Posted: March 12th, 2023

Three

Public budgeting systems consist of numerous participants and various processes that bring the participants into interaction. The purpose of budgeting is to allocate scarce resources among competing public demands so as to attain societal goals and objectives. Those soci- etal ends are expressed not by philosopher kings but by mortals who must operate within the context of some prescribed allocation process—namely, the budgetary system.
This chapter provides an overview of the participants and processes involved in budgetary decision making. First, the phases of the budget cycle are reviewed. Any system has some structure or form, and budgetary systems are no exception. As will be seen, the decision-making process has several steps. This chapter outlines the process and discusses the intermingling of the budget’s cycles, both within government and among governments.
The BudgeT CyCle
The discrete activities that constitute budgeting are geared to a cycle. The cycle provides the timetable for the system to absorb and respond to new information and, therefore, allows government to be held accountable for its actions. Although existing budget systems may be less than perfect in guaranteeing adherence to this principle of responsibility, peri- odicity contributes to achieving and maintaining limited government. The budget cycle consists of four phases: (1) preparation and submission, (2) approval, (3) execution, and (4) audit and evaluation.
Preparation and Submission
The preparation and submission phase is the most difficult to describe because it has been subjected to the most reform efforts. Experiments in reformulating the preparation process abound. Although institutional units may exist over time, both procedures and substantive content vary from year to year.

Chief Executive Responsibilities
The responsibility for budget preparation varies greatly among jurisdictions. Budget reform efforts in the United States have pressed for executive budgeting, in which the chief executive has exclusive responsibility for preparing a proposed budget and submitting it to the legislative body. At the federal level, the president has such exclusive responsibility, although many factors curtail the extent to which the president can make major changes in the budget. In parliamentary systems, the prime minister (chief executive) typically has responsibility for budget preparation and submits what is usually called the “government budget” to the parliament.
Preparation authority, however, is not always assigned to state governors and local chief executives. While a majority of governors have responsibility for preparation and submis- sion, some share budget-making authority with other elected administrative officers, civil service appointees, legislative leaders, or some combination of these parties.
In parliamentary systems, if a coalition of several parties is necessary to form a govern- ment, and the coalition is held together by each of the main parties in the coalition con- trolling one or more ministries, the prime minister may have very little control over budget preparation. Such was the case with the first government under the Iraq constitution adopted in 2005. Belgium holds the modern record for parliamentary systems for failure to form a government and thus name a prime minister; as of the end of 2011,1 Belgium had failed to form a coalition government for almost two years.
At the municipal level, the mayor may or may not have budget preparation powers. In cities where the mayor is strong—has administrative control over the executive branch— the mayor normally does have budget-making power. This is not necessarily the case in weak-mayor systems and in cities operating under the commission plan, where each coun- cilor or commissioner administers a given department. Usually, city managers in council- manager systems have responsibility for budget preparation, although their ability to make budgetary recommendations may be tempered by their lack of independence. City manag- ers are appointed by councils and commonly lack tenure. Even in a city in which the mayor or chief executive does not have budget preparation responsibility, this duty is still likely to be in the hands of an executive official such as a city finance director. Thus, a majority of cities follow the principle of executive budget preparation.

Location of Budget Office
Budget preparation at the federal level is primarily a function of a budget office that was established by the Budget and Accounting Act of 19212—the Bureau of the Budget (BOB), which became a unit of the Treasury Department. Over time, the role of the BOB increased in importance. In 1939, it became part of the newly formed Executive Office of the Presi- dent. Given that the BOB was thought to be the “right arm of the president”—a common phrase in early budget literature—the move out of the Treasury, a line department, into the Executive Office of the President placed the BOB under direct presidential supervision. In 1970, President Nixon reorganized the BOB, giving it a new title, the Office of Manage- ment and Budget (OMB). The intent of the reorganization was to bring “real business management into Government at the very highest level.”

The state budget office is contained within the governor’s office in only 10 states in the United States. It is a freestanding agency in 10 other states. Most commonly (in 21 states), the budget office is within an office of management and/or administration. Notably, in 39 of the 50 states, the governor’s office sets budget targets for executive branch agencies.4
Information about professional personnel in state budget offices is presented in Tables 4–1 and 4–2. Given the significant variation in state sizes, the number of personnel assigned to budget agencies, not surprisingly, varies widely. In 2008, there were 1,675 staff assigned to budget agencies in the 50 states.5 Of those, the largest number were assigned to budget
Table 4–1 Functional Roles of Budget Agency Personnel in the Fifty States
Budget Analysts
Average Number 23 Most 245 (NY) Fewest 3 (WVA) Total Budget Staff 1,151
(1,675)
Tech/Computer
4 43 (FLA) 1 or 0 (28 states) 204
Administrative
64 112 (NY) 1 or 0 (12 states) 320
Other
120 281 (CA) 17 (17 states) 605
Source: Adapted from Head, J., and Sigritz, B. (2008). Budget processes in the states (p. 15). Washington, DC: National Association of State Budget Officers.

Education of Personnel in State Budget Offices, 2005 Percent
Level of Education
High School 2 Two Years 1 Baccalaureate 38 Master’s 54 Doctorate 4 Total (n = 41 states) 100
University Degree Major
Public Administration 31 Business Administration 24 Accounting 13 Economics 8 Other Social Sciences 8 Other Professional Majors 6 Mathematics/Sciences 3 Liberal Arts 3 Humanities 2 Other 2 Total (n = 35 states) 100
Source: Data from Burns, R. C. (2006). Unpublished data from Survey of State Budget Offices, 2005. Morgantown, WV: Recreation, Parks, and Tourism Program, University of West Virginia.

analyst positions, as shown in Table 4–1. Another 200 were in technology- or computer- related positions. New York had the most personnel classified as budget analyst—245—and West Virginia the fewest, with only three.
Professional training of budget professionals also is diversified. As of 2005, most profes- sional staff at least had a baccalaureate degree, and more than half had a master’s degree or higher. Table 4–2 shows that the largest degree field was public administration (31%), followed by business administration and accounting. The professional staff size varied from five to 278 employees, with the mean being 30 and the median 20.6
Steps in the Preparation Stage
In the federal government, budget preparation starts in the spring, a full year and a half before the budget year starts, or even earlier for large agencies. Agencies begin by assess- ing their programs and considering which programs require revision and whether new programs should be recommended. At approximately the same time, the president’s staff makes estimates of anticipated economic trends to determine available revenue under existing tax legislation. The next step is for the president to issue general budget and fiscal policy guidelines, which agencies use to develop their individual budgets. In late summer, these budgets are submitted to the OMB. Throughout the fall and into the later months of the year, OMB staff members review agency requests and hold hearings with agency spokes- persons. Not until late in the process, usually in November, December, and into January, does the president become deeply involved in the process. It culminates in February with the submission of a proposed budget to Congress for the forthcoming fiscal year that starts in October of that same calendar year.
At the state and local levels, a similar process is used where executive budgeting systems prevail. The central budget office issues budget request instructions, reviews the submitted requests, and makes recommendations to the chief executive, who decides which items to recommend to the legislative body. In jurisdictions not using executive budgeting, the chief executive and the budget office play minor roles. In this type of system, the line agen- cies direct their budget requests to the legislative body.

Political Factors
The preparation phase, as well as the other three phases in the budget cycle, is replete with political considerations, both bureaucratic and partisan, in addition to policy con- siderations. Each organizational unit is concerned with its own survival and advancement. Line agencies and their subunits attempt to protect against budget cuts and may strive for increased resources. Budget offices often play negative roles, attempting to limit agency growth or imposing agency budget cuts. Budget offices are always conscious of the fact that the chief executive (the governor or mayor, for example) can overrule whatever they propose. All members of the executive branch are concerned with their relationships with the legislative branch and the general citizenry. The chief executive is especially concerned about partisan calculations: Which alternatives will be advantageous to his or her political party? Of course, there is concern for developing programs for the common good, but this concern plays out in a complicated game of political maneuvering.7

Fragmentation
One complaint about the preparation phase is that it tends to be highly fragmented. Organizational units within line agencies tend to be concerned primarily with their own programs and frequently fail to take a broad perspective. Even the budget office may be myopic, although it will be forced into considering the budget as a whole. Some agencies also will privately and some not so privately engage in separate discussions with the legisla- tive branch to try to restore cuts made by the budget office, thereby weakening the notion of the executive budget. Only the chief executive is unquestionably committed to viewing the budget in its entirety in the preparation phase.

Revenue and Appropriation Bills
The budget is approved by a legislative body, such as Congress, a state legislature, a county board of supervisors, a city council, or a school board. The important role of the legisla- ture in the United States traces back to the American rebellion against “taxation without representation.” For this reason, the “power of the purse” is considered to be a crucial responsibility of the people’s representatives. The legislature reviews the executive’s bud- get recommendations and often has access to the original agency budget requests, which enables it to make comparisons. At the federal level, revenue measures are enacted sepa- rately and are controlled by House and Senate committees other than the appropriations committees. This is not the case in many states, however.
Congress is normally not privy to original budget requests, although ways are often found to obtain this information, such as questions being put to agency representatives in committee hearings. The fragmented approach to budgeting in the preparation phase is not characteristic of the approval phase at the local level. A city council may have a separate finance committee, but normally the council as a whole participates actively in the approval process. Local legislative bodies may take several preliminary votes on pieces of the budget but then adopt the budget as a whole by a single vote.
Most states, like the federal government, separate tax and other revenue measures from appropriations or spending bills. Some states place most or all of their spending provisions in a single appropriation bill, whereas others create hundreds of appropriation bills. Most state legislatures are free to augment or reduce the governor’s budget, but some are restricted in their ability to increase the budget. Likewise, many parliamentary systems allow the parliament to modify—but not increase—the government’s budget proposal.
At the federal level, the revenue and appropriation processes have been markedly frag- mented and involve numerous committees and subcommittees. Not only have revenue raising and spending been treated as separate processes, but the expenditure side is handled in many different major appropriation bills instead of being treated as a whole. Reforms introduced in 1974 attempted to integrate these divergent processes and pieces of legislation, but the system had numerous flaws.8 The chapter on budget approval and the U.S. Congress discusses in detail efforts at reforming the congressional budget process.

Budget Cycles
The legislature holds a series of hearings at which the central budget office and the individual agencies testify. These hearings can be lovefests in which the committees that oversee agencies are eager to recommend increased appropriations for the agencies’ pro- grams. Conversely, tensions are common in such hearings. An executive may emphasize the need to restrain expenses, while legislators may seek expansion of various programs and corresponding increases in expenditures. Tensions are sometimes particularly keen between Congress and the president’s budget director, especially during periods of divided government in which the president is of one party and Congress is controlled by the other.
In both the preparation and the approval phases, one or two issues often dominate budget deliberations. If a state government is projecting a major decline in revenues due to a weakening of the economy, closing the gap between low revenues and higher expen- ditures will be a major concern. At the federal level, wrestling with a huge budget deficit was a primary focus in budgeting from the 1980s until the mid-1990s, and renewed again with the return of large budget deficits associated with the recession starting in 2007 and the large stimulus measures adopted to try to restart the economy, all financed entirely by borrowing.
Since September 11, 2001, both the president and Congress have been deeply con- cerned with fighting terrorism on a global scale and increasing domestic security. The result has been huge outlays of funds without comparable revenue increases, turning the budget surpluses of the 1990s into record-breaking deficits. With the budget so far out of balance, budget proposals considered of highest priority, particularly proposals to fight terrorism and continue the ongoing wars and to stimulate the economy in the latter part of the decade, have been placed in a favored position relative to other priorities in the bud- get. Some measures were introduced to cut spending in less favored programs, but these were relatively minor compared with the deficit increases

xecutive Signature or Veto Powers
The final step of the approval stage is signing the appropriation and tax bills into law. The president, governors, and, in some cases, mayors have the power to veto. A veto sends the measure back to the legislative body for further consideration. Most governors (44 of them) have item-veto power, which allows them to veto specific portions of an appropriation bill but still sign it. In no case can the executive augment parts of the budget beyond that pro- vided by the legislature. However, 38 governors have the authority to reduce the enacted budget without legislative approval.9 The president was given a form of item veto that took effect in 1997, but it was invalidated by the Supreme Court the following year (see the chapter on budget approval and the U.S. Congress).
execution
Apportionment Process
Execution, the third phase, commences with the beginning of the fiscal year—October 1 for the federal government and July 1 for most state governments. Some form of central- ized control during this phase is common at all levels of government and is usually main- tained by the budget office. Following congressional passage of an appropriation bill and
its signing by the president, agencies must submit to the OMB a proposed plan for appor- tionment (see the chapter on budget execution). This plan indicates the funds required for operations, typically on a quarterly basis. The apportionment process is used in part to ensure that agencies do not commit all their available funds in a period shorter than the 12-month fiscal year. The intent is to avoid the need for supplemental appropriations from Congress.
The apportionment process is substantively important in that program adjustments must be made to bring planned spending into balance with available revenue. Because an agency most likely did not obtain all the funds requested, either from the president in the preparation phase or from Congress in the approval phase, plans for the coming fiscal year must be revised. To varying degrees, state and local governments also use an apportion- ment process.

Impoundment
The chief executive may assert control in the apportionment process through a form of item veto known as “impoundment,” which is basically a refusal to release some funds to agencies. Thomas Jefferson often is considered the first president to have impounded funds. President Nixon impounded so extensively that Congress took legislative action. The 1974 legislation, in a sense, was a treaty between Congress and the White House allow- ing limited impoundment powers for the president. These limited impoundment powers have resulted in very little reduction in spending.
Allotments
At the federal level, once funds are apportioned, agencies and departments make allot- ments. This process grants budgetary authority to subunits such as bureaus and divisions. Allotments are made on a monthly or quarterly basis, and like the apportionment process, the allotment process is used to control spending over the course of the fiscal year. Control is often extensive and detailed, requiring approval by the department budget office for any shift in available funds from one item to another, such as from travel to wages. Some transfers may require clearance by the central budget office. At other levels, it is a one-stage allotment process, typically without using the term apportionment.
Preaudits
Before an expenditure is made, a form of preaudit is conducted. Basically, the preaudit ensures that funds are committed only for approved purposes and that an agency has suf- ficient resources in its budget to meet the proposed expenditure. The responsibility for this function varies widely, with the budget and/or accounting office being responsible for it in some jurisdictions and independently elected comptrollers being responsible for it in others. Later, after approval is granted and a purchase is made, the treasurer or other responsible official writes a check or makes an electronic fund transfer for the expenditure.

Execution Subsystems
During budget execution, several subsystems are in operation. Taxes and other debts to government are collected. The Internal Revenue Service (IRS) in the Treasury Department
is responsible for this set of tasks at the federal level. Cash is managed in the sense that monies temporarily not needed are invested. Supplies, materials, and equipment are pro- cured, and strategies are developed to protect the government against loss or damage of property and against liability suits. Accounting and information systems are in operation. For state and local governments, bonds are sold and the proceeds are used to finance con- struction of facilities and the acquisition of major equipment

audit and evaluation
The final phase of the budgetary process is audit and evaluation. The objectives of this phase are undergoing considerable change, but initially the main goal was to guarantee executive compliance with the provisions of appropriation bills, particularly to ensure hon- esty in dispensing public monies and to prevent needless waste. In accord with this goal, accounting procedures are prescribed and auditors check the books maintained by agency personnel. In recent years, the scope of auditing has been broadened to encompass studies of the effectiveness of government programs.
Location of the Audit Function
In the federal government, considerable controversy was generated concerning the appro- priate organizational location of the audit function. In 1920, President Woodrow Wilson vetoed legislation that would have established the federal budget system on the grounds that he opposed the creation of an auditing office answerable to Congress rather than to the president. Nevertheless, the General Accounting Office (GAO) was established in 1921 by the Budget and Accounting Act and was made an arm of Congress, with the justifica- tion being that an audit unit outside of the executive branch should be created to provide objective assessments of expenditure practices.
The GAO over the years underwent a gradual and major set of changes that led to its name being changed in 2004 to the Government Accountability Office.10 It obviously retained its initials of “GAO.”

GAO Functions
The GAO is headed by the comptroller general, who is appointed by the president, upon the advice and consent of the Senate, for only one term of 15 years. The comptroller gen- eral can be removed by Congress only by impeachment or joint resolution. There has never been such an effort, and as of 2011, there had been only eight people in this position since its creation in 1921.
The GAO does not maintain accounts, but rather audits the accounts of operating agen- cies and evaluates their accounting systems. With major reforms in accounting and audit- ing undertaken by the executive branch at the direction of Congress, and especially with the creation of independent inspectors general within executive departments and agen- cies, the GAO conducts far fewer audits than it once did.
The GAO provides a variety of other services. It gives Congress opinions on legal issues, such as advising on whether a particular agency acted within the law in some specific instance under consideration. It also resolves bid protests over the awarding of government contracts.

Where the GAO has gained major responsibility is in the arena of assessing the results of government programs. Comptroller General David Walker has said that the GAO’s “activi- ties [are] designed to determine what programs and policies work and which ones don’t. This also involves sharing various best practices and benchmarking information. It means looking horizontally across the silos of government and vertically between the levels of gov- ernment.”11 This responsibility for evaluating government programs has sometimes led to criticism of the GAO. In particular, some members of Congress have claimed that the office has lost its neutrality and become a policy advocate.
The GAO’s focus of course can change over time as the result of specific congressional direction, or more generally to resonate with the most critical issues of the time. The new- est comptroller general, Eugene Dodaro, reflected in his opening statement at his confir- mation hearing the criticality of the size of the budget and budget deficits: “It is critical for GAO to provide insights into the government’s financial condition and outlook and to seek ways to contribute to a more efficient and fiscally sustainable government. This includes working to help agencies identify and reduce billions of dollars in improper payments; identifying areas of duplication, overlap and fragmentation, as well as other opportunities to save money and enhance revenue; and helping promote more effective financial, infor- mation technology, acquisition, and performance management practices that can lead to eliminating wasteful approaches, provide greater efficiency, and ensure better accountabil- ity of taxpayer dollars.”12
In 2002, the General Accounting Office engaged in a historical conflict with the White House. President George W. Bush had created the National Energy Policy Development Group (NEPDG) to recommend a new energy policy for the government. Vice President Dick Cheney chaired the group. After the group completed its work, the GAO asked to see important records. Of particular concern was the list of companies and individuals from industry that had supplied advice. The energy giant Enron had collapsed, leaving many stockholders with huge losses and company employees without retirement benefits. Some suspected that Enron, which had close ties to President Bush before he left Texas for Washington, had exerted undue influence on the design of the energy policy.
The White House refused to release the requested documents, which prompted the GAO to file suit in U.S. district court against Vice President Cheney and the NEPDG.13 This move marked the GAO’s first suit in its history against a high-ranking government official. The GAO contended that taxpayers’ dollars were used by the group, and consequently, the GAO had a right to know how those dollars were spent. The White House’s position was that it had a right to obtain information and advice on a confidential basis and should not be required to release the documents. A U.S. district court ruled that the comptroller general had not been harmed by the withholding of information and therefore lacked standing—namely, the right to bring suit.14 The GAO decided not to appeal the ruling.
State and Local Auditors
At the state and local levels, the issue of organizational responsibility for auditing has been resolved in different ways. The alternatives are to have the audit function performed by a unit answerable to the legislative body, to the chief executive, to the citizenry directly, or to some combination of these. The use of an elected auditor is defended on the grounds
that objectivity can be achieved if the auditor is independent of the executive and legisla- tive branches. The opposing arguments are that the electorate cannot suitably judge the qualifications of candidates for auditor and that the election process necessarily forces the auditor to become a biased rather than an objective analyst. States primarily use elected and legislative auditors.

Sample Cycle
Figure 4–1 is a sample budget cycle. It is the one used in Pennsylvania, which, like most states, has a fiscal year beginning July 1. As can be seen, preparation begins with budget instructions being issued in August. Pennsylvania also issues Program Policy Guidelines (PPGs), which provide substantive policy guidance to agencies for preparing their budget requests. Submission by the agencies occurs in October, followed by budget office analy- sis and the governor’s review from October through January. In February, the governor submits the budget to the legislature, which deliberates through the spring. The budget is adopted by the legislature by July 1, the beginning of the new fiscal year. Agencies then submit to the budget office what Pennsylvania calls a “rebudget.” This is a reworking of their budget requests to reflect what the legislature approved as distinguished from what the agencies requested. The diagram does not show the audit phase that begins at the end of the fiscal year.

States that operate with biennial budgets—there are 23 of these states—operate with a 24-month cycle. North Carolina, for example, adopts a two-year budget in odd-numbered years. By April of the even-numbered years, the governor submits to the legislature recom- mendations for adjustments necessary for the second year of the budget. The state leg- islature meets to act on the governor’s recommendations. This is called the short session, because constitutionally the legislature can deal with only a limited number of issues, pri- marily making adjustments to the two-year budget adopted in the previous year.15
SCramBled BudgeT CyCleS
Although it is easy to speak of a budget cycle, no single cycle actually exists. Instead, a cycle exists for each budget period, and several cycles are in operation at any given time. The decision-making process does not simply proceed from preparation and submission to approval, execution, and finally audit. Decision making is complicated by the existence of several budget cycles for which information is imperfect and incomplete.
Overlapping Cycles
A pattern of overlapping cycles can be seen in Figure 4–2, which shows the sequencing of five budget cycles typical of a large state with an annual budget process. Only cycle 3 in the diagram displays the complete period covering 39 months. The preparation and submis- sion phase requires at least nine months, approval six months, execution 12 months, and audit 12 months. The same general pattern is found at the federal level, except that the execution phase begins on October 1, giving Congress approximately eight months to con- sider the budget. As indicated by the diagram, three or four budget periods are likely to be in progress at any point in time.
Budget preparation is complicated by this scrambling or intermingling of cycles. In the first place, preparation begins perhaps 15 months before the budget is to go into effect. Moreover, much of the preparation phase is completed without knowledge of the legisla- ture’s actions in the preceding budget period.

Federal Experience
At the federal level, this problem has proved especially thorny. Congress historically has been slow to pass appropriation bills, and the approval phase was rarely completed by the start of the fiscal year when it began July 1. The usual procedure was to pass a continuation bill permitting agencies to spend at the rate of the previous year’s budget while Congress continued to deliberate on the new year’s budget. Although the budget calendar adopted in the 1970s gave Congress an additional three months, which was expected to permit completion of the approval phase, agencies’ preparation problems for the following year’s budget request persisted. In any given year, an agency begins to prepare its budget request during the spring and summer, even as Congress deliberates on the agency’s upcoming budget. Despite the additional time granted to Congress to act on the budget, work on the budget was completed on time in only three out of 36 years from the time the new bud- get calendar went into effect through 2010.16 This obviously compounds the problem of scrambled budget cycles.
Links Between Budget Phases
While a budget is being prepared, another one is being executed. The budget being exe- cuted may be for the immediately preceding budget year, but it can also be for the one before. As can be seen in Figure 4–2, in the early stages of preparation for cycle 4 the execu- tion phase is in operation for cycle 2. Under such conditions, the executive branch may not know the effects of ongoing programs but is nevertheless required to begin a new budget, recommending changes upward or downward. Sometimes a new program may be created, and an agency must then recommend changes in the program for inclusion in the next budget without any opportunity for assessing its merits.
Length of Preparation Phase
The cycle, particularly the preparation phase, may be even longer than indicated above, especially when agencies must rely upon other agencies or subunits for information. For example, in preparing the education component of a state budget, a department of educa- tion will require budget information and requests from state universities and colleges early to meet deadlines imposed by the governor’s budget office. The reliability and validity of data undoubtedly decrease as the lead time increases. Therefore, the earlier these schools submit their budget requests to the state capital, the less likely it is that such requests will be based on accurate assessments of future requirements.
Other Considerations
Besides the factors already mentioned, other issues further complicate budget cycles— most notably, intergovernmental considerations and the timing of budget years.
Intergovernmental Factors
Another problem arises from intermingled budget cycles because the three main levels of government are interdependent. For the federal government, the main problem is assess- ing needs and finding resources to meet these needs. A state government must assess its
needs and those of local governments and must then search for funds by raising state taxes, providing for new forms of taxation by local governments, or obtaining federal revenues. In preparing budgets, governors take into account whatever information is available on the likelihood of certain actions by the president and Congress. For instance, the president may have recommended a major increase in educational programs that would significantly increase funds flowing to the states, but considerable doubt will exist as to whether Con- gress will accept the recommendation. In such a case, how should a governor shape the education portion of the state budget? The problem is even worse at the local level, which is dependent on both the state and federal governments for funds.

Budget Years
Budget cycles are further complicated by a lack of uniformity in the budget period. Although most state governments have budget years beginning July 1, four states do not: New York’s begins April 1; Texas’s begins September 1; and Alabama’s and Michigan’s begin the same day as the federal fiscal year—October 1.17 Consistency does not even exist within each state. It is common for a state to begin its fiscal year on July 1 but to have to deal with local governments operating with different start dates, such as January 1, April 1, or September 1.
A case can be made for staggering the budget year for different levels of government. This practice might assist decision makers at one level by providing information about action taken at other levels. For example, the federal government might complete action on its budget by October 1. States could then begin a budget year on the following April 1 and local governments on July 1. Under such an arrangement, states could base their bud- getary decisions on knowledge of available financial support from Washington. Local gov- ernments, in turn, would know the aid available from both Washington and their respective state capitals.
Rearranging the dates for fiscal years is no panacea, however. Information about finan- cial support from other governments is only one of many items used in decision making. Also, any slippage by the legislature in completing its appropriations work by the time a fiscal year begins would void the advantages of staggered budget cycles. In addition, there is no direct translation from appropriations to aid to other governments. Money does not automatically flow to states and communities as soon as Congress passes an appropriation bill. Instead, state and local governments must apply for assistance, a process that typically requires many months.
Annual and Biennial Budgets
Not only is there inconsistency in the date on which budget years begin, but the length of the budget period also varies. Whereas the federal government and most local govern- ments operate under annual budgets, as noted above, 23 states have biennial (two-year) budgets. Such a system violates the once-standard principle of annuality.18 The argument is that annual budgets allow for careful and frequent supervision of the executive by the legislature and that this approach serves to promote greater responsibility in government. The problem with the annual budget, however, is that little breathing time is available. Both the executive and legislative branches are continuously in the throes of budgeting. The biennial approach, on the other hand, relieves participants of many routine budget matters and may allow greater time for more thorough analysis of government activities.

Chapter 5

PrinciPles of TaxaTion
A chief concern that public officials have for any tax is the extent to which that tax will generate adequate revenue to fund the services provided by the government. The major revenue sources used by governments—income taxes, property taxes, and sales taxes—are used in large part because the number and value of taxable events or the value of the base are so large and therefore have the potential to generate so much income. There are other reasons, aside from the adequacy of revenue, however, to choose one particular revenue
source over another. These can include the equity (or fairness) of the revenue source, the extent to which the revenue source distorts economic choices, the cost of administering the tax, and the political feasibility of particular revenue sources. Few, if any, governments rely on a single source of revenue, and therefore, issues arise over how much any one source should contribute to the total budget of a government.

adequacy of revenue
Not all revenue sources have the same potential for growth. In general, as an individual’s wealth or income goes up, he or she tends to demand more from government. For this rea- son, governments normally seek to avoid sources of revenue that do not have the potential to grow as fast as income or wealth. In addition, as noted above, some sources of revenue can produce large amounts of income for the government at relatively low rates, because of the sheer size of the tax base. To illustrate these points, consider the federal income tax and taxes on cigarettes. The federal income tax runs off a large tax base, and because of its progressive rate structure, higher levels of income are taxed at higher rates. A tax on cigarettes, on the other hand, runs off a relatively smaller base (sales of cigarettes), and demand for cigarettes does not tend to grow with income. For this reason, the progressive income tax is a much more productive revenue source than the cigarette tax. Taxes on cigarette sales, however, do not generate nearly as much controversy among a majority of voters and therefore may be more attractive to lawmakers.
In addition to the sheer size of the base, it is important for tax policymakers to take into account the potential of the tax base to respond to changes in tax rates. For many taxes, as tax rates increase, they discourage engaging in the taxed activity. Thus, a higher sales tax increases the price of goods (thus decreasing the amount of goods sold), and high marginal income tax rates may encourage some individuals to choose “leisure” over work, at least at the margin. One study of a range of taxes in North Carolina confirmed the existence of this relationship between tax rates and the tax base.1 Conversely, where demand for a given good is “inelastic” (that is, where demand does not respond to price), an increase in the tax rate is much less likely to discourage consumption. This tends to be true, for example, of the cigarette tax, since many people are addicted to the good in question. However, there is evidence that higher prices do discourage consumption among some smokers, including young adults age 18 to 24.2 The important implication for the adequacy of revenue is that behavioral responses to taxes must be factored in when doing revenue estimates, lest these estimates overstate the amount of revenue that will be generated for a given tax rate.
equity
As important a question of how much money is going to be raised from a tax is the question of who will pay that tax. In fact, the question of “who pays” is often the central question of taxation. Consider the debate about whether or not to extend the Bush tax cuts enacted in 2001 and 2003, and for whom. Republicans have generally argued that all of the tax cuts should be extended. Democrats, on the other hand, have taken the position that only those households whose incomes are less than $250,000 per year should continue to enjoy these
tax cuts. The result of the Democratic-supported policy would be a significant tax increase for upper-income taxpayers and an income tax system where a higher proportion of taxes are paid by these wealthier taxpayers. President Obama and the Congress agreed to extend the tax cuts for everyone for 2011 and 2012, or beyond the point of the 2012 presidential election.3
There are two general principles of tax equity. The first is the ability to pay principle, which says that the taxpaying capacity of different taxpayers should be taken into account in designing the tax system. The second is the benefit principle, which says there should be some relationship between the benefits received by the taxpayer and taxes paid.

Ability to Pay
Different taxpayers have different levels of income and wealth and, therefore, may have different capacities to bear the cost of financing government.4 One sense of equity relates to the “ability to pay” principle. A tax should be related to the taxpayer’s income or wealth or, more generally, to the taxpayer’s ability to pay the tax. A taxpayer who can afford to pay more should pay more. Some consider that equitable. This principle implies that a tax imposes the same loss of utility for each taxpayer or, as economists refer to it, the equal absolute sacrifice.5 Equity has both horizontal and vertical dimensions.
Horizontal Equity
Horizontal equity refers to charging the same amount to different taxpayers whose ability to pay (usually measured by income levels) is the same. If two taxpayers living in the same jurisdiction are the same on relevant dimensions, and they pay different levels of tax, that tax would violate the principle of horizontal equity. That can occur, for example, because the way a tax is administered may erroneously identify two taxpayers as being the same, when in fact they are different. This can be a particular problem for the property tax, because the level of tax paid is usually a direct function of assessed values of property. If two parcels are erroneously valued the same, when in fact one could sell for more on the market, then these two taxpayers are being treated as if they are the same, when they in fact may be quite different. It is important to note that whether two taxpayers are “the same” is frequently in the eye of the beholder. If two taxpayers have the same level of income, for example, but one is supporting a family of five on that income while the other is a single taxpayer with no dependents, simply differentiating tax paid on the basis of income fails to account for real differences in ability to pay. In this case, a tax that appears to be horizon- tally equitable may not be at all.
Vertical Equity
While there is nearly universal agreement that horizontal equity should be adhered to, vertical equity is a somewhat harder principle on which to obtain consensus. Put sim- ply, vertical equity has to do with “treating different taxpayers differently.” Normally, this implies knowledge of how a given tax affects different people, or income groups, in the society. Vertical equity is normally measured by computing the effective tax rate, which is computed by dividing the tax paid by a given individual by some measure of wealth or
income. The computation of the effective tax rate can yield conclusions that a given tax,
or tax system, is:
• Progressive, if effective tax rates are higher for higher-income taxpayers than for lower-income taxpayers;
• Proportional, if effective tax rates are essentially the same across different income categories; or
• Regressive, if lower-income taxpayers experience higher effective tax rates than higher-income taxpayers.

Knowing whether a tax is progressive, proportional, or regressive involves knowing more than just the tax rate. For example, a sales tax on purchases seems to treat all taxpayers equally but is often actually regressive in that poorer families may spend a greater propor- tion of their incomes on taxed items than wealthier families do.
Most people would argue for tax systems that are either proportional or progressive. But even if there is general agreement that a tax system should be progressive (as is gen- erally true for the federal income tax), this does not mean that there is agreement con- cerning how progressive the tax should be. Since debates about progressivity are actually debates about the portion of the tax burden to be borne by different taxpaying groups, they are important and can create substantial controversy. In addition to the direct tax bur- den borne by different taxpayers, some Republicans in Congress have wanted to make the income tax less progressive, arguing that many upper-income taxpayers are “job creators” and that lower tax rates therefore have a positive effect on employment.6
Overall, the entire U.S. system of revenue, at the national level, is progressive, but that masks some variation by revenue source. While the federal income tax is quite progressive, the payroll tax (for Social Security and Medicare) is actually regressive, because there is an income ceiling above which Social Security taxes are not paid. In 2011, taypayers and employers were assessed the payroll tax only on the first $106,800 of payroll income.7 The revenue system cannot be judged independently of certain government expenditure pro- grams. Transfer payments, such as various forms of aid to poor families, are somewhat like “negative” taxes in their effect and increase the progressivity of the tax and transfer system considered together.
A Congressional Budget Office (CBO) study of the incidence of federal taxes—individual income, social insurance, corporate income, and excise taxes—found that, in 2007, the highest quintile (the one-fifth of households earning the most incomes) experienced an overall effective tax rate of 25.1% for all federal taxes. This compared to 17.4% in the next highest quintile, and only 4.0% for the lowest quintile. While the individual and corporate income taxes are even more progressive than the overall system, both excise taxes and social insurance taxes tend to be more regressive. Another measure of the level of progres- sivity of the federal individual income tax is illustrated by the fact that households in the top quintile (one fifth of all taxpaying households) paid 86% of all income taxes in 2007. This was the main reason that these same taxpayers paid two-thirds (69%) of all federal taxes in the same year. The top 1% of households, by income, targeted by the “Occupy” protests in 2011, pay 28% of all federal taxes and 40% of all individual income taxes.8

Benefit Received
Another concept to keep in mind is that of benefit received. Some revenue is derived from payments by recipients for services rendered or benefits received. User charges or fees are notable examples—for example, municipal parking garage fees, bus fares, and water and sewer charges. People who park in the garage pay for that service. The principle of payment for services results in an efficient allocation of public sector resources, because people will use only the amount of a particular service for which they are willing to pay. This process is similar to the way in which the private market works. That is, the private market produces no more of those goods than people are willing to purchase.
However, if all government services were paid for by fees, some people would be unable to pay and necessarily would be excluded. Elementary and secondary education, for exam- ple, is the most expensive local government service. If government provided this service entirely by charging parents and students the cost of providing education, many parents would be unable to send their children to school. This situation would lead to segments of the society being uneducated and unable to secure employment that required the ability to read, write, and the like. Because of the spillover effects (the fact that lack of education would adversely affect others in the society), many government services cannot be appropriately supported solely through user fees.
In addition, the public supports education for equity reasons. Everyone should have access to at least some level of education regardless of their ability to pay for it. Simi- larly, public goods have positive externalities—that is, they benefit all citizens regardless of whether one actually uses the service. Education, for example, benefits the entire commu- nity by making it more attractive to businesses making location decisions, and it benefits the entire economy by increasing the productivity of the workforce. The benefit received principle simply cannot be applied uniformly to all government services.
Moreover, particular taxes may be structured to permit the overall tax system to bet- ter adhere to the benefit principle. For example, the State of Florida has a sales tax but no income tax. This permits substantial taxation of visitors to the state to obtain revenue from individuals who are causing state services to be provided, but might other- wise not pay the cost of any of these services. Tourists would not pay income taxes were the state to have one, yet tourists impose burdens on government services. Therefore, sales taxes help to make tourists pay for the costs they impose. Of course, tourists not only generate costs, but also generate jobs and income for Florida. If the state were to impose what was perceived as an onerous sales tax rate, that might drive tourists away to other states.
The problem of nonresident service provisions is also the justification for nonresi- dent income taxes (so-called commuter taxes) in many metropolitan areas, which tax income earned in a jurisdiction, even by nonresidents, as a means of exacting payment from them for services provided. Some major metropolitan areas with a significant population of suburban commuters impose commuter taxes. An important exception is Washington, D.C., which has been prohibited by Congress from levying such a tax and is prohibited by the federal courts from imposing such a tax without the approval of Congress.9

economic efficiency
According to the related concept of efficiency, an efficient tax is one that does not appre- ciably affect the allocation of resources in the private sector, such as between consumption and saving or among competing items for consumption. Taxes on alcohol, for example, seem to have no appreciable effect on consumption of alcoholic beverages. However, taxes can be used for regulatory purposes, as opposed to purely efficient revenue-raising pur- poses. Increased taxes on tobacco obviously increase the price of cigarettes, and studies have found that higher prices do discourage consumption among some smokers, including young adults age 18 to 24.10 Other tax provisions that exclude some items from taxation, such as selected tax deferrals on personal income saved for retirement, are designed to influence behavior and may not be neutral or simply efficient.
Tax systems that are progressive can be inefficient and have unintentional conse- quences. If tax rates are particularly high for wealthy persons, for instance, then the system may encourage them to spend more time on leisure and less on working and earning more income. In many European countries, that effect—encouraging people to spend more time on leisure and less on purely income-earning activities—might be perceived as a posi- tive outcome of the tax.
Tax system design generally tries to consider both equity and efficiency objectives. Use of taxes to regulate behavior, as in increased tobacco taxes, is generally not considered in the overall design of a tax system, but rather is typically legislated separately. Extensive research has focused on how to consider both principles simultaneously while developing optimal tax structures that are designed to achieve an optimal balance between efficiency and equity objectives.11
cost of administration
Generally, taxes that are expensive to administer should be avoided. Money spent to col- lect taxes represents a net loss to society, and therefore, the less spent on tax administra- tion, the better. There are a number of specific costs associated with tax collection. Some costs are to the government, some to the taxpayer, and some to an intermediary, such as the shopkeeper who collects the sales tax. The individual income tax, for example, may be relatively cheap for the government to administer (given the level of revenue produced), but it can be quite costly for individuals to comply with all of the specific requirements of reporting income and calculating taxes owed. These high compliance costs occur primarily because of the complexity of the tax system. But this complexity, in part, represents the cost of attempting to promote equity. Most of the allowable deductions and credits for the fed- eral income tax, for example, stem from attempts to adjust the tax to allow for individual taxpayer conditions.
On the other hand, there are taxes where the cost of compliance is relatively low, but the cost of initial collection by the government is high. Consider the case of the local property tax. Because the government is obliged to place a value on properties, it needs to expend substantial resources to identify the amount of taxes required to be paid and to collect those taxes in the first instance.
In addition to the cost of initial collection, there is the separate cost to the government of enforcement. Enforcement tends to be more difficult and costly in cases where the laws and rules surrounding the revenue source are complex, and where the responsibility for initial collection (for determining the amount of tax to be paid) lies with the taxpayer. Thus, the income tax is relatively costly to enforce, while the property tax is much less costly. In the latter case, there is much less room for interpretation by the taxpayer—the amount is not normally in dispute. (See the chapter on budget execution, which includes a section on tax administration that goes into greater detail on particular techniques and issues.)

Political feasibility
Even taxes that score well on adequacy, equity, efficiency, and ease of administration still may fall short if they cannot be raised in the current political environment. States with- out an income tax will probably find it almost impossible to enact one, despite whatever other appeals such a tax may have. Tobacco-growing states probably will find it difficult to raise cigarette taxes, while such taxes may be relatively appealing in states that do not grow tobacco. In fact, it is not surprising that there is wide variation in the per-pack tax rates in different states. For example, Virginia and Kentucky, which are major tobacco-growing states, taxed cigarettes at 30 cents per pack in 2010. In contrast, Rhode Island taxed them at $2.46 per pack.12
income, Payroll, and ProPerTy Taxes
Many of the major revenue sources used by governments are based on income or wealth— property values being the primary wealth that is taxed in the United States to generate rev- enue. These bases are partially desirable because they are large; a relatively large amount of revenue can be raised at relatively low rates. They are also used because it is easy to adjust the tax to individual taxpayer conditions; that is, those taxpayers with relatively higher incomes have a relatively greater ability to pay taxes. Similarly, taxpayers with a great deal of property wealth may be viewed as having an extraordinary ability to pay, though that is not necessarily true for the elderly, who may have a valuable residence but after retire- ment have much less income with which to pay the tax. The major revenue sources in this category are the personal income tax, the corporate income tax, the payroll tax (primarily used for Social Security and Medicare), and the property tax.
The Personal income Tax
The income tax is a relatively recent, but important, addition to the revenue sources used by governments. Until the passage of the 16th Amendment to the Constitution, ratified in 1913, the taxation of income was not permitted in the United States.13 Since that time, the income tax has become the most important revenue source for the federal government, in addition to being an important source for many state and local governments. By tradition and for convenience, state and local income taxes tend to operate in a way that is similar to
he federal income tax, albeit with very different rate structures. This section describes the structure of the federal income tax system, and then discusses briefly the particular charac- teristics of state and local personal income tax systems. Income taxes, in general, have the following structure:
1. The computation of income (in the case of the federal income tax, adjusted gross in- come, or AGI), which is the initial calculation of the tax base.
2. Reductions to adjusted gross income because of individual taxpayer characteristics. These take the form of deductions (standard or itemized) or exemptions (for the taxpayer and dependents).
3. The application of tax rates (graduated in the case of the federal income tax) to taxable income, which is the result of AGI minus deductions and exemptions.
4. Reductions in the tax paid as a result of tax credits, which are dollar-for-dollar reduc- tions in taxes paid.

Computing Adjusted Gross Income
Not all income is taxed. In the case of the federal government, decisions have been made about precisely which types of income should be subject to taxation and which should not. Econo- mists have historically embraced a very broad definition of income, called the Haig-Simons defi- nition, which defines income as any increase in an individual’s potential ability to consume.14 This includes some of the income used in the federal definition, including salaries, wages, commissions and tips, dividends, interest, rents, alimony, and unemployment compensation. Excluded from the federal definition, however, are most employee benefits (such as employer- provided health insurance and contributions to pension funds), disability retirement, workers’ compensation, food stamps, and interest earned on some state and local bonds.
This arguably advantages people who have more of the excluded income. For example, two individuals whose adjusted gross income is the same may in fact be not equally well off, if one of them is being provided a subsidy by his employer for health insurance and retire- ment benefits (not counted in adjusted gross income, and therefore not taxed), while the other is not. For this reason, the more sources of income included in the tax base, the more equitable the income tax. When the base excludes sizable segments of income, vigorous debates immediately arise over whether some interests are receiving undue favoritism as a result of legislative lobbying.15
Tax codes also provide for adjustments to gross income that typically have the effect of removing portions of income from the base. For example, the federal tax code excludes expenses for moving to accept a new job, some job-related educational expenses, and some employer-paid business reimbursements. The result of the components of income that are included (above), less these adjustments, becomes the base from which exemptions and deductions are subtracted, or adjusted gross income.
Exemptions and Deductions
Individual exemptions and deductions may further reduce the individual income tax base. Exemptions are reductions to the tax base that literally result from one’s existence. If you

file income taxes, you can claim yourself as an exemption. Moreover, the more dependents that a taxpayer claims on his or her return, the more exemptions, and therefore the greater the dollar amount from exemptions. In 2011, the federal exemption was $3,700 for most taxpayers. This means that a married couple filing jointly could claim $7,400 in exemp- tions. If they had three children, that rose to $18,500. There is one caveat to this. As a result of changes to income tax laws in 1993, the personal exemption was, until 2009, reduced for higher-income taxpayers (those who are married filing jointly with incomes greater than $250,200 in 2009, for example) and were eventually phased out entirely. This phase-out is not in effect for 2010, 2011, and 2012, but it is scheduled to resurface, under current law, in 2013.16
More important than exemptions for many people are deductions. Each taxpayer is per- mitted to claim a standard deduction without providing any documentation. This standard deduction varies according to the filing status of the taxpayer. In 2011, the standard deduc- tion was $5,800 for a single person, and $11,600 for married people filing jointly (regard- less of the number of dependents).
Itemized deductions are much more complicated. These deductions literally attempt to adjust taxable income to reflect differences in individual taxpayer conditions. As such, they can vary widely from one taxpayer to another, but they also require that the taxpayer main- tain supporting evidence for the deduction. Taxpayers itemize their deductions when their totals are greater than the standard deductions. The main itemized deductions include:
• Home mortgage interest —the interest paid on borrowed funds for a taxpayer’s first two properties can be deducted from income. This represents an important subsidy for homeowners and establishes a significant incentive for home ownership. It decreases the progressivity of the federal income tax system, however, since more tax benefits are provided to higher-income individuals, a higher proportion of whom are home- owners.17
• Unreimbursed health expenses —health care expenses, to the extent that they are not reimbursed, may be deducted from income. An important caveat, however, is that only those unreimbursed expenses that exceed 7.5% of adjusted gross income can be deducted. This means that a taxpayer with an AGI of $100,000, and unreimbursed medical expenses of $8,000, could deduct only $500 from his or her taxes.
• State and local taxes —many taxes paid to state and local governments are exempt from federal taxation. This includes all state and local income and property taxes, and many vehicle licensing and registration fees. Since 2004, it has also included sales taxes paid (an earlier sales tax deduction had been repealed in 1986), but taxpayers are not permitted to deduct both income taxes and sales taxes. Historically, the real property tax and state income taxes have been the taxes most frequently claimed as deductions from federal taxes.18
• Charitable contributions —payments made by cash or check to recognized nonprofit organizations are deductible. In addition, items donated to such institutions may also be deducted (provided there is evidence of both the donation and its value), as well as miles driven on behalf of a charity.19
• Business expenses —particularly for self-employed individuals, a wide variety of business expenses can be deducted. These include the cost of providing for retirement and
health benefits, and even a portion of home mortgage costs provided the taxpayer uses the deducted portion of his home solely for business. Even non-self-employed individuals can deduct a variety of expenses, especially related to unreimbursed job costs and certain entertainment expenses. The Internal Revenue Service, however, has been relatively vigilant concerning unwarranted business expense deductions.
These exclusions, inclusions, adjustments, and deductions to the income base are intended to yield income figures for individuals and families that further horizontal and vertical tax equity. These factors together are meant to recognize variations in total income and the circumstances involved in earning that income and meeting living expenses. Indi- viduals earning the same income but having different numbers of family members and expenses will be treated differently, while others with unequal gross incomes ultimately may have the same ability to pay when adjustments and deductions are taken into account.

Rate Structure
The vertical equity of the tax system at the federal level is also affected by the use of a pro- gressive rate structure. Tax law changes since 2001 have altered tax brackets, reducing the amount of taxes that almost all taxpayers are liable to pay. In 2011, the federal income tax had six tax brackets, which varied from 10% (for the first $17,000 in taxable income for a married couple) to 35% (for taxable income in excess of $379,150 for married taxpayers). It is important to note that the nature of the income tax is such that different portions of income are taxed at different rates. Therefore, even someone with taxable income of $1,000,000 will see the first $17,000 of that income taxed at only 10%. This taxpayer would experience each of the tax brackets for various portions of income. exhibit 5–1 shows a tax calculation for a hypothetical taxpayer, demonstrating the sequence of taxation, from the calculation of AGI, to taxable income, to tax paid.
exhibit 5–1 Example of Computation of the Federal Income Tax in 2011
John and Bernadette Public are a married couple who file their taxes jointly. They have two dependent children. Their adjusted gross income, consisting of $150,000 in sala- ries and $20,000 in interest, was $170,000 in 2011. They claim a $1,600 tax credit for the care of their dependent children. They itemize deductions, and have three such deductions in 2011: $15,000 in home mortgage interest, $2,000 in state and local taxes, and $1,000 in charitable contributions. The calculation below shows how they compute their federal income tax liability for 2011. The personal exemption (claimed for each of them plus their dependents) is $3,700.
In calculating the Publics’ taxes, we first compute their taxable income. Next, we re- duce the taxable income by the sum of their itemized deductions (they have chosen to itemize because their itemized deductions exceed the standard deduction) and person- al exemptions, to arrive at taxable income. Tax liability is then computed by applying the tax rates from the tax table below to their taxable income (recall that in doing this, different portions of their income are taxed at different rates). Finally, the tax liability is reduced by the tax credit in order to arrive at the total tax paid.

step 1: adjusted Gross income
Salaries—$150,000 Interest—$20,000 Total AGI—$170,000
step 2: Taxable income
Adjusted gross income—$170,000 Less: Itemized deductions—$18,000 Less: Personal exemptions—$14,800 Total Taxable Income—$137,200
step 3: Tax liability
Total taxable income—$137,200 Calculating tax paid for different components of income: $17,000*.10=$1,700 $52,000*.15=$7,800 $68,200*.25=$17,050 Total Tax Liability—$26,550
step 4: Total Tax Paid
Tax liability—$26,550 Less: Tax credit—$1,600
Total Tax Paid—$24,950
2011 Tax Table: Married Filing Jointly
if taxable income is over
$0 $17,000 $69,000 $139,350 $212,300 $379,150
But not over
$17,000
$69,000 $139,350 $212,300 $379,150
No limit
marginal tax rate is
10% 15% 25% 28% 33% 35%
Some have proposed a flat rate income tax, or alternatively a national sales tax, to replace the existing federal income tax system. Either of these taxes would likely impose relatively high rates in order to replace the revenue from the existing income tax. In addition, both would be less progressive than the current federal system, although recent research sug- gests that taxpayers who support such a change do not believe the current system is as progressive as it is, and do not believe that a “reformed” system would be as regressive as it would be.20 The original “9–9–9” proposal from Republican Presidential hopeful Herman Cain in 2011 would have imposed a flat individual income tax rate of 9%, coupled with a national sales tax of 9%, and a corporate income tax rate of 9%.21
In 2010, chairs of the President’s Commission on Fiscal Responsibility, otherwise known as the Bowles-Simpson Commission, recommended as part of their deficit reduction proposals
the elimination of a number of exemptions and deductions. At the same time, they pro- posed reducing individual income tax rates. Since the package was designed to reduce the federal budget deficit, and to slow the growth in federal debt, the loss of revenue from reductions in rates was more than offset by the added revenue that would come from the elimination of these tax breaks. Among the tax preferences targeted by the Bowles-Simpson Commission were some of the largest and most popular, including the provision of retire- ment and other benefits by employers and the home mortgage interest deduction.22

Tax Credits
Unlike tax deductions, tax credits are dollar-for-dollar reductions in taxes that are applied after all the preceding steps have been completed. Perhaps the largest tax credit is the earned income tax credit (EITC), established in 1975. This is a tax credit for the “working poor” and can behave like a negative income tax, in that individuals can receive a credit in excess of the tax that they are required to pay. In this case, they receive a check from the government for the amount by which the credit exceeds their liability.23 Research shows that the EITC is heavily used by low-income individuals because it has been around so long, and because it is effectively targeted to low-income individuals.24 Other tax credits are pro- vided for children (provided that the taxpayer’s income is less than $110,000 for married taxpayers filing jointly) and for child and dependent care expenses (for example, having a caregiver come into your home to care for a child or an aging relative).
The Alternative Minimum Tax
The alternative minimum tax (AMT) is a feature of the federal income tax system. First introduced in 1969, its intent is to collect taxes from wealthy individuals who might be able to shelter that income from the regular income tax system.25 The AMT is literally a shadow income tax system. Taxpayers are required to calculate their taxes in two ways— under the regular tax system and the AMT—and are required, in effect, to pay the higher amount.
The AMT has become more controversial in recent years because it applies to more and more taxpayers. CBO estimates that 4 million people paid the AMT in 2009. The AMT has expanded its reach for two reasons. First, unlike many of the features of the regular tax system, the parameters of the AMT are not indexed for inflation. Second, because many people are experiencing reduction in taxes under the regular tax system due to the recent tax cuts, they are pushed onto the AMT.26 Because more people have been affected by the AMT over time, there has been substantial pressure to reform or eliminate the AMT. This is particularly true because more and more taxpayers who do not consider themselves wealthy are nonetheless paying the AMT. For example, until 2000 there was never any year in which the AMT affected more than 1% of taxpayers.27 The vast majority of those taxpay- ers had very high levels of income. CBO estimated that, without changes to the law by 2010, 84% of taxpayers with incomes between $100,000 and $200,000 would have paid the AMT. Eliminating the AMT, however, would be costly. CBO estimated that abolishing the AMT would result in $620 billion in lost revenue from fiscal year 2010 to fiscal year 2019, repre- senting a loss of roughly 4% in individual income tax receipts over that period. Over the

past several years, the government has passed legislation to “patch” the AMT by adjusting rate brackets, exemptions, deductions, and credits, thus limiting its effect on additional taxpayers.

State and Local Income Taxes
Most personal income taxes levied by the states and local governments are modeled on the federal tax. The states sometimes use the federal base or a modification of it. Some state income taxes, such as Colorado, Illinois, Indiana, and Pennsylvania, are simply a pro- portion of the federal tax owed. Most states have some kind of graduated rate structure, although the marginal tax rates are uniformly lower than federal marginal rates. Hawaii and Oregon had the highest marginal tax rates (11%) in 2010.29 When the federal govern- ment modifies its tax laws, changes inadvertently occur in state taxes. Local income taxes tend to be simple to calculate and involve flat, rather than progressive, tax rates.
Indexing
The federal government and some states use indexing in various forms to adjust income taxes in accordance with changes in price levels. If tax brackets are not altered and prices subsequently rise, then inflation will produce higher tax revenues because rising incomes will place citizens in higher tax brackets without any real increase in buying power. Besides adjusting tax brackets, other indexing techniques include modifying the standard deduc- tion or personal exemption. A controversial issue is the measure of inflation used to adjust tax brackets (and many other revenue and expenditure elements). The consumer price index historically has been used, but many now feel that it overstates inflation, causing taxes to be lower than they should be and, more importantly, causing federal benefit pro- grams to extend benefits greater than should be, as discussed in the chapter on govern- ment and the economy.
Enforcement
A key income tax issue is enforcement. As noted above, the individual income tax relies heavily on honest self-reporting by taxpayers. Although employers withhold an important proportion of total individual income taxes paid, thereby enforcing tax collection for the Internal Revenue Service (IRS), enforcement remains a problem—and an especially dif- ficult problem when taxpayers think the tax is unfair. Much income is never identified and thus never becomes part of the tax base. A large underground economy operates in which transactions occur in trade, payments in kind, and unrecorded payments in cash never become part of the income tax base. Measuring the size of that invisible economy is naturally difficult, but the World Bank estimated in 2010 that the “informal sector” for Organization of Economic Cooperation and Development (OECD) countries was 16.6% of gross domestic product (GDP).30 According to this same study, for the United States, income equal to an estimated 8.4% of GDP is unrecorded and therefore untaxed. In addi- tion to this unrecorded income, the U.S. income tax relies heavily on self-reporting, which may also contribute to an exaggeration of deductions, which also has the effect of reducing the tax collected.

Tax Expenditures
Revenues that could be, but are not, collected constitute tax expenditures and can aid or hinder attempts to achieve an optimal balance. According to federal law, tax expenditures are “revenue losses … which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”31
Tax expenditures are not new. Home mortgage interest payments (on up to two homes) have been deductible from income since 1910, for example. While tax expenditures may exist for any tax, the individual income tax, at the national and state levels, includes by far the largest number of tax expenditures, primarily because of the significant number of per- mitted deductions from gross income. Numerous exemptions from taxation or deductions from income for corporations have crept into law over the years as well.32
The largest income tax expenditures in the federal budget (with estimates of fiscal year 2012 revenue losses) are the exclusion of employer contributions for medical insurance ($184 billion), the mortgage interest deduction on owner-occupied homes ($99 billion), contributions to 401(k) plans ($67 billion), the step-up basis of capital gains at death ($61 billion), and the exclusion of imputed rental income ($51 billion). Together, these five income tax expenditures were estimated to cost the federal government more than $450 billion in 2012.33
Tax expenditures are not automatically bad. The public policy goal for the home mort- gage interest deduction is to encourage and enable individual family home ownership. Exclu- sion of employer pension and medical insurance contributions is meant to increase savings for pensions and reduce the cost of health care. The housing exemption may help make housing affordable to moderate-income families, but it also benefits more affluent taxpayers and may be of no benefit to low-income families. Is the housing exemption, then, a factor that furthers or detracts from equity? Given the recent wave of foreclosures, there is also some reason to believe that the mortgage interest deduction, along with other policies that reduced the cost of housing, encouraged people who could not afford homes to buy them.
Since the 1970s, tax expenditures have become an important issue in debates over tax reform. These measures reduce the revenue flowing into government treasuries and can represent “loopholes” for the wealthy. Increasingly, policymakers and analysts also recog- nize that these tax expenditures represent an alternative form in which to confer benefits to citizens. That is, if the goal of a program is to encourage affordable housing, there is no difference between sending a potential developer a check for $50,000 or giving the same developer a $50,000 tax break. Benefits conferred on the spending side, however, tend to be much more transparent than those provided through the tax code.
Like the federal government, some state governments routinely report estimates of tax expenditures as a part of their budgets.
corporate income Taxes
Taxes on corporate earnings have been defended as appropriate given the size of corpo- rate economic power and the fact that some individuals might be able to escape taxation by
“hiding” their income in corporations. On the other hand, corporate income taxes seem to result in double taxation. First a corporation is taxed, and then individuals are taxed on dividends paid on their corporate stock holdings. There have been proposals to replace the corporate income tax with a tax on net business receipts to avoid this double taxation, but these proposals have not attracted much interest. Proposals to exclude dividends from individual income taxation also have been unsuccessful.

Tax Base
Corporate taxes use net corporate earnings as a base. Whereas the individual income tax base basically considers income before expenses, except for some deductions and exclu- sions, corporate income taxes apply only to net profit after operating expenses. In addition, some deductions are allowed for capital losses, operating losses, depreciation of capital investments, charitable contributions, and expenditures for research and development. How these deductions are applied is often controversial, such as how rapidly a corporation can depreciate capital investments. The federal corporate tax rates gradually increase from 15% to 35% as net earnings increase.
As a percentage of GDP, receipts from the federal corporate income tax are actually lower than those of every other OECD country with the exception of Turkey.34 Many states have corporate income taxes as well, although the importance of the corporate income tax has declined at the state level in recent years. In 2010, corporate income taxes accounted for approximately 5% of overall state revenues, about one-half of the level of two decades earlier.35
In addition to the overall amount of money collected from the corporate income tax, these taxes can also be compared, across countries, in terms of their overall rate structures. In 2010, including both national and state/local government corporate taxes, the United States corporate tax rates, at 39.2%, were higher than those of any other OECD countries with the exception of Japan, which had a rate of 39.5%. Looking at national government taxation of corporate income, only France (at 34.4%) and Belgium (at 34%) exceeded the top rate in the United States (32.7%).36
Tax Incidence
The primary issue as regards corporate taxation is who actually carries the burden of cor- porate taxes. Corporations may be able to increase prices and, in effect, make consumers pay the tax, or they may limit wage increases to workers and, in effect, have them pay the tax. Another option is to take taxes out of profits, thereby reducing dividends for investors. Corporations probably use some combination of these shifts.
An issue involving state corporate taxes is whether they affect decisions to locate and expand operations in one state over another. Legislators and executives in a state govern- ment fear that any increase in their corporate income taxes will discourage corporations from locating in the state and encourage others to move out of the state. The expectation is that what a state loses in tax revenue, it will gain from companies already there expanding their operations in the state and from companies relocating to the state (see discussion of what is sometimes called smokestack chasing in the intergovernmental chapter).

Payroll Taxes
Insurance trust funds, which are separate accounts set up to hold certain earmarked reve- nues (see the chapter on financial management), are financed by means of charges on sala- ries and wages (the charges are paid by employees, employers, or both). These are typically referred to as payroll taxes, and they are differentiated from income taxes because they are taxes on wages and salaries only, as opposed to more comprehensive taxes on income. These charges are not taxes inasmuch as they do not generate revenue to be used to pay for services; instead, the programs provide benefits to the people who are covered by them. Employers and employees pay into these systems, and people earn benefit credits through contributions made during their working careers. As of 2011, the full rate paid for Social Security taxes was 12.4%, and for Medicare taxes it was 2.9%. Each of these was equally divided between employees and employers. Two other caveats apply for Social Security taxes. First, as of 2011, they were paid on the first $106,800 of payroll income. Second, they were temporarily reduced to 8.4% for 2011 and 2012 as part of an economic stimulus effort. Social insurance receipts rose as a percentage of GDP from 4.5% in 1972 (as low as 3% in the early 1960s) to 0% in 2010.37
Social Security and Supplemental Security Income
Social Security is a trust program of vast proportions. Its complexities far exceed the scope of this text. Here we sketch its overall structure.
Three major programs are administered directly by the Social Security Administration. The first, Old Age and Survivors Insurance, is a benefits program for retired workers and their survivors. The second program, Disability Insurance (DI), provides benefits for cov- ered workers who are disabled and cannot work. In 2010, the Social Security Administra- tion paid out benefits to 52.5 million individuals, including 36.4 million retired workers, 9.7 million disabled workers, and 6.4 million spouses, children, or survivors of retired or disabled workers. In fiscal year 2010, benefits paid out for Old Age and Survivors Insur- ance benefits totaled $557.2 billion. Total benefits for DI in the same year totaled $118.3 billion.38
The third major program under Social Security provides monthly benefits to people who are aged, blind, and disabled. This program is known as Supplemental Security Income (SSI).39 SSI funds come from general tax revenues, rather than from employer-employee contributions. Unlike DI, SSI does not require work credits for eligibility but does require that recipients be needy. It is possible to qualify for both programs, although qualifying for DI has the effect of reducing SSI benefits. In 2009, 7.7 million people received $46.6 billion in benefits under the SSI program.40
Legislation passed in 1983 greatly modified the financing of Old Age and Survivors Insur- ance to improve the solvency for the long term. Estimates then were that the trust fund would be insolvent before 1990 unless corrective actions were taken. While the increases in both the employer and the employee contribution rates and an increase in the amount of annual income subject to the tax will satisfy the fund’s needs for some decades, the consen- sus is that the program will need revising again, and that the longer reform is postponed, the more dramatic will be the changes required.

For some time, various analysts have projecting that the point would come when Social Security benefit outlays would exceed payroll taxes in the trust fund. Taken together, the Social Security trust funds are projected to be in deficit, excluding interest paid to them, in each year beyond 2010, for at least 75 years (without any changes). As a whole, the Social Security trust funds were still in surplus for fiscal year 2010, largely because of interest paid to the trust funds from the balance of the federal government.41 CBO estimates that Social Security will have enough revenues to cover all scheduled benefits until fiscal year 2038, because of the repayment of funds that the trust funds have loaned to the non–Social Security portion of the federal budget. After 2038, however, unless there is an additional infusion of funds into the trust funds, Social Security will be able to pay only 79% of the full amount of current projected benefits.42 Such a change would inevitably create a political crisis of overwhelming magnitude.
Several issues have fueled the debate over Social Security reform, and the motivations for reform among many groups are not necessarily consistent. First is the issue we might label “violation of trust.” This issue is based on a misunderstanding in some circles concerning the nature of the Social Security trust funds. Many citizens assume that the funds they and their employers contribute to the system are being held in trust, invested much like pen- sion funds to yield the benefits that will be paid out to them in the future. Politicians make a similar claim in their criticisms of Social Security. In reality, each year’s payments into the Social Security Trust Fund are used to pay claims to beneficiaries in that year. Historically, at least for the past 25 years, the payments into the fund have exceeded payments to ben- eficiaries out of the fund. Those excess payments created a surplus in the fund, and that surplus in turn has been lent to the U.S. Treasury at the equivalent of the 30-year Treasury bond to finance part of other federal spending. The alternative to the Treasury borrowing from the Social Security fund is to force the Treasury to borrow from the U.S. and overseas capital markets. Under such a scheme, the surplus Social Security funds would need to be invested rather than sit idle—perhaps in the stock market (discussed below).
Thus, one motivation for reform is the political point of view that the fund should behave as a revolving fund, with proceeds paid into the fund being invested, as in most pension funds. That view somewhat naively assumes that private pension funds pay out benefits commensurate with the results of investment of funds paid in. That statement is true of defined contribution plans (retirement plans where individuals pay a set amount into a retirement plan, but are not guaranteed a specific return), but defined benefit plans pay out specific levels of benefits regardless of whether the fund investments are sufficient to meet those benefit payouts. Just as an employer with a defined benefits pension fund is obligated to meet the benefit payouts defined in the plan, from business net profits if necessary, so the federal government is obligated to meet whatever Congress determines will be the benefit structure, first from the trust fund itself and then from other federal rev- enues as necessary. Unless Congress fails to appropriate funds to meet legislated benefits (if and when the surplus in the fund turns into a deficit) or passes legislation so as to lower benefits, then the trust fund issue really is not an issue. Instead, it is a convenient political football for both parties to kick around.
A second motivation for reform is closely linked to the debates on the federal budget surplus or deficit. Because the fund shows a surplus, and all revenue to the fund counts as
part of the federal government’s revenue total, the size of the federal deficit is lower than if Social Security figures were excluded. The more fiscally conservative believe that the prac- tice of using the trust fund surplus to finance part of other spending is inappropriate. Such a practice, according to this argument, represents a nontransparent imposition of taxes, as tax payments that were advertised as supporting Social Security are, at least in the short run, used to finance other government spending.
A third issue discussed by advocates for reform is that the funds being paid into Social Security should be earning more than the implicit 30-year Treasury bond rate. The bull market of the 1990s particularly fueled this aspect of the debate, as stocks earned dramatic returns—two and three times the rate of the 30-year Treasury bond. Proposals have been advanced to invest the funds flowing into the trust fund in the stock market, so as to earn higher benefits for future pensioners. This notion has gotten a lot less traction recently, as the effect of the recession that started in 2007 on the U.S. stock market now gives some pause when it comes to the investment of Social Security assets in riskier equities than U.S. Treasury securities.

Medicare
Medicare, the largest federal health insurance program, is administered by the Centers for Medicare and Medicaid Services (CMS) in the Department of Health and Human Services. Medicare provides basic health insurance to the elderly, with a separately funded catastrophic coverage component, and is funded by payroll tax contributions, pre- miums paid by persons covered under the program, and general revenues. Medicare also covers people on DI once they have been receiving DI benefits for 24 months. These ben- eficiaries are under age 65.
Medicare has become one of the major contributors to rapidly rising federal expendi- tures for health care. Medicare outlays totaled more than almost $520 billion in fiscal year 2010.43 In 2002, Congress and the Bush administration passed the Medicare Moderniza- tion Act, which established, for the first time, a prescription drug benefit for Medicare that took effect in 2006. Estimates of the 10-year cost of this entitlement expansion ranged from $400 billion to $500 billion, although subsequent estimates suggest that this original cost assumption was overstated.44
The combination of the same demographic factors that are driving the Social Security imbalance and the pace of medical care inflation contribute to an even bleaker long-term outlook for Medicare than for Social Security. In fiscal year 2010, the two Medicare trust funds combined had a deficit of $21 billion, consisting of a surplus of $9 billion in the Supplementary Medical Insurance (Part B) fund, which was more than offset by a deficit of $30 billion in the Hospital Insurance (Part A) fund.45 The Patient Protection and Afford- able Care Act (PPACA) of 2010, to the extent that it aims to reduce health care costs in the overall system, is designed to reduce Medicare costs as well, at least in the long run.46 According to estimates by the Congressional Budget Office, while overall health care costs (and Medicare costs) will be reduced somewhat, the reform does not involve a major down- ward shift in health care costs.47
Reform proposals have been especially aimed at reducing the incentives for physi- cians and hospitals to order expensive treatments for Medicare patients and to reduce
the possibilities for fraudulent charges. Holding down reimbursement rates slowed the slide toward a Medicare deficit, and on the agenda for longer-term reform is moving more people into managed care organizations and away from individual physicians. Per- haps the most controversial reform proposal in recent years was the reform suggested by Congressman Paul Ryan (R-WI), as part of the House budget resolution in 2011. The Ryan plan would have created a cap on the amount that the federal government could spend on each beneficiary. Spending over the amount of the cap would be the responsi- bility of the consumer. This proposed change would have fundamentally changed Medi- care and shifted much of the financial risk to beneficiaries. In addition, the House budget resolution advocated increasing the Medicare eligibility age from 65 to 67, beginning in 2022.

Medicaid
The second-largest federal health program, but one that is not funded by the payroll tax, is Medicaid. It is funded by federal and state tax revenues as opposed to payroll taxes. In aggregate, the federal government pays about 57% of the costs of Medicaid, with state and local governments paying the remainder. This federal percentage will increase, as the fed- eral government has committed, as a part of the new health reform law, to pick up 100% of the cost of newly eligible beneficiaries through 2016, and 90% of the cost after that through 2020.49 From 1970 through 2010, total federal Medicaid spending increased from $2.7 billion to almost $273 billion, which represented a sixfold increase in the size of the program as a percentage of GDP (from 0.3% to 1.9%).50 Medicaid provides medical care to the poor and the medically indigent (persons who are not classified as poor but who cannot afford medical care). Medicaid and SSI are not trust programs as defined earlier, because their funds come from general tax revenues and not revenues earmarked for special trust funds. (For a discussion of Medicaid, see the chapter on intergovernmental relations.)
Unemployment Insurance
The second largest insurance trust for state governments is unemployment insurance (UI). This program is administered by the states within a framework imposed by the federal gov- ernment. A floor on benefits is set nationally, with states having the option of exceeding the floor. The program is supported by payroll taxes paid mainly by employers, although in a few states employees are required to make supplementary payments. It is expected to generate sufficient revenues during prosperous periods to cover payments to unemployed workers during recessionary periods. State programs can sometimes run into a deficit situ- ation, such as during a sustained recession or occasionally because of temporary timing differences between payments into the funds and payments out. In such cases, the federal government lends money to the states but expects repayment with interest. Obviously, a state with a declining tax base can face severe problems in financing its unemployment insurance program. In addition, a sustained period of unemployment will deplete state resources and will typically require the federal government to step in and extend unem- ployment benefits beyond the regular UI benefits. In fact, during the recession that started in 2007, state governments had to borrow $42 billion from the federal Treasury just to finance their UI costs.

Workers’ Compensation
Another important insurance trust at the state level is workers’ compensation, which pro- vides cash benefits to persons who, because of job-related injuries and illnesses, are unable to work. Accidents at work may disable people temporarily or permanently. Poor working conditions can cause physical and mental health problems. In addition to cash benefits, the program pays for medical care and rehabilitation services.
Property Taxes
Taxes on wealth are based on accumulated value in some asset rather than on current earnings from the asset. Real and personal property, financial assets, and equipment are important types of wealth that sometimes are subject to taxation. The wealth tax that is most important in the eyes of taxpayers, however, is the real property or real estate tax. The property tax is the one most reviled by taxpayers, largely because it is regarded by many as the most unfair. In fact, in a 2005 Gallup poll more than twice the Americans responding to a survey question (42%) rated the property tax as the “worst” (least fair) tax after the next most hated tax, the federal income tax (20%).52
This tax is the almost exclusive domain of local governments. Despite forecasts of its demise, the property tax remains the largest single own-source generator of revenue for local governments (it is exceeded only by intergovernmental revenue), although it has declined in recent years relative to other state and local taxes.
The property tax funds almost 75% of locally raised school district revenues. In recent years, courts in at least 17 states, however, have overturned their states’ financing systems that relied heavily on local property taxes.53 The argument is that despite state aid to local school districts, almost sole reliance on the property tax to finance education at the local level means unequal education opportunities across the state (see the chapter on inter- governmental relations). The property tax is also the most important source of local own- source revenue for funding urban services in developing countries, although user charges (discussed in the chapter on budgeting for transaction-based revenues) may be a faster growing source of local revenue in the more prosperous emerging market economies.54
The justification for using the property tax as the major revenue source for local govern- ment is that the services provided by local government supposedly increase the economic value of one’s property. It is widely thought that people select their place of residence based on the quality of local schools and other public services. In high-quality service juris- dictions, housing costs are typically higher, reflecting higher costs for delivering services and higher expectations of home buyers for quality services. Property taxes reimburse local government for higher-quality services. The argument goes as follows: If more general taxes, such as the sales tax, were used to finance services that benefit property owners, then property owners would be less aware of the costs of those services and therefore insist on more and higher-quality services. Evidence has been found to support this argument in developing countries, where demand for urban services is much higher in cities that do not use property and other local taxes and charges to finance those services.55
The property tax is also less susceptible to tax avoidance than other broad-based taxes because it is clearly visible and is immobile. People can buy goods in other jurisdictions or
order goods over the Internet and easily avoid paying sales tax. Property taxes, by compari- son, are difficult to avoid. To the extent that they operate as a quasi-price for the public services provided in a given jurisdiction, property taxes are justified on the basis of the ben- efit principle, as described above. One argument is that homeowners understand that the value of local public services substantially affects the value of their homes, and that they are vigilant in their control of local government largely for that reason.56
One way to tie the benefits of services affecting property values to taxes on property is through tax increment financing (see the chapter on capital finance and debt management for discussion of bond issues backed by expected tax incremental increases). Tax incre- ment financing has been used in redevelopment of inner cities to capitalize on the eco- nomic and financial gains that stem from a major rehabilitation project for a contiguous area usually characterized by urban blight and abandoned properties. Prior to city govern- ment action, many property owners in such areas derive no benefits from their properties, and the city is able to collect little or no property tax. A redevelopment project changes conditions so that the property in the redeveloped area attains new value, and the property tax gains from that new value are set aside to pay for financing the redevelopment. Some use also has been made of tax increment financing in rural areas, but it is not as valuable a tool there. Property tax rates are typically much lower in rural areas, land values are more volatile, and investors in bonds to support rural infrastructure tax increment funded proj- ects perceive higher risks.57
The main policy issue with the property tax is its regressive nature. Higher-income tax- payers tend to have a larger proportion of their wealth in assets that are not subject to the property tax. As a consequence, these taxpayers generally pay a disproportionately lower property tax (as a percentage of their income) as compared with middle- and lower- income taxpayers, whose only major asset may be their homes. For middle- and lower- income taxpayers, most of their wealth is being taxed each year. For renters, the regressive effects of the property tax depend on the extent to which the landlord can pass on the property tax through the rent. For all these reasons, the regressive nature of the property tax fuels controversy. In addition, the property tax is relatively complicated to implement and to maintain. Because the local jurisdiction must establish the tax base (the value of each property within the jurisdiction) rather than basing it on some external objective source, updating the tax base for the property tax is always controversial when carried out.

Tax Base
The base of the real property tax is the assessed value of the land and any improvements on it, such as homes, factories, and other structures. The value is what the property would sell for if placed on the market. Value for commercial and industrial property is sometimes reflected in the income earned by a corporation from the property or facility.
Often the assessed value of property may increase beyond the ability of taxpayers to afford the tax bills. One leading example of this would be in cases where there are rapidly rising property values, and longtime residents (who might not be able to afford to buy their houses in the current market) experience ever-increasing tax bills. These residents may be “property rich” but “income poor.” Many states and localities have instituted homestead exemptions to address this sort of problem. Under these exemptions, a set initial amount is
on costs to provide a given level of output.60 The recession that began in 2007 differed from other recent recessions in that there were substantial dislocations in the housing market, which resulted in depressed property tax bases across the entire country.61

Assessment
After registering all properties in the taxing jurisdiction, the first major step to generating revenue from the tax is to assess the value of the properties. Local governments do not, in fact, have a direct way of measuring the actual market value of all properties in their jurisdiction. At any given time, the local government can know directly what recent proper- ties have sold for, but this is only a small fraction of all the properties in the registered base. This creates a substantial challenge, in that they need to establish an assessed value for each property absent real information on the sales price of most properties.
Many governments use the market data approach to assessment. In this method, properties that have not sold are assessed by comparison to similar properties where a market price can be observed. The greatest challenge here is ensuring that properties that are assumed to be comparable are comparable in fact. The probability of doing this can be improved by inspecting individual properties and cataloguing their characteristics, but this is a time- consuming process, particularly if done on an annual basis. Adjustments to property values may be done annually or only once every several years.
While the goal in many jurisdictions is to assess each property at its full market value, in practice many jurisdictions assess parcels at a percentage or fraction of the full market value. The ratio of the assessed value to the market value is known as the assessment ratio. A home whose market value is $120,000 would be assessed at only $24,000 if the assessment ratio were 20%. In practice, it should make no difference whether the full value or a frac- tion of it is used. Fractional assessment simply requires a higher tax rate than market value assessment to produce the same revenue.
Taxpayers may find some psychological solace in fractional assessment, but problems arise in cases where properties within the same jurisdiction are assessed at different frac- tions of their market values. This occurs, for example, if reassessments are done on dif- ferent properties at different times. If some properties are assessed at one percentage of market value and other properties at a different percentage, then the tax burden is no longer proportionate to the value of the property. This is less likely to be an issue where properties are assessed at 100% of market value, particularly because taxpayers are much more likely to know whether their property has been overassessed in this case. Even where the goal is assessing at full market value, fractional assessment may be used to differentiate types of properties. For example, rural property may be assessed at a lower fraction than highly developed property.
Inaccurate and inconsistent assessment practices can cause problems of both horizontal and vertical equity. Horizontal equity problems exist because properties that have the same market value in fact are assessed at different rates, resulting in taxpayers who should be paying the same level of tax paying different levels. Numerous studies have found evidence of horizontal inequity because of lack of data, assessor error, or bias.62 Vertical equity con- cerns exist when properties of different market values are assessed at different percentages of those market values. A study found that, in particular, lower-valued houses were assessed

loser to their full market value than higher-valued houses. This means that less-affluent taxpayers pay a higher percentage of local property taxes than would be the case were all properties valued at the same percentage of full market value.63
For a local government instituting the property tax for the first time, the valuation pro- cess is almost overwhelming. Traditional valuation procedures involve comprehensive tax mapping to locate every property. An assessor must visit each property, measuring the foundation to determine square footage, noting construction details, and recording infor- mation about the condition of the structure.
For most jurisdictions in the United States, properties have been constructed under building permits that require supplying information about construction details to the local jurisdiction. Periodic inspections of the properties when under construction, conducted by local code enforcement officers or building inspectors, provide additional information. A database, then, can be devised using existing building records and information about sales of properties when deeds are transferred. As new structures are built, they can be added to the database.
exhibit 5–2 shows a property tax valuation system in Orange County, North Carolina, that is considered a model for the country. Techniques such as those used in Orange County help to foster a perception of fairness among taxpayers. Property owners conclude that they are paying their fair share and are not being overcharged while other taxpayers are being undercharged. If these equity considerations are met, then the likelihood of a taxpayer revolt is minimized. However, it does not make the property tax popular, as it is likely that it is the most hated tax in the country.
exhibit 5–2 Property Tax Valuation in Orange County, NC
Orange County, North Carolina, has what is considered a model property tax valuation system.
It is fully computerized and includes diverse information about each property in the county. Besides information about the location of each lot, the size of the structure, and the number of baths, a drawing of the lot and the location of the structure on it are included in the computerized file and can be displayed onscreen. Of course, printed maps of properties are available as well.
characteristics of Properties
• Property address • Plot map and reference to deed register • Area of lot (square footage) • Occupancy (single-family dwelling, two-family, multifamily) • Size of dwelling (square footage of living space) • Number of structures • Number of stories of each structure • Basement, slab, or crawl space • Foundation construction method

• Exterior construction method • Roof type and roofing materials • Number of rooms • Number of bathrooms • Number of bedrooms • Year built • Number of fireplaces • Interior finish • Floor type • Built-in appliances • HVAC system • Special features (spas, etc.) • Landscaping • Land topography • Utility connections • Paved or unpaved driveway • Last sale price and date

Tax Rates
Property tax rates are a percentage of assessed value. The rate is expressed in mills, with one mill being one-tenth of 1%. As applied to property taxes, a one-mill rate yields $1 of revenue for every $1,000 of assessed value. A property tax rate of 68.5 mills as applied to a $120,000 property assessed at 20% of market value would yield $1,644 (120 × 0.2 × 68.5 = 1,644).
Local jurisdictions often determine the annual property tax rate by calculating back- ward from projected expenditures minus other revenues. The property tax increase is then expected to make up the budget gap. The community’s decision makers simply determine how many additional mills will be needed to close the gap. Of course, attempts are made to avoid such tax increases by keeping expenditures as low as considered possible. The pro- cess of adjusting the tax rate to match expenditure requirements probably accounts for the great popularity of the property tax among local officials. This tax is one over which offi- cials have considerable control, unlike other taxes that depend on the economy (income and sales taxes) or intergovernmental aid.
Many local governments in areas of rapidly increasing property values have found that they are able to accommodate budgetary increases above the base level at declining prop- erty tax rates. In most of these cases, the rate of assessment increase exceeds the percent- age of rate reduction, thus resulting in a rising tax bill. The key decision for any local government involves how often to reassess properties. With the housing boom of the 1990s and 2000s, substantial incentives existed to reassess properties frequently in order to take advantage of increasing property values and therefore be able to produce increasing levels of revenue at declining property tax rates. This may result from increased demands on the part of citizens for additional services, or from desires by government officials to expand
government.64 As noted above, these trends toward “easy money” from the property tax at declining rates reversed themselves dramatically after 2008. Taxpayers expected govern- ments to downgrade the assessed value of their property, since they knew that in many cases there had been precipitous declines in market values. Even though property values had dropped, however, this did not decrease the need that local governments had for prop- erty tax revenue. This left most local governments in the difficult position of having to raise property tax rates or reduce service levels, or both.

Circuit Breakers
As taxes rise, some property owners may encounter considerable difficulty in paying their tax bills and may even be forced to sell their homes and move into rental housing. To alleviate this problem, several states use circuit breaker systems that set a limit on taxes, par- ticularly for low-income elderly persons. A qualified homeowner pays an amount up to the limit, and the state pays any additional amount owed. Often a state bases the limit on some income criterion: when property taxes exceed a specified percentage of the taxpayer’s income, the state pays the difference.65
Personal Property
Besides taxing real property, some jurisdictions tax personal property. For individuals, such property includes furniture, vehicles, clothing, jewelry, and the like. Intangible personal property includes stocks, bonds, and other financial instruments such as mortgages. For corporations, personal property includes equipment, raw materials, and items in inventory. Taxes on personal property are unpopular and subject to considerable evasion.
Taxing and Spending Limitations
Although citizens seemingly have had little opportunity to affect taxes and spending other than through the process of selecting elected representatives, 1978 changed all that. In that year, California voters approved Proposition 13, an initiative that limited the property tax rate to 1% of market value. That provision by itself would have required a rollback in taxes, but an additional provision further cut taxes. Property assessments were to be returned to their values in 1975, when property was considerably less expensive.
Although tax limitation measures were not new, Proposition 13 began a new era in which government officials were forced to consider taxpayer reaction and to limit taxes and spending.66 Many state and local governments followed California’s lead during the late 1970s and early 1980s by passing statutory limits or, in some cases, adding restrictions to state constitutions. California voters approved Proposition 4 in 1979, which limited both state and local government expenditures. In the following years, restrictive measures were adopted in about half of the states. Massachusetts, which had come to be known as “Taxachusetts,” gained notoriety in 1980 as a result of its passage of Proposition 2 1/2. This measure required that local governments reduce taxes by 15% each year until they equaled 2.5% of market value.67
“By 1990, 21 states had enacted potentially binding limitations and 13 had enacted non- binding limitations on the finances of their local governments.”68 The elections of 1994 and 1996 brought more conservative control to many state legislatures and ushered in a

new round of tax limitation proposals.69 Oregon, Colorado, and Missouri also passed tax or spending limitations in the mid- to late 1990s.
The original stimulus behind what came to be known as the taxpayers’ revolt was the sharp rise in property values and, consequently, tax bills, but a more generally negative attitude emerged—the attitude that government officials have an insatiable appetite for spending. This attitude has been on display once again in recent years, with the rise of the Tea Party movement. This movement has, as one of its core values, the notion that virtually all taxes, at all levels of government, are too high. Besides taxing too much, governments allegedly use the revenues to interfere needlessly in the lives of citizens and the operations of corporations. Property taxes remain one of the most criticized forms of taxation. This is probably because of dissatisfaction with the results school systems are producing, which are funded almost entirely by property taxes.70 The result has been several types of tax and expenditure limitations. One review classified them into five categories:
1. Overall property tax limitation (for example, limit maximum annual percentage increase)
2. Specific property tax limitation (for example, limit use of property tax to finance education)
3. Property tax levy limit (for example, implement ceiling on amount of tax) 4. General revenue or general expenditure increase limit (for example, limit annual
expenditure increase to a specific limit) 5. Property tax assessment increase limit (limit the assessed value increase)71
Most of these limitations focus on the property tax specifically, but the fourth (overall revenue or expenditure limits) is more broadly restrictive and can apply at the state as well as the local level. Taxpayers’ concerns have caused many state and local governments to increase communication with the public on what is accomplished with tax dollars and how taxes are kept to a minimum. Minnesota, for example, enacted a law requiring the construction of an overall index calculating the cost of everything residents pay to the government as a percentage of personal income. Not only are taxes included, but so are all fees, charges, and any other payment to government. The index is kept for different state departments and individual local governments so that citizens throughout the state can compare their own government with others and with limitation guidelines.72
The effects of these limitations has varied, but in most cases local governments made up for the revenue loss through other sources, usually non-general-revenue sources. In some cases, state governments almost immediately made up for the shortfall.73 Overall, spending may have declined in some jurisdictions, but not enough to show up in aggregate figures for individual states. There is some evidence, however, that these limitations are more con- straining on local property taxes in the long run than in the short run.74 The main effects seem to have been sixfold.
First, state legislatures and local governments are much more reluctant to initiate new programs and especially to propose tax increases or new taxes. In the case of new pro- grams, this is presumably because there is more uncertainty surrounding the affordability of these programs in the future. The reluctance to impose tax increases probably relates to
knowledge of the underlying disposition of taxpayers toward these increases in states with tax and expenditure limitations (TELs).
Second, combined with major cutbacks in federal aid to states and localities, as well as state aid to local governments, the limitation movement set these governments on an imaginative hunt for alternative finance measures. The significantly greater use of impact fees, discussed earlier, and other direct charges to those benefiting from services was an outgrowth of the tax revolt.
Third, states provided increased financial assistance to hard-pressed local governments. For example, when Michigan ran into problems with property tax funding for education, the state increased the sales tax and, in turn, used state funds for formerly local educa- tion funds. A more explicit example is Oregon’s experience with Ballot Measure 5, which required the state to replace lost property tax revenue with state aid, thus shifting many of the fiscal effects of the initiatives to the state government.75 Sometimes that state aid has come at a price—namely, various strings attached by states for their aid. One simple example is that Oregon prohibited local governments from giving their employees salary increases greater than those given to state employees.
Fourth, overall expenditures have been cut somewhat and some services have been reduced, either in quality or quantity, as a means of curbing spending.76 Essential services such as law enforcement and fire protection have been maintained, albeit at decreased levels. Budget problems forced cutbacks in maintenance of buildings and purchase of new vehicles and equipment.77 Overall, however, tax and expenditure limitations did not mate- rially change the relative amounts that state and local governments spend on government functions.78 Some evidence indicates that spending cuts have produced long-term quality decline, at least in some services. For example, public school student performance has declined in several states that have imposed expenditure limitations, even after control- ling for a number of other possible influences.79 Moreover, a 2006 study argues that TELs tend to have had a positive increase on economic growth at the state level, while local-level effects on economic growth have been negative, but only in the short run.80
Fifth, tax and expenditure limitations have had differential effects on the capacity of local governments to rely on local property taxes to deliver services. A nationwide study found that these limitations do not offer a uniform constraint across jurisdictions, but rather represent a greater constraint for some than others. In the case of both general- purpose governments (cities or counties) and school districts, there is significant variation across these jurisdictions within single metropolitan areas. In particular, the effects seem to be “greatest within counties comprising the urban core and those with relatively more disadvantaged populations.”81
Sixth, tax and expenditure limitation enacted through citizen referenda have been found to be more constraining than those enacted through legislation. A 2010 study con- cluded that the legislatively enacted TELs are more likely to have loopholes that enable governments to wiggle out of them when they become too constraining.82
One clear conclusion that can be reached about TELs is that their effects are complex and go far beyond simply constraining taxing and spending. This conclusion has been sustained over 30 years of research and experience with TELs. A 2009 Lincoln Institute of Land Policy study surveyed officials in municipalities that had enacted TELs, and the
results were decidedly mixed. While 36% said that their TELs had impacted budgets, for example, 40% said they had had no clear effect. Furthermore, while 20% said that the TELs in their cities had reduced service provision, 13% said that they had sought out new revenue sources.83 It is difficult to reach the conclusion that tax and expenditure limitations clearly limit either taxes or spending; their effects are much more complicated. Still, the rise of the Tea Party movement likely signals a renewed interest in such budget-limiting rules.

summary
Governments use numerous revenue sources to support their operations, with taxes obvi- ously being one of the most important types. In devising a tax system, governments need to consider the adequacy of the tax revenue being produced, the equity of the tax sys- tem (on both ability-to-pay grounds and on the basis of who benefits from local public services), economic efficiency, collectability, and political feasibility. Taxes on personal and corporate income are important sources of income for the federal government and state governments. They are highly complex taxes, and the personal income tax in particu- lar is usually adjusted to individual taxpayer conditions. Payroll taxes are typically used to finance particular services, and are earmarked for those purposes. By far the largest payroll taxes are for Social Security and Medicare. The property tax, which is the largest tax for local governments, is heavily influenced by assessment practices, which can substantially affect the equity and the production of the tax. The use of property taxes is constrained by the imposition of constitutional or statutory limitations.

Walden, M. (2003). Dynamic revenue curves for North Carolina taxes. Public Budgeting & Finance, 23, Winter, 49–64.
2.Farrelly, M. (2008). The impact of tobacco control programs on adult smoking. American Journal of Public Health, 98, 304–309.
3.Herszenhorn, D., & Stolberg, S. (2010). Obama defends tax deal, but his party stays hostile. New York Times, December 7.
4. Lambert, P., & Naughton, H. (2009). The equal absolute sacrifice principle revisited. Journal of Economic Surveys, 23(2), 328–349.
5.The House Republican plan for America’s job creators. (2011). GOP.gov. Retrieved February 21, 2012, from http://www.gop.gov/indepth/jobs/taxes.
6.Internal Revenue Service (2010). Circular E: Employers tax guide, December 29, 1. 7. U.S. Congressional Budget Office (2010). Average federal tax rates in 2007 (p. 6). Washington, DC: U.S. Government Printing Office. Retrieved February 24, 2012, from http://www.cbo.gov/sites/default/
files/cbofiles/attachments/AverageFedTaxRates2007 . 8. U.S. Congressional Budget Office (2010). Average federal tax rates in 2007, 6. 9. Weiss, E. (2005). D.C.’s bid to impose commuter tax denied. Washington Post, November 5.
10.Farrelly, M. (2008). The impact of tobacco control programs on adult smoking. American Journal of Public Health, 98, 304–309.

Chapter 6

In addition to income, payroll, and wealth-based taxes covered in the previous chapter on budgeting for revenues, governments raise revenue from a number of sources that are based on largely voluntary transactions. The largest and most important of these is the gen- eral retail sales tax. There are also a number of sales taxes levied on specific goods, includ- ing taxes on luxury goods such as expensive automobiles, so-called sin taxes on liquor and cigarettes, and benefit-based excises on items like motor fuel. Governments have expanded their use of fees and charges, many of which are used to finance related services. Over the past 35 years, the use of lotteries and games of chance as a revenue source for state govern- ments has mushroomed. Although having grown over the years, neither charges nor gam- bling revenues represent a primary source of revenue for general-purpose governments. Many special districts such as water and sewer authorities get the majority of their revenue from charges, however.
This chapter reviews each of these revenue sources, discussing their applications and the political and economic issues surrounding them. In doing so, we discuss how these revenue sources stack up relative to other criteria.
Retail SaleS and OtheR COnSumptiOn taxeS
Sales taxes are one of the most important sources of revenue for state governments. Forty- five of the 50 states (all but Alaska, Delaware, Montana, New Hampshire, and Oregon) levy a general sales tax, and it is the largest state-generated source of revenue for many of them.1 All states have at least some selective sales taxes. Overall, the general and selective sales taxes account for more than 23% of total state general revenues from all sources. Income taxes are the second largest single general revenue source, at 19%, followed by user charges, which account for about 11% of general revenues. However, all taxes account for just more than 50% of state general revenues. If one looks at the sales tax as a propor- tion of tax revenues only, sales taxes account for almost half of state tax revenue.2
There are two types of sales taxes. The general sales tax is a tax on all (or most) con- sumed goods and sometimes services. Specific sales taxes are taxes on a particular type of good or service. There are also two varieties of sales tax. Ad valorem taxes are levied as a percentage of the purchase price of an item. If an item subject to a sales tax costs twice as

much as another item subject to a sales tax, the tax paid is twice the amount as well. General sales taxes are ad valorem taxes.
Unit taxes, on the other, hand, are levied per unit of the item sold, without regard to price. This means that more expensive brands are taxed at the same level as less expensive brands. Gasoline, or cigarette, or liquor taxes, are usually unit taxes, since taxation is based on the gallons (in the case of gasoline or liquor) or packs (in the case of cigarettes) sold. The production from ad valorem taxes, for obvious reasons, tends to rise as prices increase, while unit taxes yield relatively flat revenues.

General Sales taxes
The general sales tax is the largest revenue source for state governments and is used by many local governments as well. Many state governments raise as much as one-fourth to one-third of state tax revenue from this source. Some states raise as much as one-half. Sales tax revenues result from the size of the tax base—in this case, the value of the taxed goods that are sold—and the rates applied to that base.
Tax Base
While all three levels of government rely on some form of consumption tax, state govern- ments are the most dependent, particularly on retail sales taxes. The base of any consump- tion tax is a product or class of goods (sometimes services) whose value is measured in terms of retail gross sales or receipts. The base is a function of which products and services are included and excluded. All states except Illinois exempt prescription medicines (Illinois taxes these at a lower rate of 1%), and 31 of the 45 states with sales taxes exclude food, except for that sold in restaurants, delis, or some specialty foods sold in grocery stores.3 Some states have opted for reducing the sales tax rate on food compared to other taxed items, rather than eliminating it altogether.
Other commonly excluded items are clothing, household fuels, soaps, and some toilet- ries. Some items may be exempt from the general sales tax only because they are subject to another sales tax. Cigarettes, gasoline, and alcoholic beverages are examples of specific goods exempted from the general sales tax for this reason. States generally are not pre- cluded from levying two taxes on one sale. Such double taxation may occur, for example, when a general sales tax and a specific sales tax are placed on cigarettes and alcoholic beverages.
The justification for these commodities’ exemptions is typically that they make the sales tax less regressive, to the extent that the nontaxed items are necessities. The clearest case is food, where lower-income persons spend a larger percentage of their income on this com- modity than higher-income persons. This same justification applies to the exemption for prescription and other medicines.4 Tax exemptions for clothing are less clear on vertical equity grounds, although some states exempt only a portion of the cost of a given article of clothing (the first $100, for example) in an effort to offset this problem.
The most notable items not included in most sales tax bases are services, such as the professional services of doctors and lawyers, dry cleaners, or accountants. A Council of State Governments study found that consumption expenditures for tangible goods are

ess than those for services.5 States that exclude services from the sales tax base may forgo considerable revenue, depending on the distribution between the “goods” and “services” economy in that state.
However, applying the sales tax to services is so unpopular that few states have imple- mented that option. Only three states (Hawaii, New Mexico, and South Dakota) tax most services.6 In fact, when the State of Florida passed a law that applied the sales tax to services in 1986, it was forced to repeal that tax the next year when citizens and affected interests “discovered” the tax.7
The most debated current issue regarding the application of the sales tax concerns the ability of states to tax mail-order or Internet sales. As more and more commerce has switched from traditional retail outlets to mail-order or Internet outlets, state and local governments have lost substantial revenue because of the difficulty in enforcing the use tax (a tax paid by the purchaser on items where sales tax was not paid at purchase). exhibit 6–1 discusses the issues surrounding the taxation of mail-order and Internet sales.

Taxation of Mail-Order and Internet Sales
States currently have only limited authority to tax mail-order sales and have been lobby- ing Congress to pass legislation allowing full taxation. The reason is a simple one. Mail- order sales vastly increased starting in the 1980s and constitute a potentially lucrative source of revenue.
U.S. Supreme Court interpretations of the due process and interstate commerce clauses have been fairly restrictive on states’ ability to tax interstate sales. A 1967 case (National Bellas Hess, Inc. v. Department of Revenue, State of Illinois) concluded that a mail- order firm had to have a substantial nexus of business in a state in the form of a physi- cal presence. A 1992 case (Quill Corporation v. North Dakota) relaxed the so-called nexus doctrine, holding that the due process clause of the Constitution does not bar enforce- ment of North Dakota’s use tax on the Quill Corporation, but on other grounds it still refused to overrule Bellas Hess.1
An additional complication is the growth of sales through cable and satellite television and other electronic commerce. Use of the Internet as a mechanism to place orders shipped interstate has become a significant mode of commerce, and it will continue to grow as more users gain access to electronic sources. One estimate put na- tional losses from the failure to tax Internet sales nationwide at $11 billion in 2012, and at least $52 billion over the six-year period between 2007 and 2012. States with relatively large revenue losses, according to this estimate, included California ($8.7 billion), Texas ($4.0 billion), New York ($4.0 billion), and Florida ($3.7 billion).2 Although the principle has not been tested in any court case so far, Internet commerce is being treated the same as interstate mail-order and phone sales. Recent research demon- strates a small, but statistically significant, relationship between the state sales tax rate and the propensity of consumers to purchase online, with higher sales tax rates leading to more online spending.3
There are a number of significant policy problems raised by the mail-order and Inter- net sales issue. First, as noted above, is the sheer magnitude of the revenue loss. This puts those states that rely more heavily on the sales tax (for example, those with only a

sales tax) at a significant disadvantage compared to states with both an income and a sales tax, or only an income tax. Second, there is the problem that it creates for tradi- tional “bricks and mortar” businesses, whose costs—rent, for example—are higher than for online businesses, and who must include the tax in the cost of the price of their goods. Third, to the extent that some taxpayers can avoid paying the sales tax through Internet or mail-order purchasing, the tax burden is shifted to those who do not engage in these kinds of transactions. To the extent that traditional sales fall more heavily on lower-income individuals without access to the Internet, this would tend to make the sales tax more regressive.
In 1998, Congress passed the Internet Tax Freedom Act, which has been subsequently extended, the last time in 2007.4 That act placed a moratorium on taxing Internet sales, or other taxes on Internet services or transactions. This moratorium is currently in effect through 2014. The initial 1998 Act included the appointment of an Advisory Commission on Electronic Commerce to deal with the issue.5 The commission deadlocked without effectively solving the problem. In its wake, some states have taken matters into their own hands. Some states attempt to tax Internet purchases by ask- ing taxpayers filing individual income tax returns to report on goods purchased from out of state through online sources, but have not created any effective enforcement mechanisms.
More generally, state governments have joined together to create the Streamlined Sales Tax Project. This project intends to simplify and make consistent across the states the application and administration of the sales tax. Success with this approach might overcome judicial objections to requiring retailers to collect sales taxes for all 45 states, each of which has a different system, as an undue burden.6 Some research suggests that, under some circumstances, firms might have incentives to comply voluntarily with the collection of sales tax on Internet sales. The authors of this study, however, were not sanguine about the ability of states to simplify tax administration sufficiently to create widespread voluntary compliance.7

Tax Rates
State sales tax rates vary from as low as 2.9% (Colorado) to as high as 8.25% (California).8 To avoid levies of a fraction of a cent, bracket systems are used in which a set amount is collected regardless of the specific sale. For example, a 5% tax might yield 5 cents on any purchase starting at 81 cents or 90 cents. With computers and electronic scanners at check- out counters in stores, determinations can be quickly made as to whether an item is taxable and how much tax, if any, should be charged.
Many states permit a separate local sales tax on top of the state sales tax. Local sales tax rates vary widely, from a low of only 0.03% in Idaho to a high of 4.69% in Louisiana.9 Local sales taxes are typically collected by the state and remitted to the local treasury.
Sales taxes are regressive in that higher-income consumers typically have more discretion- ary income and may spend it on items not subject to sales taxes. As noted above, the more the base of the sales tax excludes necessities (such as food and prescription drugs) and includes luxury or nonessential goods and services, the less regressive the tax is likely to be.
This regressive nature of the sales tax may represent a somewhat counterintuitive result, since sales taxes almost always employ a single rate (as opposed to the federal income tax, for example, which has graduated rates). Because of that single rate, some people may think of them as not regressive at all, but rather proportional. Even though sales taxes are levied on a flat-rate basis, however, does not mean that everyone pays the same portion of their income in tax. On the contrary, the vertical equity implications of the tax are substantially dependent on the portion of an individual’s income that is spent on taxed items.
Consider a case where one taxpayer earns $50,000 in income and spends $40,000 of that on items subject to the sales tax, while a second taxpayer earns $80,000 and spends $60,000 of that on tax items. The first taxpayer will pay $2,000 in tax ($40,000 times 5%), which rep- resents an effective tax rate of 4% ($2,000/$50,000). The second taxpayer pays more in tax ($3,000, or $60,000 times 5%), for an effective tax rate of 3.75% ($3,000/$80,000). Even if the sales tax rate is 5% for each taxpayer, the lower-income taxpayer will have a higher effec- tive tax rate than the higher-income taxpayer. Thus a tax that appears proportional may actually be regressive. As noted above, the exemption of necessities such as food and drugs tend to have the effect of making the tax less regressive and even progressive in some cases.
The general sales tax continues to be a relatively popular and widespread form of taxa- tion, but state and local governments increasingly see threats to the sales tax as a revenue source, for several reasons. First, as noted in Exhibit 6–1, the threat to the productivity of the tax resulting from sales to remote vendors is a real one. Second, the trend is toward more services (that tend not to be taxed) and fewer goods (that are subject to the tax), which impacts the productivity of the tax. Third, legislatures have had a tendency in recent years to provide tax exemptions (in particular, in the form of tax “holidays” to encour- age shopping in the state during specific time periods such as the weekend before school starts) that have questionable results but impose substantial revenue losses. For these rea- sons, one noted sales tax expert is concerned about the viability of the sales tax as a revenue source, and sees those states that rely heavily on the sales tax as having a more difficult time keeping pace with demands for services.10

The Value-Added Tax
Increased concerns about the robustness of the U.S. tax system, especially the intergov- ernmental system of taxation and revenue transfers (see the chapter on intergovern- mental relations), have led some to advocate adoption of a value-added tax (VAT).11 The United States is one of the few industrialized countries without a VAT. As its name implies, a VAT is a consumption tax on the value added by producers and distributors at every stage in the production, distribution, and sales process. Interest in the VAT in the United States seemed to peak in the early 1990s. Proposed during the 1992 election by then-candidate Bill Clinton, the VAT did not get serious attention in Congress. During recent presidential campaigns, it has not been mentioned at all, but has instead been superseded by various candidates’ proposals for fundamental income tax reform, includ- ing various flat-tax alternatives. Tax professionals argue that it is superior to many other forms of consumption taxation, but it just has not generated much enthusiasm in the United States.12
Efforts to reduce the federal budget deficit have revived calls for some kind of national sales tax in the United States. The highest profile of these was proposed by the Bipartisan Policy Center’s (BPC) debt reduction proposal. This BPC initiative was headed by former Senator Pete Domenici (R-NM) and CBO founding director Alice Rivlin. The Domenici- Rivlin proposal was for a 6.5% “debt reduction sales tax,” phased in over two years.13

Selective Sales taxes
Selective sales taxes are normally referred to as excise taxes. There are three general cat- egories of excise taxes: luxury excises, sumptuary excises, and benefit-based excises. They differ according both to the specific types of sales that are taxed and to the fiscal or social goals of the tax.

Luxury Excises
These excise taxes are levied on items that are “uniquely or predominantly consumed by the rich,” meaning that the act of purchasing the good itself is considered to be evidence of an extraordinary ability to pay taxes.14 At one time, federal excise taxes were levied on a wide range of luxury goods, such as jewelry, yachts, and expensive automobiles. The logic of these taxes rests on the assumption that the purchase of such goods is prima facie evi- dence that the consumer can afford the tax. The overall effect of these taxes, then, is to make the tax system more progressive. There are some problems created by luxury excises. One problem is that the definition of what is a “luxury” is in no way fixed. That is, a watch is not a luxury, but an “expensive watch” may be. A car is not a luxury, but an “expensive car” may be. The problem, of course, is that there is no standard definition for “expensive,” so any definition used is by necessity somewhat arbitrary. Some families may have a need to purchase a more expensive car in order to accommodate their family. For a single person, the purchase of such a vehicle may be a luxury. Thus, the definition of a luxury item is clearly open to debate and interpretation.
Another issue with luxury excises is that they can create distortions between taxed and untaxed goods. The luxury tax itself changes the relative price of the luxury item compared
o items that are not subject to the tax. This means that tax policy is discriminatory against these luxury items relative to other goods that may be purchased. This has the effect of discouraging, at the margin, purchases of these items, which has the related effect of dis- advantaging retailers and producers of luxury goods, perhaps to the point of driving them out of business. In 1990, a new federal luxury tax on yachts was criticized as bankrupting yacht producers and sellers, although it was difficult to evaluate the specific cause of the problems experienced by producers and sellers since the imposition of the tax occurred virtually simultaneously with the economic recession of the early 1990s.
Luxury excise taxes tend not to exist at the state level, and the federal luxury tax has ebbed and flowed according primarily to political factors. The most recent experience with expanding federal luxury taxation was under the Omnibus Budget Reconciliation Act of 1990, when luxury taxes on boats (over $100,000), automobiles (over $30,000), airplanes (over $250,000), and furs and jewelry (over $10,000) were imposed. These taxes proved unpopular, however, and all have since been repealed.15

Sumptuary Excises
These sales taxes are regulatory in nature. Taxes on alcohol and tobacco have been justi- fied as deterring people from consuming these commodities. In reality, the evidence sug- gests that the demand for these products is relatively inelastic, casting doubt on whether taxes discourage usage. These items tend to be relatively demand inelastic in large part because they are addictive in nature. Therefore, a smoker is unlikely to stop smoking, or even cut back, because of higher taxes on a pack of cigarettes.
In the 1990s, a substantial tax increase on tobacco was proposed as an important source of financing for federal health care reform. The rationale was that smokers are one of the major sources of health care insurance utilization and that those who create those costs should be the ones to pay taxes to fund them—a sort of reverse benefit principle. The pro- posal, however, did not get serious review in Congress. Nevertheless, some states have sub- stantially increased tobacco taxes both as a revenue measure and as a health regulatory measure. Large increases in tobacco taxes have reportedly discouraged youth from smoking.
Sumptuary excises, regardless of their regulatory nature, tend to be somewhat regres- sive, for two reasons. First, there is a tendency toward greater alcohol and cigarette con- sumption among lower-income groups than higher-income groups. Second, and perhaps even more important, since these taxes are unit taxes instead of ad valorem taxes, effective tax rates are higher for lower-priced brands. While this is likely less of an issue for cigarettes (because the price difference between brands is not great) it is a much larger issue for alcoholic beverages, where there is a huge price range for bottles of wine or spirits (or even six-packs of beer). As an example, if the tax on wine amounted to 50 cents per bottle, this would represent a 10% tax on a $5 bottle, but only a 2% tax on a $25 bottle.
There is a federal alcohol beverage tax, and many states levy liquor taxes as well. Both federal and state alcohol taxes are levied on a unit basis. In fiscal year 2010, the federal tax was $13.50 per “proof gallon” (about $2.14 for an 80-proof bottle) of distilled spirits, $18 per 31-gallon barrel of beer (or $0.58 per gallon, and roughly 5 cents per can), and $1.07 per gallon (about 21 cents per bottle) of table wine (provided that the alcohol content was 14% or less)

lOtteRieS, CaSinOS, and OtheR FORmS OF GamblinG
For the past 40 years in the United States, state governments have increasingly operated lotteries and other games of chance in an effort to raise revenues. In addition, more and more states have permitted casino gambling and slot machines over recent years, and have taxed and regulated these activities. Governments had taxed gambling activities, such as horse and dog racing, for many years earlier, but with the advent of lotteries in the 1960s the states became more directly involved in the operation of games of chance.

lotteries and Gambling
Since 1963, when New Hampshire began the first modern state lottery, all but eight states have launched lottery programs. In 2009, states generated $17.7 billion in net revenue from all lottery games.33 This represented just under 3% of overall state rev- enues from their own sources (that is, excluding grants and other intergovernmental revenues).
There is wide variation from state to state in the importance of the lottery as a revenue source. The State of New York raised $2.5 billion from the lottery in 2009, or 2.9% of its own-source general revenue of $86 billion. Income from lotteries in other large states varied substantially, with California collecting about 0.8% and Florida almost 3% of their own-source general revenue from lotteries. Some small states raise substantial sums from their lotteries. West Virginia raised 9% of its own-source general revenue from the lottery in 2009, while the figure was 8% in Rhode Island and 6% in Delaware.34
Revenues generated from the programs can vary considerably from year to year, depend- ing on lottery activity in adjacent states, the size of jackpots, and the extent to which a lottery has “matured” and lost the public’s interest. State lottery revenues rose rapidly in the late 1980s and early 1990s, then leveled off by the mid-1990s. Recent years have seen a resurgence in interest by both the public, attracted in part by very large, multistate payouts, and the states, in attempts to recover from the economic downturn of the early 2000s and the recession that started in 2007. Still, the biggest increase in lottery sales came between 1985 and 1995, when sales more than tripled. Since 1995, lottery sales have leveled off, more closely tracking the rate of inflation over that period.35 During the recession that started in 2007, lottery proceeds were relatively stable, and were certainly less volatile than income and sales tax revenues. Between 2007 and 2008, lottery proceeds to states increased by approximately 2%, and then dropped by that same 2% between 2008 and 2009. By con- trast, state income tax revenues declined by more than 11%, and general sales tax revenues by 6%, between 2008 and 2009.36
Even with all of this activity, the lottery is not a significant revenue source for most states. Recent research not only demonstrates that lotteries do not raise much revenue,
but also provides evidence that the revenue that is raised from the lottery often comes at the expense of revenues from other sources, especially sales and excise taxes. Put simply, either taxpayers may substitute spending on the lottery for other spending subject to the sales tax, or politicians may feel less pressure to raise taxes from other sources because of the revenue generated by the lottery.3

privatize lotteries hit a snag in October 2008, when the U.S. Department of Justice issued an opinion that states could not enter into long-term leases with non-state actors to operate lotteries. The Justice Department argued that federal law required the state to “exercise actual control over all significant business decisions made by a lottery enterprise and retain all but a minimal share of the equity interest in the profits and losses of the business.” It is permissible, according to this opinion, for the state to contract out provision of goods and services necessary to operate the lottery, but ultimate control over the lottery must remain with the state.46 In September 2010, Illinois became the first state to hand over management of its lottery to a private firm, although the state (as required by the Justice Department) will “retain ownership and regulatory oversight

Casino Gambling
In addition to lotteries, a number of states have legalized casino gambling and similar forms of amusement, such as slot machines. While in 1988, legalized casino gambling existed only in Nevada and New Jersey, in 2011, 29 states had Native American casinos, 15 states had non–Native American casinos as standalone properties, and 7 other states that did not have standalone casinos had casinos at racetracks.48 Native American casinos operate substan- tially differently than non–Native American casinos. In the case of the former, states negoti- ate with tribes for the state “take” of casino revenues. In the latter case, taxes are levied on gross receipts or adjusted gross receipts (gross receipts less winnings). Some states use a flat scale, while others use an adjusted scale. States also raise money from licensing fees and fees for gaming devices, such as slot machines. The chapter on intergovernmental relations discusses the relationships between states and Native American tribes concerning casino gambling.
Most states raise little or no money from amusement taxes. In 2009, there were only 10 states that raised more than $100 million in revenues from these taxes.49 Although in some states, such as Louisiana, casino gambling has cut into state lottery revenues, other states are generating significant revenues from such ventures. Some states receive substan- tial support from amusement taxes, including the obvious leader, Nevada (home of Las Vegas and Reno), which generated $832 million in amusement taxes in 2009, or 12% of total own-source revenues in that year. Other significant contributions from amusement taxes came in Indiana (4.3%), Louisiana (4.1%), and Mississippi (3.4%). Nationwide research suggests that, while there is significant “cannibalization” of lottery revenues from casinos, states as a whole seem to benefit, from a revenue perspective, from having both lotteries and casino gambling.50
Overall, however, the enthusiasm for tax and economic benefits from lotteries, casinos, and other legalized gambling has waned somewhat, except in those states where neigh- boring states seem to be attracting residents of nonlottery states to cross state borders to purchase lottery tickets. For example, one argument used in 2002 in North Carolina to support a lottery proposal was the amount of money that North Carolina residents were spending in the neighboring Virginia and South Carolina lotteries. The Commonwealth of Pennsylvania introduced slot machines in November 2006, an action that arguably could have been influenced by the existence of casinos in neighboring New Jersey. The economic

benefits in terms of employment and increased tax revenues have been less than expected, though definitely positive. Hard evidence of social consequences has been difficult to find, although opponents of legalized gambling anecdotally argue that the social costs exceed the economic benefits.

One of the selling points often used to market the lottery and other forms of gambling revenues is that their proceeds will be used to support spending for some specific (usually popular) policy area. For example, many states earmark lottery revenues, or other gam- ing revenues, for education or senior citizen programs. It is frequently difficult, however, to make the case that this earmarking actually leads to a net increase in funding for these areas. In cases where funds are dedicated to education, for example, lottery earmarking may simply have the effect of freeing up other revenues that would have been spent on edu- cation to be used for other purposes.52 This is because of the fungibility of revenues, given that some sources can be substituted for others without increasing spending for particular programs (see the chapter on intergovernmental relations). In some states where lottery earnings are earmarked to support education, state legislatures have cut other state educa- tion spending by commensurate amounts.53
An exception was found to this general rule in Georgia, where lottery revenues have stimulated additional spending in the areas advertised by lottery proponents. According to the authors of this study, this occurred because of the specific structure of the earmark, the transparency of the budget process, and the commitment of the governor to increase funds rather than substitute them.54

Pari-Mutuel Wagering Taxes
In addition to lottery and amusement taxes, some states allow betting on sporting competi- tions, primarily horse racing (although some states also have legalized dog racing and jai- alai). These are more similar to amusement taxes than lotteries in the sense that the activity is not operated by the state, but is regulated and taxed by the state. Nationwide, pari-mutuel taxes generated only $232 million in 2007. This represented only 0.02% of total own-source revenue for states in that year. Only California ($37.5 million), New York ($28.1 million), Florida ($28.1 million), and Pennsylvania ($24.7 million) raised more than $20 million in that year, but in each of these cases, the revenue from this source made an inconsequential contribution to state revenues.

SummaRy
Some revenue sources, instead of being taxes on income or wealth, are taxes on individual transactions. Among these are general and specific sales taxes, user charges, and revenue raised from games of chance, such as lotteries. These revenue sources have in common that they are levied on a more or less voluntary basis. That is, individuals have relatively more “choice” in whether they engage in the transaction or pay the tax.
The general sales tax is the largest single revenue source for state governments, and is also used by many local governments. The tax is levied on sales made at the retail level. Many states exclude particular transactions from the tax base. Among the most frequent exclusions are food and prescription drugs. By and large, these exclusions make the tax
less regressive, since they are necessities and thus tend to represent a larger percentage of total spending for lower-income taxpayers than for higher-income taxpayers. In recent years, the viability of the sales tax has been threatened by the increased spending by con- sumers from remote vendors, including both mail-order and Internet sales. States and local governments lack a reliable way to collect taxes on these transactions.
Sales taxes are also levied on particular types of transactions. There are three general categories of these selective sales, or excise, taxes. First, luxury excises are levied on items (such as boats or luxury automobiles) the purchase of which is viewed as evidence of an extraordinary taxpaying ability. Second, sumptuary excises (so-called sin taxes) are levied on items such as cigarettes and liquor, ostensibly to discourage consumption of these goods that are thought to cause harm to both the individual who consumes them and society as a whole. Third, benefit-based excises operate as a quasi-price by taxing individuals and then using the proceeds of those taxes to finance benefits used by the specific taxpayers on whom the tax is levied. A classic example of this is gasoline taxes used to finance transporta- tion projects, especially highways.
Increasingly, governments charge citizens directly for their purchase of individual services, or have dedicated revenue from charges for particular spending programs or functions. In this way, government services can be made to resemble market transac- tions. User charges have been growing at all levels of government and include such varied items as federal postal service fees, state university tuition, and local water and sewer fees.
Many state governments rely on revenue from gambling to finance a portion of state government services. While most states do not raise much money from gambling, games of chance have been a growth industry for states. There are substantial differences between lotteries and other forms of gaming revenue. In the case of lotteries, the games are oper- ated directly by the government, with games marketed, tickets sold, and proceeds paid directly to state coffers. In the case of other games of chance, such as casino gambling, the games are not operated by the state but are taxed by the government. Casino gambling has been on the increase in recent years, including both Native American and non–Native American components.

1.Tax Foundation (2010). State sales, gasoline, cigarette, and alcohol taxes. Retrieved December 7, 2011, from http://www.taxfoundation.org/files/state_various_sales_rates_2000-2010 .
2. U.S. Bureau of the Census (2011). State government finances summary: 2009. Governments Division Briefs, January. Retrieved February 24, 2012, from http://www2.census.gov/govs/ state/09statesummaryreport .
3.Federation of Tax Administrators (2011). State sales tax rates and food and drug exemptions. Retrieved December 7, 2011, from http://www.taxadmin.org/fta/rate/sales .
4.Due, J., & Mikesell, J. (2005). Retail sales tax, state and local. In J. Cordes, R. Ebel, & J. Gravelle (Eds.), Encyclopedia of taxation and tax policy (p. 337). Washington, DC: Urban Institute Press.
5.CanagaRetna, S. (2010). State fiscal issues. Presentation at the Southern Legislative Conference of the Council of State Governments, at the 2010 Division of Insurance and Research Economist and Analyst Meeting Federal Deposit Insurance Corporation (FDIC), Dallas, Texas, October 7. Retrieved December 7, 2011, from http://knowledgecenter.csg.org/drupal/content/state-fiscal-issues

Robert D. Lee Jr., Ronald W. Johnson, Philip G. Joyce. (2013). Public Budgeting Systems, 9th Edition ISBN: 9781449627904

Chapter 4 Questions

1. What is the fundamental purpose of public budgeting?

2. What are the four phases the budget cycle?

3. What was the intent of the 1970 reorganization of the former federal Bureau of the Budget (BOB) and renaming it the Office of Management and Budget (OMB)?

4. At the state and local levels, what is the most common first step in the budget preparation process?

5. What are some of the dominant political considerations involved in the preparation phase of public budgets?

Chapter 5 Questions 

1. What are the four major considerations given to adopting a revenue source known as the principles of taxation?

2. What are the two fundamental doctrines of tax equity?

3. Briefly explain the difference between horizontal and vertical tax equity.

4. What is the most costly local government service?

5. How do economists define income

 Chapter 6 Questions 

1. What are some examples of goods subject to selective sales taxes?

2.  Why are sales taxes considered regressive?

3.  What is a value-added tax?

4.  What is the equity principle behind benefit based excise taxes?

5.  What is the equity principle behind user fees?