What is the State and Local Fiscal Relationship?
Local governments – cities, special districts and counties – are the entities closest to the people. They all have locally-elected governing boards and provide most of the direct services to citizens.
Revenues to pay for local services come from a variety of sources that can include property taxes, local sales and use taxes, utility user taxes, business license taxes, and hotel occupancy taxes. State and federal funds are a large source of funding for health and human services. Vehicle license fees are also a source of funding for local county governments.
What Services Do Local Governments Provide?
- Cities provide basic municipal services to incorporated local communities, including police and fire protection, building and planning approvals, parks and recreation programs, street maintenance, etc. Some cities offer more limited basic services and rely on special districts to provide specific dedicated functions.
- Special Districts provide specific services, such as water or sewer or fire, etc., within certain service areas.
- Counties fulfill a hybrid role by providing health and social services, as an agent of the state for state and federally funded programs. They also provide countywide services within their jurisdiction, such as jails and elections, and provide municipal services in unincorporated areas.
What Are the Revenue Sources for Local Governments?
- Cities: sales and users taxes, property taxes, business license taxes (such as gross receipts taxes) hotel taxes and utility user taxes are collected to fund day to day operations. Charges for city utilities are limited to the cost of providing the service.
- Special Districts: Quite often these services are funded by user fees, although some such as fire and hospital districts, receive the bulk of their funding from a share of the property tax.
- Counties: the bulk of county programs are funded by intergovernmental revenues such as state and federal funds. Often counties must use the local tax revenues to fund programs mandated by the state, and over which the county has little programmatic or operational control. Local sales and use taxes, vehicle license fees and property taxes are the primary sources of funding for programs that are not funded by the state or federal government.
Even though there are requirements for the state to reimburse local agencies for state mandated programs, reimbursement has been suspended in recent years due to state budget shortfalls.
What's Happening Now?
- Local governments have very little control over their financial resources. The state controls the allocation of property taxes, which was historically, a primary source of local revenue.
- The state has itaken or borrowed local government funds in dire economic times at the same time that local government entities are also suffering economically. Local governments have responded by sponsoring iniatives which have locked in exisiting funding formulas.
- Since 1990, the state has “realigned” services to counties along with some funding sources.
A Brief History of Local/State Funding
In 1910, the Separation of Sources Act determined that:
- The State would tax railroads, telegraph and telephones.
- Local government would tax property. Each local government would set its own tax rate.
- Each level of government could determine how its own taxes would be used.
Since then, the Separation of Sources Act, which was the basis for establishing local and state tax authority and revenue streams has been modified by voter initiatives and legislation.
Proposition 13/ AB 8 – In 1978, California voters amended their Constitution by passing Proposition 13, which set the maximum property tax rate at 1 percent of assessed valuation, set the assessed valuation based on purchase price or significant improvements, and required new two-thirds vote requirements for state tax increases and for new local special taxes,
Prop 13 had two significant effects for local governments across the state.
- First, it immediately cut property taxes by about fifty percent and eliminated governments’ authority to adjust the property tax rate for local needs; this helped taxpayers but drastically reduced—and forever limited—a significant source of local government revenue.
- Second, it gave the state government the power to allocate the remaining property tax revenues.
In 1979, the state assumed about $1 billion of the cost for county “safety net” programs, and allocated the limited property tax to each local government based on its proportionate share of revenues prior to Prop. 13. This AB 8 formula remains in effect today.
Voter Approval Required for All Local Taxes (1986, 1996)
In 1986 voters approved Proposition 62, which required approval by the voters of any new loca, general-purpose tx (charter cities excepted). This was followed in 1996 by Proposition 218, which imposed this requirement on charter cities as well. Proposition 218 also defined all parcel taxes, requiring a two-thirds vote.
Realignment (Health and Human Service, 1991)
In 1991, the state enacted a major change in the state and local government relationship, known as realignment. In the areas of mental health care, social services, and health care, realignment transferred programs from the state to county control, altered program cost-sharing ratios, and provided counties with dedicated tax revenues from the sales tax and vehicle license fee to pay for these changes.
Property Tax Shift/Educational Revenue Augmentation Fund (ERAF) (1992-1993)
When California’s economy took a downturn in the early 1990’s, the state used its allocation power over property taxes to shift about one-sixth of property tax revenues from cities, counties and special districts to schools in 1992 and 1993. ERAF is the name of the fund into which the shifted funds are originally deposited. The shift had the effect of reducing the state’s payments to schools by billions of dollars, at the expense of other local agencies.
Vehicle License Fee/ Property Tax Swap (2004)
In 1998-2000, when the economic times were good, the state dramatically reduced the state vehicle license fee, which was basically a local revenue, but replaced local governments’ lost VLF revenues with a backfill from the state General Fund.
When the economy later hit a downturn, the state sold bonds (in 2004 & 2008) to finance state budget deficits (Economic Recovery Bonds, ERB). These bonds were repaid by a complicated swap of taxes necessitated by the need to have a dedicated source of revenue to repay the bonds. 1/4 of 1 cent sales tax revenue which had gone to local governments was dedicated to repayong the ERBs. The loss of sales tax revenue for local governments was replaced with ERAF funds and the state backfilled the schools for the loss of the ERAF revenue.
Proposition 1A (November 2004)
This constitutional amendment, approved by the voters, was designed to protect against further reduction or diversion of property tax and sales tax and strengthen the state’s obligation to reimburse local governments for state-mandated programs. It allows the state to borrow money from local governments no more than twice in a decade. Repayment of the loan must be paid back within three years.
Proposition 22 (November 2010)
This constitutional amendment approved by the voters, prohibited the state from taking revenue derived from locally imposed taxes, such as hotel taxes, parcel taxes, utility taxes and sales taxes, as well as local public transit and transportation funds from Proposition 42 gas tax or the Highway Users Tax. This proposition arose from an action by the California State Legislature in 2009 to “raid” $ 5 billion from city, county, transit, redevelopment and special district funds.
Realignment (Criminal Justice, 2011)
AB 109 and AB 117 began the transfer of the responsibility from the State prisons to counties for custody of low level criminal offenders and for the monitoring of certain parolees. The Legislature provided the counties with funding as part of the budget process. This realignment was triggered in large part by the need to reduce overcrowding in the state's prisons to comply with federal court orders. Funding was initially supplied through the 2011-2012 budget. Proposition 30, which was approved by voters in November 2012, contains a provision that requires the state to continue to transfer to local governments each year the same share of tax revenues transferred in 2011 in order to meet these new responsibilities.
Redevelopment Agency Abolition (2011)
Proposition 18, passed in 1952, established a process under a city or county that could declare an area to be blighted and in need of redevelopment. After this declaration, mmost property tax revenue growth from the "project area" would be distributed to the city or county's redevelopment agency, instead of the other local agencies serving the project area. By 2011, about 11% of all property tax revenue statewide was going to redevelopment agencies, rather than counties, cities, and schools. As a result of Proposition 1A the Legislature was powerless to reallocate this revenue. So in 2011, the Legislature passed AB X1 26, which eliminated redevelopment agencies in California. As a result, the property tax revenue previously distributed to the redevelopment agencies will go to other local governmental entities, including school districts. Cities and counties will get more total revenue. School districts will probably not see any change in their total revenue from this change, because the increased revenue from property taxes will be offset by reduced revenue from the state’s general fund.
Note: Schools and Prop 98- Local schools and community colleges also have locally elected governing boards but have a very different relationship with the state. Due to that complexity they are not included in this discussion. Passed in 1988, Proposition 98 established a constitutional mandate for minimum state spending for K-14 education. Currently this funding takes more than 40% of the state General Fund. See language from LAO “Proposition 98 and K-12 Education, Feb 25, 2010.
Information on Local Governments
- Strengthening California Cities: League of California Cities
- Background information and city-by city data on city financing and key fiscal issues: California City Finance
- What Do Counties Do? California State Association of Counties
- What’s So Special About Special Districts? California Special Districts Association
- Understanding the Basics of County and City Revenues:Institute for Local Government, 2008
- Ten Events That Shaped California State-Local Fiscal Relations: Legislative Analyst’s Office