Financing Options for Subnational Governments
September 24, 2015
By Davis Berlind, C’16
In the United States, the federal government uses vertical fund transfers to insure subnational governments against the risk of asymmetrical shocks to their regional economies. The most notable of these vertical transfers is Medicaid, a program funded by a progressive federal income tax, which smoothes healthcare consumption throughout the nation by transferring funds from high to low-need areas.
The US lacks a system of general fiscal assistance or equalization from the federal government to the subnational level. The vertical fund transfers that do exist tend to focus on narrow issues of poverty alleviation and consumption. This summer I had the opportunity to conduct an independent research project for the Metropolitan Policy Program at the Brookings Institution, and I chose to focus on the policy vacuum that has existed since the death of the State and Local Fiscal Assistance Act in 1986. In particular, my research focuses on the function and flaws of horizontal fund transfers (i.e. revenue sharing programs) and the potential alternative of intergovernmental investment using a system of Local Government Investment Pools (LGIPs) and municipal debt.
II. Revenue Sharing
An alternative to vertical fund transfers that is common outside of the US is the use of horizontal fund transfers. Rather than have the central government collect taxes and choose how to distribute the revenues between the various subnational governments, the subnational governments themselves enter into agreements to shift revenue between each other via equalization transfers. There are four primary purposes used to justify tax-base sharing:
- Efficiency—Limits competition for tax-base between municipalities, which otherwise would lead to an inefficient race to the bottom in regulations that are key for generating local revenue.
- Equity—Reduces inter-municipal inequalities in tax rates and public services by providing proportionally larger shares of the pool to low tax-base areas.
- Insurance—Insures all participants against future changes in growth patterns (i.e. provide counties with countercyclical assistance).
- Cooperation—Encourages increased interconnectivity of local economies in order to promote joint economic development efforts and long-term regional growth.
The most prominent example of revenue sharing in the US is the Twin Cities Fiscal Disparities program, a tax-base sharing program that covers the seven core Minnesota counties in the Twin Cities Metropolitan Area. The program pools 40 percent of the annual growth in the commercial-industrial tax-base for each county, then redistributes the tax-base back to participating municipalities and school districts based on formulas indexed to each county’s tax base and population. The Twin Cities Fiscal Disparities Program has existed since 1971; despite the program’s long history and reported success (former Minnesota State Representative Myron Orfield claims the program has reduced tax-base disparities between participating municipalities from 50:1 to roughly 12:1), it remains a public policy anomaly. The reasons behind the continued opposition to revenue sharing programs are twofold:
- Political—Perhaps the most obvious barrier revenue sharing programs face is a political one. As was the case with the repeal of the State and Local Fiscal Assistance Act, voters may be sympathetic towards taxes that benefit the local community, but it is a much tougher sell for legislators to support policies that can potentially increase taxes on their constituency and send the benefits of the increased revenue elsewhere.
- Soft Budget Constraints—A common problem with revenue sharing programs of both horizontal and vertical designs is that they allow the participating governments to consume beyond their means. In other words, the budget constraints are softened for the governments on the receiving side of these pools. Whereas state and local governments must normally find a way to balance their budgets, revenue sharing encourages these subnational governments to incur budget deficits and make up the difference with grants from the shared revenue pool. As mentioned before, revenue sharing is essentially a form of insurance that spreads out the risk of economic downturn between participating governments, and as with most forms of insurance, there exists a significant risk of moral-hazard. Operating under the assumption that other participating governments will bail them out, local governments participating in revenue sharing programs may pursue riskier policies and face less incentive to encourage growth or eliminate inefficiencies.
III. Municipal Bonds and Local Government Investment Pools
One possible alternative to revenue sharing for subnational governments in need of extra funding is to issue debt. States, cities and other local governmental organizations are typically permitted to sell municipal bonds in order to finance various development projects. There are two broad categories of municipal bonds:
- General Obligation Bonds—“Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer’s unlimited or limited taxing power. In many cases, general obligation bonds are also voter-approved.”
- Revenue Bonds—“Principal and interest are secured by revenues derived from tolls, charges or rents from the facility built with the proceeds of the bond issue. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals and subsidized housing. Many of these bonds are issued by special authorities created for that particular purpose.”
As evidenced by the chart below, revenue generated by municipal bonds goes towards supporting public goods and services that are crucial for developing regional quality-of-place.
Municipal bonds have the potential to circumvent the accountability issues that plague revenue sharing programs. Horizontal and vertical fund transfers are essentially cash grants with no strings attached, and without any predetermined growth standards or oversight measures ensuring effective use of transfer funds, struggling municipalities are able to continue functioning inefficiently, buoyed by the surrounding municipalities. Municipal bonds solve this problem in two ways:
- Interest—The governments or agencies issuing municipal debt must pay interest on that debt, meaning municipalities must actively find ways to prudently allocate the funds from bond sales and boost revenues for the purpose of servicing their debt. In the case of revenue bonds, municipalities issuing must maintain an even greater degree of transparency by guaranteeing interest payments with revenues from specific projects.
- Credit Ratings—Most municipal debt is rated by one or more Nationally Recognized Statistical Ratings Organization (NRSO). The S&P Municipal Bond Index, for instance, rates more than 21,000 municipal bonds. These ratings are a measurement of the likelihood that the municipality issuing the debt will be able to make its interest payments and return the principal investment upon the bonds maturity. Naturally, municipalities issuing higher quality debt will be able to attract a greater deal of investment. Therefore, it is in the best interest of local governments and agencies issuing debt to seek the highest credit rating possible, which means demonstrating sound fiscal policy and a propensity towards growth. In game theoretic terms, credit ratings are the equivalent of requiring disclosure on the part of local governments, eliminating the possibility of adverse selection (poorly managed localities will likely be the ones most in need of capital investment, but if creditors can’t tell the difference between a high-risk and low-risk municipality, they will end up investing at a suboptimal level).
Just as subnational governments have the legal power to sell debt, many also have the authority buy the debt of other institutions. Forty-four states in the US have at least one Local Government Investment Pool (LGIP). LGIPs operate like money market mutual funds for participating subnational governments and other governmental entities within municipalities. By pooling their surplus and idle funds, participating local governments gain access to “economies of scale, full-time portfolio management, diversification, and liquidity (especially in the case of pools that seek a constant net asset value of $1.00).” The interest that the LGIP earns is normally allocated to the participants on a daily basis, proportionate to the size of the investment. With services like check writing or wire transfers, LGIPs also offer a high degree of liquidity. These features add value as cash management tools and allow participating local governments to pull out their surplus funds when budget shortfalls arise.
During the course of my research, I have examined the portfolios of 96 LGIPs, revealing a great deal of interesting information in the process. What’s most interesting to me though, is that the average LGIP only invests 0.8 percent of its portfolio in municipal securities, despite municipal debt having a similar term structure to corporate debt (8.0 percent) and being comparably as safe as federal government and agency debt (28.6 percent). Even more interesting is that I have discovered a statistically significant positive correlation between the percentage of municipal debt investment and the APR of the sample LGIPs (when I ran a regression using the different categories of investment, investment in municipal debt was the only variable able to predict APR at a significant level). This relationship varies as the LGIPs are decomposed by credit ratings, but the message remains clear; LGIPs that invest more heavily in municipal bonds enjoy greater returns.
This finding has important public policy implications. Part of the reason for the extremely low levels of investment in municipal debt by LGIPs is the stringent set of state regulations on municipal debt investments. Many states ban LGIP investment in municipal bonds outright, and those that do allow it often specify the municipal bonds must come from the same state as the LGIP. While long-term municipal debt does increase the risk and decrease the liquidity of LGIPs (though these effects can be minimized by investing in short-term municipal bonds), I believe nonetheless that the benefits still outweigh, considering both the predicted increases to APR and the benefits of redirecting revenue throughout the nation to local governments where capital is in greater demand. The incentives are uniquely aligned in this case such that everyone can benefit. Local politicians that want to keep LGIP investment in-state are only hurting themselves by cutting off access to potentially more secure, more profitable municipal debt. Therefore, policymakers should take steps to encourage greater intergovernmental investment, where investment flows from wealthy LGIPs to promising local economies in need of a spark, and the growth is shared all around.
- Conlan, Timothy J., and Paul L. Posner. Intergovernmental Management for the 21st Century. Washington, DC: Brookings Institution Press, 2007.
- Auerback, Marshall. The Next New Deal (blog). The Roosevelt Institute. http://www.nextnewdeal.net/revenue-sharing-states-how-it-works-why-we-need-it-and-why-nixon-liked-it.
- Hinze, Steve. House Research Department. Minnesota House of Representatives. The Fiscal Disparities Program: Commercial-Industrial Tax-Base Sharing. 2012. http://www.house.leg.state.mn.us/hrd/pubs/ss/ssfisdis.pdf. (accessed July 21, 2015).
- Independent Business (blog).The Institute for Local Self-Reliance. http://www.ilsr.org/rule/tax- base-sharing/2301-2/.
- Sala-i-Martin, Xavier, and Jeffrey Sachs. “Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States.” NBER Working Paper No. 3855, National Bureau of Economic Research, Cambridge, MA, 1991. http://www.nber.org/papers/w3855.pdf (accessed July 21, 2015).
- Buettner, Thiess. “Equalization Transfers and Dynamic Fiscal Adjustment: Results for German Municipalities and a US-German Comparison.” IFIR Working Paper No. 2007-07, Institute for Federalism & Intergovernmental Relations, Morehead State University, Lexington, KY, 2007. http://www.ifigr.org/publication/ifir_working_papers/IFIR-WP-2007-07.pdf (accessed July 21, 2015).
- Qian, Yingyi, and Gérard Roland. “Federalism and the Soft Budget Constraint.” American Economic Review 88, no. 5 (1998): 1143-1162.
- “Types of Tax-Exempt Municipal Bonds.” Securities Industry and Financial Markets
- Association. http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=24&id=240. (accessed July 21, 2015).
- National Association of Counties, Legal County Investments. A State by State Report. Washington: NACO 2010. http://www.naco.org/sites/default/files/documents/Legal%20County%20Investments%20A%20State%20By%20State%20Report.pdf. (accessed July 21, 2015).
- “Local Government Investment Pools.” Government Finance Officers Association. http://www.gfoa.org/local-government-investment-pools, (accessed July 21, 2015).
 Xavier Sala-i-Martin and Jeffrey Sachs, “Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States” (working paper, National Bureau of Economic Research, Cambridge, 1991).
 Marshall Auerback, “Revenue Sharing for the States: How it Works, Why We Need It and Why Nixon Liked It!,” The Next New Deal (blog), The Roosevelt Institute, May 11, 2011, http://www.nextnewdeal.net/revenue-sharing-states-how-it-works-why-we-need-it-and-why-nixon-liked-it. (accessed July 21, 2015).
 For an in-depth comparison of vertical and horizontal transfers in the US and Germany respectively, see Thiess Buettner, “Equalization Transfers and Dynamic Fiscal Adjustment: Results for German Municipalities and a US-German Comparison” (working paper, Institute for Federalism & Intergovernmental Relations, Lexington, 2007).
 Steve Hinze, House Research Department, Minnesota House of Representatives, The Fiscal Disparities Program: Commercial-Industrial Tax-Base Sharing. 2012. http://www.house.leg.state.mn.us/hrd/pubs/ss/ssfisdis.pdf. (accessed July 21, 2015).
“Tax-Base Sharing – Metropolitan Revenue Distribution, MN,” Independent Business (blog), The Institute for Local Self-Reliance, December 9, 2002 http://www.ilsr.org/rule/tax-base-sharing/2301-2/. (accessed July 21, 2015).
 National Association of Counties, Legal County Investments, A State by State Report, Washington: NACO 2010, http://www.naco.org/sites/default/files/documents/Legal%20County%20Investments%20A%20State%20By%20State%20Report.pdf. (accessed July 21, 2015).
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