Case Exercise – Politics, Taxes, and Budgeting

After reading the case entitled, “Unknown Taxpayer Preferences”, respond to the following questions based on the the “decision problems” discussed on p. 15-16 of the case:

1- As the city manager, examine the options available for budget changes and articulate at least three potential directions. What are the strengths and weaknesses of each? Ultimately, what is your recommendation to the city council?

2- Looking back, what could City Manager Catler and the council have done differently during the budget process to understand better the taxpayers’ preferences?

The paper does not need to systematically answer these questions in order, but they should be addressed at some point in the whole of the paper. Be sure to cite the attached module materials and readings as part of your explanation and defense. Please write in a concise manner that still comprehensively establishes the identified themes.

Below is a recommended outline template as a guide to the paper:

-Introduction [one paragraph, 1/2 page] – briefly summarize the problem faced by City Manager Catler
-Option #1 [one paragraph, 1/2 page] – briefly describe the option and its strengths and weaknesses
-Option #2 [one paragraph, 1/2 page] – briefly describe the option and its strengths and weaknesses
-Option #3 [one paragraph, 1/2 page] – briefly describe the option and its strengths and weaknesses
-Recommendation [two paragraphs, 1 page] – compare all options against each other in terms of relative strengths and weaknesses, identify your recommendation and defend why it is best using the comparative analysis.

Review Module 5

Module 5 Overview

In this module, we will focus on the policy function. Financial, fiscal, and budgetary policy establish the boundaries of the government influence and attach dollars to major government activities. In this module, we will explore the following aspects of budgeting as policy:

  • Fiscal Policy
  • Translating Policy into the Budget
  • Budget as a Statement of Priorities

Each of the aspects are introduced briefly below.

Fiscal Policy

One of the major policies established by the budget is fiscal policy. It can come in many forms: tax and fee structure, monetary policy, spending policy, and fiscal federalism. All of it is influenced by public economics. Since the public sector is a significant employer, spender, and regulator, how a government sets its fiscal policy can have tremendous effect not only on government performance but on the local, regional, national, and/or global economy. We will examine each form of fiscal policy and how they interact to impact government activities and the broader economy.

Translating Policy into the Budget

The government can influence the economy, but economy most definitely impacts government. This is just one of the many environmental factors that can affect the budget and the policies it establishes. Effective planning can alleviate the challenges and take advantage of the opportunities presented by environmental factors [more on that in Module 4], but budgeting must respond to these external influences in the short-term. The external influences are responded to in general with fiscal policy, but the policy still needs to be translated into budgetary allocations. We will briefly explore this process.

Budget Document as a Priorities Statement

The budget document, along with its review process, will be introduced first. Then, we will explore how the budget document incorporates the various policies of the organization to present a coherent statement of organizational priorities. After all, budgetary policy is established by the interplay of competing values and priorities and therefore the budget document should report what government does and does not do and to what extent will it do those things it has authorized. In terms of policy, the budget document spells out the rules of the game and reports the winners and losers.

The budgetary cycle, along with financial management practices, define the authorized activities of government and controls government action to occur within those bounds. As you progress through this module, keep in mind how the concepts and tools described work independently and with one another to define government and holds itself accountable for that definition.

Fiscal policy…

The economy plays a tremendous amount of influence on government activities. In addition, the government is a significant player in most economies. Therefore, how governments respond to and influence the economy is of great importance. The primary vehicle to address the economy in the budgetary process is known as fiscal policy, which is how the government utilizes its taxing and spending power to influence the economy. In this mini-module, you will be introduced to 1] public economics, 2] the various taxes and public fees and a system to evaluate them, 3] public expenditures and their functions, 4] fiscal federalism, and 5] other fiscal policy tools. Once you possess a working knowledge of fiscal policy can be utilized, you will gain a better understanding of the policy function of budgeting.


What is Policy?

The word “policy” can take on many meanings, so it is important to define the term at the outset. While many think of rules or regulations, policy takes on a broader meaning. “Policy” refers to the decisions made by governments that determine its role in the economy. By enacting laws, the government defines which portions of the economy are within its jurisdiction, and which are left to the private sector. The policy function of budgeting also recognizes the need to attach funding to the activities a government determines is within its policy jurisdiction. Thus, when we evaluate the policy function of budgeting, one should go beyond looking at the organization’s internal budgeting and financial policies and look toward how its revenue policies [tax and fee structures] and expenditure policies [how much is spent on which functions] affect the fiscal condition of the organization and the government’s ability to meet political demands. First, we turn to a description of public economics to better understand the division between public and private.


Public Economics

Don’t worry, you have not entered an economics class and there is no math required to understand the following material. But the public sector does play an integral role in our economic system. To understand why, though, requires a brief explanation of capitalism and public sector economics.


Capitalism and Public Economics

In macroeconomics [the economies of nations or states], there are private goods and public goods. Private goods are those that can be individually purchased and priced. So, any consumer goods like clothes, electronics, food, vehicles, etc. are considered private goods. Beyond tangible products, private goods also include services, such as attorneys, doctors, accountants, repair persons, and the like. In contrast, public goods cannot be individually purchased or priced. Typical examples includes roads, police patrol, fire protection, and similar goods and services. What makes public goods distinctive? Let’s use a lighthouse as an example, which shines a beacon of light out to sea to simultaneously guide ships and warn them of the coastline. Can you only provide the light to those who have individually purchased “lighthouse service”–no, the light is a collective good that cannot be individualized…everyone sees the light regardless of who you intend to see it. Therefore, there is no profit motive [the driver of private economic activity] in operating a lighthouse because everyone can use it, regardless of who paid. But, there is still a need for the lighthouse, so someone other than the private sector has to build and operate it.

That’s the economic basis for government–there are some economic functions that cannot be delivered by the private sector due to market failures like the lighthouse, or because they are collectively valued goods [more on these in a bit]. Market failures occur when the mechanisms of the free capitalistic market fail to produce necessary goods, or overproduces some goods to the detriment of the public. Market failures can include: 1] free-rider situations like the lighthouse where people who do not pay still receive the good; 2] externalities, where individuals other than the consumer and purchaser are affected by the transaction, such as pollution generated during manufacturing; 3] imperfect competition, when market forces create monopolies over time that limit the number of choices available to the consumer; 4] imperfect information, when consumers are not provided with enough information to make an educated purchase or cannot reasonably be expected to understand the ramifications of their purchase, [this happens often with credit cards, home mortgages, and other complex agreements]; 5] incomplete markets, where there is not enough of a profit incentive to offer a wide variety of competitive options to the consumer [student loans, flood insurance, etc.], and finally 6] macroeconomic disturbances, such as recessions and depressions. You do not need to memorize all of these for this class, but I provide these examples of market failure to demonstrate that there are times when the free market does indeed fail, which is used to justify government involvement in the economy.

There are other reasons why government may take on greater economic responsibility, and these are called collectively valued goods. They include merit goods, which are typically government regulations placed on a group of actors to promote safety, health, and well-being–no-smoking and seat belt laws are good examples. Also, equity goods provide support to the free market by temporarily assisting those harmed by economic activity [unemployed, workplace injury, etc.]. Finally, redistributive goods are an intervention in the free market to transfer wealth from the rich to the poor.

Congratulations, you just passed Public Sector Economics in less than 15 minutes! In all seriousness, though, this discussion demonstrates that the free market is not perfect and government must assume some economic responsibility to address market failures and provide collectively valued goods. Indeed, the question of how much government economic responsibility is appropriate drives much of our political debate. Regardless, this economic system seems well-suited to allow for free-market capitalism to reign while government provides an economic backstop to address the issues that fall through the cracks. Or, does it???

Government Failure

Unfortunately, governments are also not perfect when it comes to its economic responsibilities. Sometimes, government failure occurs, when action taken to correct a market failure or provide a collectively valued good does not succeed in addressing the failure or providing greater economic equity. Why does government failure occur? There are times that a government has limited capacity to act, either through a lack of legal authority or political will. The political process also favors those with political power, who are not always interested in addressing market failures or equity concerns. Finally, sometimes government does not properly execute its economic strategy, leaving the problem unsolved and setting up a need for reform or the nonprofit sector to take on the issue.


Introduction to Taxes and other Public Revenues

Revenues are the lifeblood of public organizations. No citizens enjoy paying taxes or fees to governments, but it is a necessary evil in order to receive any public services. We have no roads, clean water, collective education, convenient waste collection, efficient water drainage, or police and fire response without taxes and public fees–plain and simple. What is not so plain and simple is what is the most appropriate combination of taxes and fees. With just a few restrictions, any government is free to configure its tax and fee policy in myriad of ways to fund its public services. Therefore, a good student of fiscal policy needs to know the various types of taxes and fees, along with their attributes. This page and the following presentation will acquaint you with each type of taxes and fees, along with a system to evaluate the effectiveness of each. We begin with a survey of typical revenue sources for local, state, and federal governments; then introduce this system to evaluate tax policy.


Public Revenue Sources

Below is a description to the various sources of money for governments to spend:

  • Taxes– mandated, involuntary transfers from individuals and organizations to a government
    • Income tax– tax placed on the earnings of an individual or organization
    • Property tax– tax placed on the property holdings of an individual or organization
    • Sales/excise tax– tax placed on the purchase of goods [and some services] of an individual or organization
  • User Fees– fees paid by an individual or organization to pay directly for a particular good or service specifically provided to that entity
  • Grants/Intergovernmental Transfers– revenues received from other governments, sometimes with conditions attached
  • Enterprise Activities– fees paid by an individual or organization to a business-like component of a government that is to operate self-sufficiently
  • Borrowing– funds received from a creditor that are to be paid back in a set amount of time
  • Innovative Financing– new financing tools that generate revenue for a government, typically by granting use of public assets or deferring costs to the future
  • Investment Earnings– funds received by the successful investment of un-utilized government revenues


Breakdown by Level of Government


Local government revenue is typically dominated by the property tax. Although states have some form of property taxes [e.g., motor vehicles], the property tax is almost exclusively the domain of the local governments. Over time, the property tax has not proven to be sufficient to pay for all local services, so local revenue has been augmented over time. Many local governments now use sales tax, and some even have a local income tax. 30% of local revenue typically comes from states and the federal government through grants as well. Fees and charges are common at the local government level as well. Below is the distribution of revenues for the city of Orlando.


States typically rely upon the sales tax to fund its services. Many have also adopted an income tax for additional revenue, although Florida has not. On average, 30% of state revenue comes from grants made by the federal government [mostly for Medicaid and education]. Below you see the revenue breakdown for Indiana [which has an income tax] and Texas [which does not]. You can see the impact of not having an income tax and how that must be made up by the sales tax and other revenue sources.




The federal government is funded primarily with the income tax, which includes corporate income and payroll taxes. The other primary revenue source for the federal government is borrowing and other debt financing. This is depicted below.


Evaluating tax policy

Before you dive into the particulars of the major revenue sources, you need a framework through which to view them. One method to do this relies upon six criteria to evaluate revenue sources, which can then be used to compare revenue reform options. The criteria are introduced below and will be used throughout the following tax and fee presentation. By using these criteria, one can effectively discuss the pros and cons between various sources of the public revenue.


Tax evaluation criteria

Reliability – How predictable and stable is the revenue stream? Does the tax produce the desired revenue? How much does it swing during good and bad economic times? Will it grow [or at least outpace inflation] over time?

Equity – How is the revenue burden distributed? Who pays? Is this a fair distribution? Does the tax burden match the goods and services provided [benefits principle]? Does the tax burden match the taxpayer’s ability to pay? Equity is evaluated in two dimensions:

  • Horizontal equity – Do people in similar financial circumstances pay the same amount of tax?
  • Vertical equity – Do people in dissimilar financial circumstances pay the same amount of tax?
    • Used for redistribution purposes
      • Progressive tax – one that transfers from rich to poor
      • Regressive tax – one that transfers from poor to rich

Compliance and Administration – Known as tax efficiency, this is a measure of how easy and inexpensive it is for the government to collect the tax.

  • In terms of compliance, how many avoid payment of tax? How easy is it to avoid the tax? How much does it cost to maximize compliance?
  • As for administration, how much does it cost to collect the tax? This includes forms, customer service, collections, auditing, enforcement, prosecution. etc.

Competition – There are two dimensions of tax collection:

  • Economic development – keeping tax rates attractive for business and residential relocation and retention
  • Border effects – Do disparities in tax at political boundaries [city limits, state lines, etc.] affect the economic behavior of taxpayers?

Economic Neutrality – Does the payment of the tax affect economic behavior? Neutrality is desired so that the tax is collected without attempts to evade.

Accountability – How visible is the tax to the taxpayers? The democratic principle states that taxpayers should know the tax they are paying at the time of payment. However, accountability is not necessarily favored by elected officials because taxpayers can become disgruntled in light of this transparency.


Fiscal Federalism

Fiscal federalism is a mechanism to achieve the economic functions of government in a federal system. In practice, this means the transfers of money among governments–typically from higher levels of government to lower–in an attempt to achieve a more equitable distribution of income, maintain high levels of employment and stable prices, and establish an efficient process of resource allocation. This aspect of fiscal policy explores how governments exercise fiscal federalism.


Intergovernmental Transfers and Grants

As mentioned earlier in the module, a tremendous amount of money is transferred between the governments. Recent figures show that 27% of state revenues come from the federal government, and 29% of local revenues come from the state along with 4% from the federal government. The general rule here is that about 30% of government revenue comes from a higher level of government–illustrating vertical fiscal federalism. However, there is an increasing amount of horizontal federalism occurring also, as government at the same level [local-local or state-state] are increasing collaborating and jointly providing public goods and services.

The largest portion of intergovernmental transfers come in the form of grants. There are many well-known grant programs: Medicaid, federal highway funds, environmental projects, Community Development Block Grants, Local Law Enforcement Block Grants, Aid to Families with Dependent Children, Head Start, education grants [title]–just to name a few. Grants are typically made to incentivize certain actions by lower levels of government and/or provide a more efficient and specialized form of service delivery. Funds are distributed either in a competitive process [The granting agency reviews all applications and ranks them in order of preference, funding the highest-ranked ones until funding is exhausted] or by a formula [distributed across the entire jurisdiction based on the proportion of some demographic, such as number of students, crime rate, uninsured individuals, etc.]. Grants are made in four categories, ranging from most specific and least flexible to least specific and most flexible:

  • Project– Project grants are for the specific completion of a particular initiative. Project grants are usually competitive, which means that potential grantees must make an application for a portion of a certain amount of available funds. These grants are restricted to one project and the activities identified in project plan, making it very specific with little flexibility.
  • Categorical– Categorical grants are usually associated with a specific program, such as Head Start or Aid to Families with Dependent Children. These tend to be more operational than project grants, meaning they fund ongoing activities over multiple years. Categorical grants can be either competitive or formulaic, depending on the program design. Since they encompass entire programs, they are less specific than projects and provide some additional flexibility to the grantee.
  • Block– Block grants are wider in scope as they are offered for a particular purpose or outcome. The Community Development and Local Law Enforcement block grants are good examples–they are offered to local governments for any projects or programs that improve community development or assist law enforcement activities, respectively. They are typically formulaic grants. They are less specific and more flexible than categorical grants.
  • Revenue Sharing– Revenue sharing is just straight transfers of funds from one government to another, no strings attached. Clearly, this is the least specific and most flexible of all intergovernmental transfers. Higher levels of government typically conduct revenue sharing to help stabilize the finances of lower levels of government and help them weather economic downturns.


Federal and State Mandates

Vertical fiscal federalism can multiple forms. In some cases, higher levels of government incentivize behavior, but in others they mandate action. These mandates can be funded or unfunded. Funded mandates are obviously more palatable to states and localities, but sometimes unfunded mandates are justified to pursue a legal or moral imperative. Federal mandates increased dramatically from the 1960s to 1990s in the areas of civil rights, environmentalism, and public safety, creating pushback from states and localities which ultimately resulted in the Unfunded Mandates Reform Act of 1995. Although the legislation itself was not terribly effective, its symbolic value marks a sea change in Washington when it comes to trying to dictate local affairs. Regardless of the prevailing sentiment, federal mandates are an important part of the fiscal federalism discussion.


Other Fiscal Policy Tools

Governments do have a few more fiscal policy tools at their disposal, and many of these have come into increased use over the past few decades. This page introduces the concepts of 1] fiscal slack, 2] tax and expenditure limits, and 3] monetary policy.


Fiscal Slack

Fiscal slack refers to the extent of non-utilized funds by a government…in other words, surplus. The total fiscal slack is the total amount of surplus [or balance] in all of the funds. The Government Accounting Standards Board [GASB] divides fund balance into five categories:

  • Nonspendable– This refers to surplus assets such as inventories. Since these items have been purchased, they are no longer in monetary form and instead are in physical form. Even though nonspendable fund balance is no longer in terms of cash, for accounting purposes these are reported in terms of monetary value.
  • Restricted– This includes amounts that can be spent only for the specific purposes stipulated by constitution, external resource providers, or through enabling legislation.
  • Committed– This includes amounts that can be used only for the specific purposes determined by a formal action of the government’s highest level of decision-making authority.
  • Assigned– This includes amounts intended to be used by the government for specific purposes but do not meet the criteria to be classified as restricted or committed.
  • Unassigned– the residual classification for the government’s general fund and includes all spendable amounts not contained in the other classifications.

Budgetary policy defines which surplus revenues fall into each of these categories. The first four categories are largely defined by federal law, state statute, municipal ordinance, or other broader forms of policy. They are typically considered as “givens” in the budgetary process and not altered without a significant policy debate. Therefore, it is the unassigned fund balance that is of most interest to budgetary policy. This is because credit rating agencies often consider the unassigned fund balance of the general fund to be an indicator of financial health. These rating agencies typically recommend that a government maintain an unassigned fund balance of 25-33% of general fund annual operating expenses to handle natural, economic, or man-made disasters. Such levels of unassigned fund balance are a substantial component of the ability to receive the top “AAA” credit rating available. Therefore, although it is tempting for budgetary decision-makers to raid the unassigned fund balance to solve budgetary shortfalls, governments must balance its short-term budgetary pressures with its long-term need to maintain a high credit rating and minimize borrowing costs. This tension ensures that the fiscal slack discussion is part of almost all annual budgetary debates.


Tax and Expenditure Limits

Tax and expenditure limits [TELs] are attempts to restrict the growth of government, mainly driven by ballot initiatives or taxpayer revolts since the mid-1970s. There are many types of TELs, but we will look at five categories:

  • Revenue– these limits restrict all revenue or specific taxes to a certain amount of growth annually, typically tied to a rate such as personal income growth, inflation, population, or a set percentage. Collection of revenue beyond these limits results in refunds to taxpayers. The State of Florida has a revenue growth limit tied to the rate of annual personal income growth.
  • Expenditures– similar to revenue limitations, but apply to spending instead. These are predominant in the West and the South.
  • Hybrids– Some states use a combination of revenue and expenditure limits.
  • Voter approval requirements– These limits are based on the process of approving increases, not the amount of increase. Where voter approval requirements exist, any revenue or expenditure increase beyond a certain amount [in some cases, zero] must be present on a ballot to voters, who must approve the question.
  • Supermajority requirements– These are similar to voter approval requirements, but are applied to the lawmaking body instead. They require more than a majority to approve of the revenue or expenditure increase.

In many ways, balanced-budget requirements are a form of expenditure limits because they force a government to ensure that its spending does not exceed its projected revenues plus fiscal slack. However, many balanced-budget requirements do not have any tremendous impact upon spending. While 37 states that spending match revenues at the end of the fiscal year [a truly balanced budget], two states only require that the legislature approve a balanced budget [which the state can deviate from during the fiscal year], and four more states only require the governor to proposed a balanced budget [allowing the actual approved budget to be out of balance]. Seven states have no balanced-budget requirement at all. And in all cases, there is no legal penalty if a state fails to pass a balanced budget–only political fallout.


Monetary Policy

At the federal level, the government utilizes monetary policy to influence the economy. Through its power to set basic interest rates [to which the credit markets tie their interest rates] and regulate the supply of money, the federal government attempts to stabilize the economy so that it does not grow or contract too fast–the goal is continued, stable growth. This is why there is so much interest in the activities of the Federal Reserve Bank, because what they decide about raising, maintaining, or lowering interest rates impacts all public and private loans and credit. Likewise, its action on money supply can increase or decrease the value of American goods compared to those from around the world.


Fiscal Policy Summary

As you can see, a number of the most visible and controversial public policy discussions occur within the budgetary process. Decisions regarding tax policy, expenditure allocation, budgetary and financial processes, monetary policy, and budgetary restrictions all occur inside the budgetary arena. Thus, the outcome defines a tremendous amount of public policy. Beyond just controlling government spending, fiscal policy provides much of the definition of government boundaries – what it does and does not do. Therefore, fiscal policy is the primary example of the policy function of budgeting.



Translating Policy into the Budget

A number of intermediate policy decisions help shape the annual budget. These decisions are largely guided by external conditions [such as the economy and politics] and broader fiscal policy. They create assumptions that must be incorporated into the budgetary calculations before allocations are determined. We examine a few here.


Short-Term Factors

These intermediate policy decisions are translated into the budget as items referred to as short-term factors. These can be related to salary and benefit guidelines or requirements [such as union agreements or promised raises], fee structures, planned capital improvements, planned program enhancements or reductions, tax policy, use of fiscal slack, assumptions about service levels, unfunded mandates, economic development strategies, inflation assumptions, and demographic assumptions.

All of these represent short-term policies that have been enacted for that particular budgetary cycle. They provide the foundation for budget building: salary guidelines lead to personnel cost projections, tax and fee policies as well as economic development strategies lead to revenue projections, service-level assumptions and unfunded mandates lead to expenditure projections, and economic and demographic assumptions influence them all. Thus, decisions must be made about the short-term factors that influence the budget, creating assumptions that are used as budgetary foundation. This relationship is depicted in the following illustration:

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