This article is part of a series on how states can manage uncertainty, balance budgets, and support communities.
States benefit from the well-being of their localities, but also feel the pain when their communities struggle. When that happens, state governments can pay a price both fiscally and economically—because of reduced tax collections, lost jobs, diminished services, and, in extreme cases, costly state bailouts.
Many local governments nationwide were struggling with growing liabilities and shrinking tax bases even before the pandemic started in early 2020. In many instances, those problems have become more severe and widespread, increasing the urgency for states to adopt policies to help municipalities thrive.
State policymakers can start by ensuring they are not imposing undue restrictions and mandates that limit local fiscal flexibility. That can happen in a variety of ways, from state laws that curb local savings to limitations on the types of taxes that localities can impose and the growth of those levies. These restrictions often serve a purpose, but some can amplify fiscal distress as municipalities work to weather a downturn.
In the long term, the strictest tax limitations can erode a local tax base over time, forcing officials to make cuts to services, increase the burden on taxpayers, or both. For example, even before the pandemic, property tax revenue in some Michigan communities hadn’t recovered fully from the Great Recession even as real estate values had rebounded. This was largely a consequence of tax limitations imposed by the state.
To avoid these outcomes, states can consider lifting tax limitations temporarily to give local officials more options to get through fiscal crises. Policymakers also can adjust limits that may prevent local revenue from fully recovering after a downturn, allowing total levies to rebound at the broader pace of economic recovery.
And they can boost local budget flexibility in other ways. For instance, state law generally dictates which transactions are covered by both state and local sales taxes. By broadening states’ sales tax bases to better align with the modern economy—such as by taxing services like professional consulting and personal care that make up an increasing share of economic activity—they could improve their own long-term budget picture as well as local revenue sustainability. In addition, states that prohibit local governments from establishing rainy day funds could lift those restrictions.
Although states could offer more fiscal control to all localities, the most distressed may need greater assistance to return to sustainable paths. Before they can help, however, states need to identify which governments are struggling. To do so, agencies can regularly monitor local fiscal conditions to detect signs of distress. In 2017, Virginia’s fiscal early warning system detected budget problems in the city of Bristol and helped to identify their sources. That allowed city leaders to put a plan in place to address them. In part because of those actions, Virginia no longer considers Bristol fiscally distressed, and the state appears to have avoided a local financial emergency.
Of course, the problems faced by struggling localities usually run deeper than government finances. They may also include the loss of critical employers, jobs, or residents, as well as a lack of investment and opportunity. By providing technical assistance, states can help local officials work through these economic challenges and build more resilient communities.
State policymakers can start by reviewing the billions of dollars already invested in economic development programs such as enterprise zones and tax increment financing designed to strengthen areas that may be struggling. In many instances, these programs have served wealthy locations instead of disadvantaged ones because the criteria used by states to target them geographically are often misguided or outdated. Despite this disappointing record, states rarely look critically at whether the programs are benefiting the people and places they are intended to help.
Maryland is an exception. Professional staff in the state Department of Legislative Services routinely draw conclusions about the targeting of place-based programs as part of regular tax credit evaluations. For example, reviews in 2021 pointed out that under the One Maryland and Enterprise Zone programs the eligible neighborhoods with the lowest need received three to four times as much funding as the most distressed ones.
The reviews recommended that policymakers re-examine and potentially consolidate the state’s place-based programs to help ensure that they offer meaningful help to distressed areas. Given their spotty record expanding economic opportunity for families that live in struggling locations, states generally would benefit from assessing how well place-based economic development programs are helping the people and places in need.
Josh Goodman is a senior officer, Adrienne Lu is a manager, and Alexandria Zhang is an officer with The Pew Charitable Trusts’ state fiscal health project.
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