index.

and did not reach their 1978 level until 1986. However, health and welfare expenditures, the largest expenditure component, grew steadily throughout the period. Their share of total expenditures increased from 34.1 percent to 47.5 percent between 1978 and 1988. Most other expenditure components also increased from their 1978 level in real dollar terms. However, there was little change in the shares of these components over this period. The cuts appar-

ently were made in the other expenditure category whose level and share declined substantially between 1978 and 1 988.14

Growth of Aggregate Government Revenue

County Components

Table 2 shows the percentage change in each revenue/expenditure component and the average annual rate of change over the 1978-88 period for all 66 Pennsylvania counties.15 Growth rates

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TABLE 2 GROWTH OF SELECTED REVENUE AND EXPENDITURE COMPONENTS: 1978-88

66 PENNSYLVANIA COUNTY GOVERNMENTS (GROWTH RATES ARE BASED ON CHANGE IN DOLLAR AMOUNTS EXPRESSED IN 1982 DOLLARS) --

Average Annuai Percentage Change Rate of Growth

Revenue Component 1978-88 (Percent)

Own-source revenue Real estate tax Other taxes Nontax revenue Total revenue Federal aid State aid Other aid

Expenditure Component Health and welfare General administration Judicial Library Corrections Highways Parks and recreation Interest Other Total expenditures

23.5 2.6** 14.7 1.9** 31.0 3.7** 38.3 3.4**

8.3 1.1* -65.0 -10.3**

37.5 3.6** 317.7 19.5**

56.0 4.5** 4.8 1.5**

15.8 1.6** 16.9 1.1 32.3 2.5** -9.2 -- 3.6**

-24.3 -. 3.8** 10.7 2.1

-34.1 - 3.9** 12.0 1.3**

*Statistically significant at the 10 percent level **Statistically sbgnificant at the 5 percent level.

are based on the dollar amounts of each component expressed In constant 1982 dollars. This period witnessed a modest increase in total county government revenues. Total revenue was 8.3 percent higher in 1988 than it was in 1978. However, its average annual rate of growth was only ‘I .1 percent. During the same time period, federal aid fell 65 percent with an average annual rate of decline of 10.3 percent All other revenue components showed a positive increase from their 1978 levels, and each had a statistrcally <significant growth rate at the 10 percent level.

The significant average annual rates of growth of own-source revenue and state aid suggest they played a part in replac- ing federal aid throughout this period. Accompanying the modest growth of own-source revenue, state aid increased at an annual rate of 3.6 percent. Al- though these two major components increased at a modest rate, their size rela-

tive to federal aid prob~ably accounts for most of the increase ini total revenue. Table 2 also shows that total expenditures increased by a greater percentage than total revenue over this period. Most expenditure components had statistically significant growth rates with the health and welfare and corrections components showing the largest increases. The only components showing a significant decline were highways, parks and recreation, and other expendlitures.

EMPIRICAL MODEL

An extensive theory of grants literature has evolved based on the work of Oates (1972), VVilde (1971), end others. These works fostered a number of empirical studies in which fiscal decisions often were assumed to be based on models of the democratic political process. This includes the median voter models in the Bergstrom and Goodman (1973) tradi- tion as well as other public choice

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models.16 Recently, lnman (1989) and Hettich and Winer (1984) have formu- lated more comprehensive public choice models of subnational government decision making.17

In this paper, we assume that local public officials exercise discretion in deter- mining the size and composition of own-source revenue. Further, local public officials are assumed to be well informed about local voters’ preferences for public services. The decision maker is assumed to maximize what he or she perceives as a well-defined utility function for the community voters subject to a revenue constraint. However, the model also recognizes that political factors may influence public officials’ revenue decisions. This includes their aware- ness that voters’ perceptions of fiscal incidence may vary over different time periods.

The primary purpose of this paper is to test whether the own-source revenue response to declining aid differs from increasing federal aid. Since the growth path of federal and state aid receipts differed over the 1978-88 period, aid receipts are distinguished by source: federal aid (GFED), state aid (GSTATE), and other aid (OAID). Most federal and state aid receipts (GFED and GSTATE) are used to finance human service programs. These human service grants support six major county-operated programs including adult services, aging, children and youth, drug and alcohol, mental health, and mental retardation. Many of the human services aid programs require a low local match. In most cases, aid receipts fund from 90 to 100 percent of local government expenditures on human service functions.18 Other county-provided social services funded by aid include adoption assistance, homeless assistance, medical assistance transportation, emer- gency medical assistance, and local public health. Most of the above programs

give financial assistance on a continuing basis. GFED and GSTATE also include project grants such as the Community Development Block Grant. They often are designed to meet capital construction needs and contribute a relatively small share to county government revenues.” OAID includes other undesignated federal and state aid as well as the county liquid fuel tax transfer. The county fuel tax allocation represents the transfer of a one-half cent of the state’s liquid fuel tax to county governments. The monies allocated by formula may be used for the construction, maintenance, and repair of highways, roads, and bridges as well as a few other related purposeszo GFED and GSTATE are assumed to be endogenous, because they either require a local match or are conditional upon a certain type of expenditure.2’ OAID is assumed exogenous, since its receipt is assumed to not de- pend upon local government revenue effort.

The structural equations in this model include a balanced budget equation and three behavioral equations in which local own-source revenue (OS) is determined simultaneously with GFED and GSTATE. These equations are generated from a constrained optimization model in which local public officials attempt to maximize the social welfare function of local voters (W), which includes local public expenditures (E) and private expenditures (P).22

w= W(E,P)

subject to a balanced budget constraint, where public and private expenditures are assumed to be financed from intergovernmental grants and local residents’ income. The equations for the balanced budget constraint and the endogenous local government revenue components can be stated as follows:

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0 E + P = INCOME t GFED

+ GSTATE + C)AID23

q OS = f,(GFE.D, XGFED, GSTATE, XGSTATE,

OAID, OS,- ,, Z, IV,,)

q GSTATE = f,(OS, GFED, XGFED, OAID,

GSTATE,-,, DHUM, DGA, N,,)

q GFED = f,(OS, GSTATE, XGSTATE,

OAID, GFEDt-,, DHUM, DGA, N,,)

where OS, ,, GSTATE,-, and GFED,-, are lagged dependent variables and Z is a vector of exogenous variables affecting own-source revenue. Each equation also includes cross-sectional dummy variables (AI,,). Equation 1 is an identity, while equations 2 through 4 are behavioral equations. Equations 2 through 4 also include interactive dummy variables (XGFED and/or XGSTATE) to test for asymmetric response. The federal aid interactive variable IS defined as XGFED = (X,)(GFED, - GFED-,), where X, = 1 if GFED, < GFED,-,. Otherwise, X, = 0.24 The same procedure is used for the specification of the state interactive dummy variable (XGSTATE).

Much of the empirical Iliterature fostered by the theory of grants assumes that local public expenditures determine own- source revenue and that local constitu- ents are well informed in communicating their choices to public officials.*!’ In this framework, own-source revenue is the balancing item between aid and expenditures in the local budget. This often has been the role assigned to the property tax in local public finance. Nonethe- less, revenue decisions also may drive

the level of local expenditures if revenue decisions are not fully dependent upon expenditures. For instance, the flypaper effect and Niskanen’s revenue- maximizing politician are examples where revenue decisions may drive ex- pendituresJ6 However, it is beyond the scope of this paper to determine causal- ity. No attempt is made to model the interdependence between own-source revenue and local public expenditures.

The theory of grants gives a reference for linking aid receipts lto local government revenue and expendrtures. The expected response of Owen-source revenue to federal aid (or state aid) can be positive or negative. This depends upon whether local governmlent expenditures increase by more than ~the amount of aid, which, in turn, derpends upon re- spective price and incoime effects of the aided expenditure.*’ If, for instance, increased aid stimulates spending by an amou ,’

ocal public t greater than

aid, then own-source revenue will increase. If, however, increased aid results in a smaller increase ini public spending, then own-source revenue will be reduced. The asymmetric response variable (XGFED) tests whetherthe response to a decrease in GFED is different in magni- tude from an increase ‘in GFED. Suppose, in equation 2, a, and a3 represent the symmetrical and asym l-l-l etrical response parameters for federal ‘aid, respectively. Then,

OS, = a, + a,(GFED,) + a,(GFED,

- GFED,-,)(X,) + . . ,

If GFED, > GFED,-,, then

OS, = a, + ,a2 (GFED,) + . . .

and if GFED, .: GFED,,,, then

OS, = J, + a,(GFED,)

+ a,(GFED, - GFED,-,) + . . .

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Alternatively, the equation for declining aid can be written as follows:

OS, = a, + (a, + a,)(GFED,)

- a, (GFED,-,) + . . .

Note that a, measures the response to a reduction in aid rather than to the level of aid.28 Alternatively, (a, + a,) gives the slope coefficient for current federal aid when it is declining. A test of asymmetric response can be conducted by deter- mining the statistical significance of a,.

The sign of the coefficient a, is of interest empirically. Compared to a symmetrical response (a, = 0), own-source revenue will tend to increase less or decrease more if d3 > 0. To illustrate, suppose d2 = -2.0 and d3 = +l .O. Symmetrical response implies that own- source revenue will increase two dollars for a dollar reduction in federal aid. However, asymmetrical response implies that own-source revenue only will increase one dollar for a dollar reduction in federal aid. Thus, own-source revenue increases less in this case than when symmetry holds. Now, suppose that d2

= +2.0 and d3 = +l .O. Symmetrical response predicts that own-source revenue will decrease two dollars for a dollar reduction in federal aid, while asymmetrical response predicts it will decrease three dollars. Thus, own-source revenue decreases more. A similar rationale suggests own-source revenue will tend to increase more or decrease less compared to symmetrical response if d3 < 0.

In any event, if d3 is significantly different from zero, it implies that the decision- making process is different for a reduction in federal aid than for an increase. A negative a, implies a public sector more favorable to increasing revenue and against reducing expenditures in a period of declining aid. On the other hand, a positive d3 implies the local gov-

ernment favors reducing revenue and expenditures.

An asymmetric response variable also is included for state aid (XGSTATE). Al- though state aid showed moderate growth during this time period, reductions did occur in selected years. The es- timate will provide a useful comparison to federal aid. It contrasts moderately growing state aid with steadily declining federal aid. The same interpretations can be made about its coefficient as were made about the federal aid asymmetric variable above.

The state aid equation also includes an asymmetric slope coefficient term for federal aid. A considerable part of aid received by county governments for any given function often includes separate allocations of federal and state aid receipts.2g For instance, most of the human service functions involve the receipt of federal and state aid. Consequently, the loss of federal aid would require additional supplementation from the state or increased own-source revenue if the service level is to be maintained. The response of state aid to a decrease in federal aid also may differ from an increase in federal aid. The asymmetric response coefficient tests whether the rate at which state aid substitutes for declining federal aid differs. If the coefficient is negative, this suggests the state government replaces lost federal aid at a higher rate than if there is symmetry. On the other hand, if the coefficient is positive, the state government replaces federal aid at a lower rate.

Table 3 gives the definitions of the endogenous and explanatory variables in the model. The data sources for all these variables were the Department of Wel- fare’s County Profile (CP) and the De- partment of Community Affairs’ Local Government F~JK~J/ Statistics (LGFS).

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TABLE 3 DEFINITION OF VARIABLES

Endogenous Variables OS county government own-source revenue per capita PT county government real estate tax receipts per capita GSTATE county government state aid receipts per capita GFED county government federal aid receipts per capita Explanatory Variables: Equations 2-4 OAID county government other aid receipts per capita

including undesignated federal and state aid and liquid fuels tax transfers

MV Market value of real estate per capih UNEMPR Annual county unemployment rate DIV Revenue diversification index defined as the sum of the

squares of four own-source revenue percentage shares, where

AGED

0% 1

GSTATE*. , GFED,-,

OR

DHUM

DGA

S, = property tax, S2 = other ‘taxes, S, = departmental earnings, and S, = miscellaneous revenue

percentage of the total population that IS over 65 years of age

lagged county government ownsource revenue per capita

lagged county government state aid receipts per capita lagged county government federal aid receipts per

capita county government revenue receipts ,per capita

excluding property tax = OS -- PT annual dollar change in human ‘service expenditures

per capita annual dollar change in general admFnistration

expenditures per capita

LGFS LGFS LGFS LGFS

LGFS

LGFS CP LGFS

CP

LGFS

LGFS LGFS

LGFS

LGFS

LGFS

Data source abbreviations are noted for each variable in Table 3.

Most of the interest will be on the variables in equation 2. However, a brief discussion of the variables in equations 2 through 4 will follow. Lagged dependent variables are included in the three equations, because the amount of aid/revenue received is assumed to be determined incrementally.30 The annual per capita changes in two county government expenditure variables, human services (DHUM) and general administration (DGA), are included because aid receipts are closely related to these expenditure categories.3’ Aid receipts for many of the human service functions are conditional upon local government expenditure. Several of the human service aid programs allow counties to spend up to

ten percent of their allocation plus earned interest for county administration. All equations also include cross- sectional dummies. The dummies account for differences in tastes, govern. mental structure, and geographic loca- tion.32

The other ald variable (OAID) in equation 2 is assumed to be received independently of local expenditures and own- source revenue. Therefore, it is expected to provide some tax reliief because there is no price effect. The other exogenous variables in equation 2 include fiscal, economic, and taste vairiables. Market value per capita (MV) is included to rneasure the fiscal capacity of the locality. The rnarket value of local real estate represents the tax base of the main revenue source for many Ilocalities. This

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variable is preferred over an income per capita variable because local economies are not closed.33 One would expect own-source revenue to be positively related to market value. The annual unemployment rate (UNEMPR) reflects cyclical fluctuations in the local economy. It is a proxy for the fiscal health of the local economy as well as its need to finance local public services. On the one hand, a high unemployment rate implies a lower capacity to finance local public services. On the other hand, a high unemployment rate may imply a greater need for social services and thus requires a greater amount of local financing. The revenue diversification index (DIV) is included to account for the ability of the local government to use alternative revenue sources. The index is the sum of the squared revenue shares of four major own-source revenue components. The index is inversely related to diversity. The more dependent a locality is upon a single source, the higher its index. A locality is likely to have a greater ability to raise revenue (OS) the more diverse its revenue structure. Finally, the percentage of the population over 65 (AGED) is the taste variable for local public services. Its sign depends upon the elderly’s preferences for the types of services provided by county governments. It is expected that, since a large proportion of county government expenditures are for human services, own-source financing would be positively related to the proportion of the elderly in the population.

EMPIRICAL RESULTS

The asymmetric response hypothesis is tested using pooled annual data for 66 Pennsylvania county governments over the 1978-88 period. Most of the data were obtained from two annual publica- tions of the Commonwealth of Pennsyl- vania. These data sources along with variable definitions are given in Table 3.

All variables expressed in dollars are in per capita terms. The nominal value of these variables is deflated by the U.S. Department of Commerce’s State and Local Government Price Index, which uses 1982 as the base year.

The three structural equations 2 through 4 were estimated using two stage least squares. This method was employed to control for possible simultaneity bias between the endogenous aid variables and own-source revenue. In addition, all equations include asymmetric response variables (XGFED and/or XGSTATE) as well as dummy variables for n - 1 counties.34 Other excluded predetermined variables were used as instrumen- tal variables in the first stage to obtain fitted values for the endogenous variables. These predetermined variables were a percentage of the population receiving cash public assistance, the annual dollar change in three separate expenditure functions (highway, parks and recreation, and library), and two tax base composition variables, one for the percentage of assessed real estate value classified as commercial and the other for the percentage classified as industrial and mining.35 While these variables were used in the first stage of estimation, none were statistically significant in the second stage.36

Two versions of the three equations were estimated. The difference between the two versions is the dependent variable in the own-source revenue equation. Version 1 uses total own-source revenue, while version 2 uses real estate taxes. The argument for using real estate tax receipts is that all other local government revenues are assumed to be determined independently of real estate taxes and intergovernmental aid. Public officials in this context use the property tax as the residual balancer of the local budget. That is, the property tax levy is adjusted based on the difference between

anticipated expenditures and anticipated revenue from nonproperty revenue sources.37 However, other own-source revenue per capit;l (OR) appears on the right-hand side of aid equations (3) and (4) because of the fungibility of local government revenue sources. It is assumed that if matching funds are required for an aid supported expenditure, all local revenue sources could be used to finance it. Although the amount of real estate taxes also may be related to the level of other local revenues (OR), it is excluded from the pr(operty tax equation because of its high negative correlation with the diversification index.38

The two-stage least-squares estimation results are given in Tablle 4. The estimation results from both the own-source revenue and property tax equations explain a considerable part of the variation in local revenue. They suggest that own- source revenue response to state and federal aid is asymmetric. A dollar increase in federal aid results in approximately an 11 cent decrease in own- source revenue, while a dollar decrease in federal aid results in a four cent decrease in own-source revenue. This result suggests that local public officials were unwilling to increase ovvn-source financing to replace reduced federal aid. De- clining federal aid apparently had an in- ducement effect. It induced a curtailment of local financing of those activities supported by federal aid. On the other hand, increasing federal aid substituted for own-source revenue. However, the revenue response to reduced state aid was different. The results show that own-source revenue increased 19 cents for each dollar reduction in state aid. Thus, own-source revenue partly substituted for the loss of state aid but was not significantly changed by increasing state aid. The difference in response perhaps implies that some of the expenditures being financed

by federal aid are different than those financed by state aid. Fdr instance, if federal aid (contains more iproject grants, then local government4 might be more likely to reduce these t

k pe of expendi-

tures than those that re related to enti- tlement programs. Anc/ther possibility is that permanent reductiions are perceived differently than temporary ones. For instance, the discontinuaInce of federal aid programs like General Bevenue Sharing are more likely to be nbticed by taxpayers lhan temporary red~uctions in aid.

The evidenc:e does not ,support an asymmetric response of the’ real estate tax to federal aid. It was fourhd that tax revenue was inversely relatbd to federal aid irrespective of whether it was increasing or decreasing. In either’ event, the response to federal aid q/as found to be substitutive. Own-source revenue increased five cents whep aid was declining (and it decreased f&e cents when aid was increasing. The re4l estate tax response to state aid was found to be asymmetric. Real estat taxes inc:reased nine cents per dollar I di ,ss of state aid.

The results for the federal aid variables (GFEID and XGFED) in tihe State Aid equation 3 imply that $ great deal of substitution between federal ancl state aid takes place. It was found that state aid was higher the sm$ller the amount of federal aid received by a county. A dollar increase in federal aid reduced state aid between 11 (version I) and 18 cents (version 2). Furthkr, asymmetric re. sponse is again supporred in the case of declining federal aid. Spate aid increased betvveen 28 and 33 c

4

nts for each dollar loss of federal aid. Th s, the tendency to substitute state aid for declining federal aid was much stronger than a symmetrical response would have predicted.

The results from the felderal aid equation also support asymmetrIc response to state aid. Both versioni indicate that

810


TABLE 4 TWO-STAGE LEAST-SQUARES RESULTS FOR 66 PENNSYLVANIA COUNTIES 1978-88

(t-STATISTICS IN PARENTHESES)

Variable OS

Version 1

GSTATE GFED PT

Version 2

GSTATE GFED

GFED

XGFED

GSTATE

XGSTATE

OAID

OS

PT

OR

MV

DIV

UNEMPR

AGED

OS,-1

PTt- I

GSTATE,-,

GFEDt-,

DHUM

DGA

Constant

R2

-0.11 (2.29)** 0.15

(1.65)* -0.04

(0.71) -0.19

(2.55)** -0.06

(0.90) -

-

-

0.46 x lo3 (1.93)*

-60.85 (5.45)**

-0.27 (1 .w

91.32 (2.24)** 0.45

(13.28)** -

-

-

-

-

118.42 (10.24)

0.84

-0.11 (2.60)**

-0.17 (1.88)*

-

-

-0.18 (2.87)**

-0.08 (1.41)

-

-

-

-

-

-

-

-

0.55 (15.91)**

-

0.47 (13.12)**

0.47 (1.18)

47.53 (4.21) 0.81

-

-

-0.17 (2.73)**

-0.37 (3.06)**

-0.39 (6.06)**

-0.07 (1.03)

-

-

-

-

-

-

-

-

-

0.61 (15.45)**

0.20 (3.15)** 0.21

(4.03)** 43.50 (3.15) 0.60

-0.05 (2.29)** 0.01

(0.34) 0.03

(1.20) -0.09

(2.85)** 0.03

(0.86) -

-

-

0.32 x lo3 (3.06)**

26.98 (5.53)**

-0.14 (1.61)

49.67 (2.74)**

-

0.56 (15.98)**

-

-

-

-

31.80 (5.96) 0.90

-0.18 (4.37)**

-0.15 (1.74)*

-

-

-

-

-0.24 (3.81)**

-

-0.44 (5.63)**

-0.82 (5.46)**

-0.53 (7.11)**

-

0.16 0.26 (1.52) (1.90)*

-0.26 -0.38 (7.29)** (6.26)**

- -

- -

- -

- -

- -

- -

0.52 (15.41)**

-

-

0.48 (13.93)**

0.10 (2.16)**

38.27 (3.04) 0.82

0.56 (13.45)**

0.45 (5.72)** 0.28

(4.86)** 45.34 (2.61) 0.56

*Statistically significant at the 10 percent level. **Statistically significant at the 5 percent level.

federal aid was lower the higher the amount of state aid received. This indicates that increasing state aid partially replaced federal aid over time and that counties receiving a smaller amount of state aid received more federal aid at a given point in time.3g In the case of declining state aid, federal aid increased by more than the predicted symmetrical response. The rate of replacement for declining state aid was relatively high. Ver- sion 1 predicts a 54 cent increase per

dollar reduction, while version 2 predicts a $1.26 increase per dollar reduction.

The other explanatory variables in the own-source revenue and real estate tax equations generally had the expected signs. Differences in fiscal variables played an important part in explaining differences in per capita local revenue. The previous year’s own-source revenue had a strong positive influence on the current year’s own-source revenue. Fur-

811

ther, own-source revenue tended to be higher and property taxes lower in counties with more diversified revenue structures. The estimates also indicate that local revenue is positively related to market value and the percentage aged while it is negatively related to the percentage unemployed.40 The negative coefficient for percentage unemployed supports the notion that local economic conditions influence the ability of counties to raise local revenue. The percentage of population 65 years and over had a positive influence on local revenue. This result suggests that the types of services provided by county governments were preferred by the aged.

The results from the aid equations indicate that lagged dependent variables have a strong inflluence on current aid levels. Similarly, the expenditure change variables, DHUM and DGA, have strong positive effects on aid in both versions 1 and 2. In version 1, the own-source revenue variable (OS) had a negative sign in both aid equations. The negative signs suggest that state aid and federal aid fa- vored counties with low revenue raising capacity. However, they were not statistically significant in either equation. In version 2, federal aid was found to be positively associated with real estate tax revenue but negatively associated with other local revenues. A possibility is that the real estate tax was being adjusted to finance expenditures for which the federal government required local revenue effort. On the other hand, both state aid and federal aid wlere found to be significantly lower in those counties that had relatively high other revenues. This suggests that aid may provide fiscal relief to counties with a low ability to raise revenue other than the real estate tax.

Concluding Remarks

Most positive studies of grants have failed to test whether the fiscal response

81

to federal aid is symm$trical. The evi-

dence from this study indicates that own-source revenue r d ,sponse is not symmetrical; local gov rnment response to declining federal ai is different from that to increasing aid. ,’ It further suggests that, while increasing ederal aid provided limited fiscal reli county governments, d

f to Pennsylvania eclining aid re-

sulted in a propensity to lower local revenue. Thus, in this per od of steadily de-

b clining flederal aid, an pparent attempt was made by counties ~to tighten their purse strings. The results also show significant interrelations ‘etween federal and state aid. State ai replaced declining federal aid at a hi her rate than a symmetrical response

i

ould have predicted. This probably diminished the im- paci of smaller federal, aid receipts on county government geberal revenues.

The response of countjes to declining state aid was quite dif erent from declin- lng federal aid. The I ev dence shows that counties increased locdl revenue in response to declining stdte aid. This differ. ence in response raise! two related questions. First, does iJ matter whether public officrals view th4 reductions in aid as temporary or permalnent? This period was one in which stat4 aid gradually increased while federal id continuously declined. Temporary re uctions in state

1

aid iundoubtedly signal d a different re-

sponse than permanen reductions in federal aid. This is conpistent with the fiscal illusion hypothes$. Taxpayers are Ilkely to be less aware lof temporary reductions than perman nt reductions. Furthermore, they are ore likely to notice the elimination of

:

ignificant aid programs like General evenue Sharing. Second, does the type ~of expenditures being financed by aid ti-natter? It is more difficult to postpone eAtitlement programs than capital im ‘rovements. If state aid is more close1 linked to entitle- “5 ment programs, this rnpy explain some


of the difference in response. While nei- ther of these possibilities is directly tested in this paper, the results are con- sktent with each.

ENDNOTES

I am grateful to Joel Slemrod and an anony- mous referee for their many helpful comments and suggestions. I also benefitted from the comments of participants in a workshop seminar sponsored by the Clarion University College of Business Administration. I finally would like to thank Dayna Shaw, Qiang Li, Brenda Fulton, and Joe Grunenwald for their assistance and support. This paper was funded by a grant from the Clarion University College of Business Summer Research Pro- gram.

’ Pennsylvania counties also receive tax revenue from an intangible personal property tax, a per capita tax, and an occupation tax. Alle- gheny county also has a hotel room rental tax. However, the real estate tax yielded almost 93 percent of total county government tax revenue in 1988.

’ Studies that have investigated the state or local government fiscal response over time include Stotsky (19911, Stine (19851, Craig and lnman (1982), Vogel and Trost (1979), and Gramlich and Galper (1973).

3 No money illusion is assumed. Taxpayers per- ceive the revenue burden of financing local public services in real terms rather than in nominal terms. See Oates (1988, p. 79, n. 1) for a discussion of this point.

4 Fiscal illusion also refers to an underestimation of perceived benefits. The early literature by authors such as Downs (1960) and Gal- braith (1958) was concerned with understate- ment of benefits. However, most of the recent empirical work has centered on the underestimation of costs.

’ See Schultze (1992) for a recent survey of the various hypotheses that attempt to explain a public sector bias toward excess spending.

6 The distribution for the number of Pennsylva- nia counties that had smaller real per capita federal aid receipts than the previous year was as follows: 10 years = 5; 9 years = 8; 8 years = 18; 7 years = 14; 6 years = 14; 5 years = 6; and 2 years = 1. The distribution for the number of Pennsylvania counties which had smaller state aid receipts than the previous year was as follows: 7 years = 7; 6 years = 14; 5 years = 16; 4 years = 16; 3 years = 8; and 2 years = 5. Federal and state aid receipts are measured in constant

813

1982 dollars using the State and Local Gov- ernment Price Index published by the U.S. De- partment of Commerce. In fact, Pennsylvania has the largest rural population in the United States. See The PSCD News (1992) for further details. All Pennsylvania counties except Philadelphia are included in this study. Philadelphia is excluded because It does not function independently of the city government. Philadelphia like other Pennsylvania cities has a much broader taxing authority than counties. In 1988, for instance, Philadelphia derived 53.2 percent of its total tax collections from the earned income tax while only 27.6 percent was received from the real estate tax. This is in sharp contrast to county governments, which receive most of their tax collecttons from the real estate tax. Allegheny, which is part of the Pittsburgh MSA, had a population of 1,450,518 In 1980 while Montgomery’s population was 643,62 1 and Delaware’s was 555,007. In all, there were 10 counties with a 1980 population greater than 300,000. Pennsylvania counties are authorized by a 1913 law to levy a tax on intangible personal property at the statutory rate of four mills. The tax applies to mortgages, stocks, bonds, annuities, and other interest-bearing obliga- tions. In 1978, the law was amended to au- thorize county commissioners to determine whether to impose and collect the tax, for the first time making this tax optional at the county level. In 1985, 18 counties did not levy the tax. See the Department of Commu- nity Affairs, Taxation Manual (1986, p. 19).

Revenue data and other fiscal data were obtained from the annual editions of Local Gov- ernment Financial Statistics published by the Commonwealth of Pennsylvania Department of Community Affairs. The Department of Community Affairs does not distinguish the various types of aid receipts, such as conditional and unconditional grants. Prior to 1984, other aid was made up of only liquid fuel tax transfers. In 1984, the Depart- ment of Community Affairs began reporting a new category of aid referred to as combined federal and state aid without distinguishing the amount provided by the federal or state government. These other aid receipts, however, are a relatrvely small part of total revenue.

The data on expenditure components also were taken from the annual editions of the Department of Community Affairs’ Local Gov- ernment financd Statistics. The components

shown were those with relatively large expenditure amounts and a consistent title throughout the period. The exception is health and welfare expenditures, which were combined into a single title beginning in 1984. The other expenditure component Includes tax collection, conservation and development, employee benefits, insurance, and miscella-- neous expenditures. The average annual rate of growth of a given revenue component (r,) is estimated by re- gressing the log of the receipts from that component against a time variable. The estimated coefficient of time (b,) is then used to find the growth rate (r-0, which equals r, = eb’ - 1. This procedure is discussed by Johnson, Johnson and Buse (1987, pp. 353-354). The growth rates are corrected for serial correlation using Beach and McKinnon’s (1978) small sample procedure. lnman (1979) offers a useful review of some approaches that have been employed to test the determinants of local government fiscal decisions In addition to the median voter model, lnman also discusses the dominant party model. Further, Wilde (1971) assumes that a local government behaves as If it is a single individual with a well-defined utility function. See Islam and Choudhury (1990) for a recent extension of the Hettich and Winer approach to empirically test the exogeneity of grants. Gade and Adkins (1990) also use the Hettich and Winer framevvork to investigate the determinants of revenue shares across state tax structures. In addition, a new grant program, the Human Services Development Fund, was lnltlated in 1984 to provide a more flexible funding source. It is structured as a block grant, which gives more latitude to address local needs and priorities within the six human service program areas See Pennsylvania Department of Public Welfare, Office of Policy, Planning and Evaluation (1986) for a discussion of this sup- plementary program. Other project grants include Public Library Service grants ancl a variety of transportation grants. However, separate data were not available by type of grant. For a detailed re- port on the type of grant instruments available to Pennsylvania localities, see the Com- monwealth of Pennsylvania, Department of Community Affairs, Catalogue of State Re- sources for Local Government (1988). See Cataiogue of State Resources for Local Government (1988, p. 93) for further details.

Federal aId also included General Revenue

Sharing, which ostensiqly is an exogenous grant. General Revenud Sharing grants were received by Pennsylvanil cqunties from 1978 through 1985. Data Ii ltatlons prevent specification of a separate f deral General Revenue

74 Sharing grant variable. onetheless, Islam and Choudhury (1990) offed empirical evidence that suggests the tax e fort

1

provisions found in general revenue shar ng formulas may make them endogenou$.

” Private expenditures (p) include local taxpayers’ private consumptio

r as well as govern-

ment expenditures of ail nonlocal government jurisdictions.

23 Since INCOME is used o finance either local public consumption (0 ) or nonlocal public

k and private consumptio (P), equation 1 also may be written as E = ~GFED t GSTATE + OAID + OS.

24 See Kmenta (1971, pp.1421-22), for a discussion of the asymmetric ~response procedure.

25 For a good review of the early empirical studies on the theory of gr;ints, see Gramlich (1977).

26 Another hypothesis is t at the level of taxes depends upon the

1 near ess of the next elec-

tion. That is, the closer the election, the less likely iaxes will be incre

t sed. See Mikesell

(1978) for a discussion f this hypothesis. 27 No attempt is made to distinguish the sepa-

rate income and substithtion effects associated with the receipt of aid. Predicting the combined effect of cha

I ges in aId receipts on

local government reven, e is the primary focus of this study.

‘* If the hypothesized owrh-source revenue equation were concerned wikh response to the level of federal aid whep it was declining, then

OS, = al + a2 (GFED,) tt a; (GFEDJX,

where a$ IS the asymm&ric response coefficient for the level of aid. It can be shown that a: is related to a3, ithe asymmetric coeffl- clent of the change varilable (GFED, - GFED, .,), in the followibg way:

a; = a3 (GFED, - GFED+,)/GFED,.

The sign of a: will be the opposite of a3, since (GFED, - GFED,-,) < 0 by definition.

” The state aid reported y the Department of Community Affairs’ Lot cial Statistics includes f s

I Government Finan- nds allocated from

the Commonwealth of Pennsylvania’s General Fund, while federal aid ncludes funds dls- bursed by the federal g vernment to the

these statistics is the in ;

o3unty government. Ho ever, the source of ividual county govern-

814.

REVENUE RESPONSE TO FEDERAL AID

ments. Therefore, some variation may be found in reporting across individual county governments. Sharansky (1967) argues for including previous expenditures in expenditure determinant studies. This is based on the premise that budget officials use previous year’s expenditures as the base for current expenditures. Similar reasoning is assumed to hold for lagged endogenous revenues. An attempt was made to relate state and federal aid to the change in a number of other expenditure variables. These included judicial, corrections, library, parks and recreation, and highways. All were not statistically significant in the various estimations so they were dropped from the aid equations. An attempt also was made to include exogenous variables that might explain differences In aid receipts across counties. These variables were related to aid criteria. They included population, population density, income per capita, and percentage of the population receiving public assistance. None of these variables was statistically significant. See Bell and Bowman (1987, p. 285) for this argument. Allegheny county is the reference county. It includes Pittsburgh central city and is the largest of the 66 counties included in the sample. The three behavioral equations 2 through 4 meet the rank-order conditions for identifica- tion. The number of excluded predetermined _ variables in equations 2 through 4 were 8, 13, and 13 respectively. This implies overiden- tification for each of the three equations. A procedure described by Maddala (1988, pp. 301-02) was used to verify that each equation satisfied the rank condition. Other economic and demographic variables were tried in the first stage. These variables included population, population density, and income per capita. They were dropped because they were highly correlated with one another as well as with other predetermined variables. This point has been made by Netzer (1966, pp. 170-71). For an example of the property tax as a residual balancer of the local budget, see Heilbrun (1987, pp. 42 l-22). The simple correlation coefficient between OR, and DIV is -0.382. This result possibly indicates a tendency among federal officials to award larger grants to those counties that receive less state aid. See Chernick (1979) for this argument in re- verse, where government officials are hypothesized to award larger grants to those locali-

ties that are willing to undertake larger project grants.

4o The unemployment rate was not statistically significant at the 10 percent level. Its p-value was approximately 16 percent in version 1 and approximately 11 percent in version 2.

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