Government Growth, Institutional Erosion, and the Fiscal Squeeze: Nebraska as a Case Study
Michael Thomas and Diana Thomas
This paper offers a case study of the state of Nebraska and of the institutional and ideological changes underpinning increasing budgets and fiscal pressures at the state level over the last century. The case study substantiates the phenomenon of the fiscal squeeze of state budgets between increasing fiscal responsibilities for local public goods production and ever greater levels of federal influence over policy priorities in the state. We identify the erosion of the institutions that define fiscal federalism as a major factor creating this squeeze. Empirically, paying for local public goods like school funding, health care funding, and pension funds, to name a few, has strained the ability of the state to keep balanced budgets. At the same time, federal mandates make it impossible for states to focus on local priorities to manage expenditure but they come with limited guarantees for federal funding and therefore create additional budgetary pressures. Whereas in the past federal government grants have been a source of funding, there is great uncertain that the federal budget will continue to aid states in financing programs that were shaped by federal government policy.
The growth of government over the last century has received much attention and study. Various theories explaining the phenomenon have been advanced from preference-based stories of government as a luxury good (Cowen 1999), over theories emphasizing the expansion of the voting franchise as causally related to government growth, to an institutional explanation of the growth of government as a ratchet effect of political crises (Higgs 1987). At the same time, governments at the local, state, and federal level are facing severe and systematic budget deficits and, in extreme cases, fiscal crises and default.
Rather than offering a broad explanation for government growth and the related fiscal malaise, we use a case study of the state of Nebraska over the last 100 years and offer an overview of the micro-foundations of institutional and ideological changes underpinning the macro-phenomenon of government growth and fiscal deficits. Put differently, this paper provides a theoretical exploration of existing empirical trends underpinning government budgets at the state, local, and federal level. We identify the erosion of the institutions that define fiscal federalism (Oats 1972, 1999) as a major factor enabling government growth and identify one important fiscal consequence of this 100-year-old trend in how public finance institutions are organized. The specific consequence we focus on is what we call the fiscal squeeze of state budgets: states, like Nebraska, have remained fiscally responsible for decisions that are now made at the level of the federal government. Empirically, paying for local or municipal expenditures like: school funding, health care funding, and pension funds, to name a few, has strained the ability of many states to keep balanced budgets and avoid debt or default. Whereas in the past federal government grants have been a source of funding, there is great uncertainty that the federal budget will continue to aid states in financing programs that were shaped by federal government policy. Either the various state budgets and programs will face much-needed reform, or state taxes will have to continue to rise as a proportion of income.1
An emerging literature on fiscal sociology (Wagner 2007) and entangled political economy (Koppl & Horwitz 2014) seeks to bridge the gap between static models of traditional public finance and the realities of entangled government budgets. We seek to contribute to this literature by offering the case of Nebraska’s fiscal situation as an example of a larger trend of financial responsibilities shifting from municipalities to states and decision making authority being turned over from states to the federal government. This separation of decision making from budgetary responsibility has resulted in a budgetary squeeze for the state of Nebraska and may be a generalizable phenomenon. Section II briefly defines the idea of the budgetary squeeze and details the movement of responsibility from the local level of government to the state as well as the problems created by federal transfers to states when they come with mandates about how to carry out those duties. Section III offers the case of Nebraska as an example of the phenomenon of the squeeze. Section IV concludes.
The Squeeze Defined
Almost all U.S. states are currently facing budgetary pressures in some shape or form (Norcross and Gonzales 2016). We have argued elsewhere that this general trend is part of a larger phenomenon which we have elsewhere referred to as the fiscal squeeze (Thomas & Thomas 2019). Among the three levels of government, each has their own means of revenue collection and is tasked with setting spending priorities. In theory, spending and revenue collection at the three levels are compartmentalized and can be analyzed independently.2 In line with the literature in institutional public finance, we argue, that, in practice, revenue collection and spending on the three levels is interrelated and trends at each level can be traced back to general phenomena dominating the public finance landscape.
The first component of the squeeze of state budgets is a result of fiscal responsibilities shifting from the local level to state budgets. Relatively straightforward fiscal models historically constrained the ability of politicians at the state and local level to increase expenditure. In Nebraska, for example, the sole source of revenue for both state and local governments were property taxes for the first roughly 100 years of the states existence. From the perspective of tax payers, spending priorities were clearly divided and attributable to either state or local portions of the property tax and prevented the state from taking on tasks that were local in nature.
Since mid-20th-Century, there has been a general trend for revenue collection and spending responsibility to shift from local government to the state level. Concerns about equity in the middle of the 20th century both at the federal and state level justified a movement away from a constrained fiscal model of largely locally funded public goods provision. The advent of the automobile had resulted in wealthier households moving to suburban communities, which left urban areas relatively poorer. At the same time, increased mobility allowed non-paying individuals from neighboring communities to take advantage of amenities financed by local property taxes. The resulting economic segregation and increased concerns over free-rider problems led to calls for a greater involvement of state government in financing public goods that were previously municipally funded. In addition, municipalities expanded in size to solve the problem of internalizing spillover effects that accrued to ever-larger geographic areas. The unfortunate consequences of larger municipalities and greater state involvement in funding local public goods were threefold: 1. aggravated fiscal commons problems (Radula 2010, Wagner 2012), 2. greater fiscal illusion (Buchanan and Wagner 1977), and 3. increased monitoring costs.
As the scale of governance organizations grew, citizens confronted a more complex governance organization and faced an increased cost of monitoring the fiscal institutions of their particular municipality. State governments were not only more complex in terms of organization and budgets but also geographically removed, which made monitoring by fiscally concerned citizens difficult. Ultimately the revenue and spending models in most states were changed so substantially that their budgets were placed on an unsustainable path.
The second side of the squeeze is the federal influence on state policy, federal-to-state.
This trend is largely the result of an increasing use by the federal government of regulation, intergovernmental grants, and matching funds to influence state policy. Over the 20th century arguments regarding the negative spillover effects of economic activity both in terms of environmental damage as well as consumer health and safety were used as the primary justification for an increase in federal regulation that affected ever greater spheres of economic life in the states. In addition, arguments about the relatively greater level of expertise of politicians and bureaucrats at the federal level as compared to their often part time counterparts at the state level, formed the basis for greater federal involvement in state policy through mandates regarding health and welfare policy in particular. The bargain of adopting federal priorities in exchange for funding has accumulated over time to limit the states’ ability to determine their own priorities.
The macro phenomenon of the squeeze is the simultaneous shift of local government responsibility as well as financing for things like school funding and policy to the state level (local to state) along with the increased oversight from the federal government through regulation and mandates for the execution of state administered programs (federal to state), which, however, comes only with limited financial support. State budgets have been squeezed between these federal mandates, which remove the states’ ability to set their own priorities, and greater responsibility for the financing of local public goods. As a result, states have taken on financial responsibility for a much greater scope of programs, which they cannot execute competently without federal expertise and guidance. We explore this trend in greater detail for the state of Nebraska below.
Nebraska: Spillover effects and Inequality – the shift from Local to State
As in most other areas of the country, Nebraska experienced a significant expansion of its metropolitan areas (most prominently Omaha) with the rise of local mass transit and the automobile over the course of the early 20th century. Workers were leaving downtown Omaha to return to their families in the newly emerging suburban areas around the city. This trend became the justification for the annexation of neighboring towns by the city of Omaha starting in the early 20th century. Annexations continued throughout the 20th century with the most recent annexation of several neighborhoods located mostly on the north-western border of the city in 2018. As the city expanded in scale, so did most aspects of its governance structure, with the exception of schooling. While the city annexed neighboring towns, the newly integrated school districts remained as separate entities.
The emerging differences in property values in different parts of the growing municipality created different revenue profiles for the school districts. As a result, inequality of public services became a more obvious reality in the unified, expanded city. The perception in Omaha public schools was that the urban school district was in crisis due to economic segregation. 3 The rise of the automobile meant that those who could afford to live in the areas to the south and west of Omaha were moving to suburbs where property values were rising quickly. The areas of town that they left behind saw property values tank.
From the point of view of the Omaha Public Schools (OPS) the rising inequality between outcomes and funding in different school districts within Omaha required attention. The OPS district invoked a line of text from previous legislation, “One city, one district” and argued that the natural course of events would have allowed Omaha city schools to expand south and west as the city grew. 6 The incorporation of new cities on the outskirts of Omaha meant that the city’s school district was “landlocked” and must find a way to tax the people who have escaped into surrounding areas, a classic spillover argument. Annexation of the surrounding school districts seemed like a plausible remedy that would help to shore up the local government revenue portion of the eroding budget, while also forcing an equalization of the now more segregated districts.
In addition to the increase in the size of the municipality and it’s school districts, calls for the state to play a larger role in redistributing resources between localities by contributing to local schools have been prominent in the conversation surrounding education since the 1960s.
Prior to 1967 education funding in Nebraska was exclusively sourced from local property taxes. In 1967, Nebraska’s legislature first passed a funding bill that redistributed income through the state. The School Foundation and Equalization Act (LB 448 1967) was part of a broader movement across different states to create more equal schooling for students that would not be dependent on where they happened to live.7 The Nebraska bill included foundational aid to all school districts based on enrollment, as well as equalization aid to redistribute towards lower income districts (Dulaney 2007). Finally, the 1967 bill also included incentive aid to allow school districts to hire better trained teachers and experiment with summer programs etc. This was the first move in homogenizing school districts in the state. The move continued the efforts to equalize outcomes for students.8 This redistribution program between the school districts in the state was financed by state taxes while local taxes and spending stayed roughly the same. As a result, the combined tax burden to finance education of Nebraska’s taxpayers increased.9 10The 1967 bill grouped schools into districts with and without high schools. One particular goal of this classification was to make it harder for residents to avoid taxes by moving to school districts without high schools. Homes in districts without a high school had lower property taxes because they merely funded elementary schools. This caused problems as some property owners were treating the low property tax districts as “tax havens.”11 In 1987 districts without a high school were merged with other districts that had a high school.12 This law also pushed back against the Tiebout competition that had led to people moving to districts without high schools.
The only obstacle for the Omaha Public Schools district in its fight for greater equalization of district revenue in Nebraska, was the question of constitutionality of collecting funds from one municipality and spending them in another. This had been interpreted as a “state use” which seemed to be prohibited by precedent in the interpretation of the Duis Amendment (Simpson 1985). Schools on the outskirts of Omaha challenged the one-city, one-district notion based on this precedent. The appeal was lost in 2005.
Following these developments, each of the school districts in Omaha were charged a common levy ($0.05 per $100 of taxable property ~ $75 a year for a home valued at $150,000). The transfer of funds to Public schools became a major source of reform within the state, that threatened the distinct spheres of local spending and state spending.
The older system of funding schools through property taxes is yielding to a newer system increasingly based on state-aid-to-local school districts. Figure 3 shows the decreasing revenue from property taxes and the increasing state aid for school districts across the country.
In line with the changes in school district financing, the tax system in Nebraska changed as municipalities increased in size and school district financing became a cross-district issue. Historically, the state of Nebraska was limited to property taxes as its sole source of revenue, as were most other U.S. states. Having a single source of government revenue provided clarity and accountability, and acted like a disciplinary mechanism
From the very beginning of Nebraska statehood there was a strong constraint placed on revenue and therefore spending. 14 A local property tax paid for things like schools and police, and there was a state property tax to run the operations of the state government. In an attempt to keep the state government’s ability to tax residents contained, voters approved the so called “Duis Amendment” in the 1954 General Election, which stipulated that in the event that the state should implement an income or sales tax system, the state general property tax would be automatically eliminated. In 1965 the Nebraska legislature, introduced the first state income tax system, thereby triggering the Duis amendment and eliminating the state-level property tax.
Business interests from across the state, who were opposed to the income tax, quickly took action and formed a referendum petition to repeal the new income tax. But farm interests similarly initiated a petition to remove the property tax provision from the constitution. On November 8th, 1966 voters approved both petitions leaving the state without any tax revenue. This situation forced the 1967 legislature to produce a new revenue bill that would return the state to a situation of having a stable source of revenues. The solution the legislators designed introduced a first ever income and sales tax system for the state of Nebraska, which was signed into law by Governor Norbert Tiemann in 1967.
Nebraska’s constitution was initially strong on fiscal restraint. By focusing on a single source of tax revenue at both the local and state level (both property taxes), the problem of fiscal illusion was minimized, taxpayers could accurately assess tax prices of the government services they received, and government expansion was therefore limited by mostly accurate assessments of the relative costs and benefit of different programs to the individual taxpayer. With the expansion of the set of priorities given to governments at the local, state, and federal level as part of the great society programs, however, a shift of decision making authority from the local to the state and federal level resulted in an aggravated commons problems (i.e. a greater number of potential beneficiaries and a more dispersed cost structure), an expansion of the scope of government, and a parallel complication of the tax structure in order to finance the newly identified priorities. As Wagner (1976) shows, this last development of increasingly complex tax/revenue structures, came with greater potential for fiscal illusion and a separation of the actual cost of government
There are excellent reasons to reconfigure a tax code. One is simply to structure the tax more equitably.15 When Nebraska moved away from the state property tax it did so completely.16 The use of income and sales taxes in its place had the feature of providing broader tax base than the state property tax. The problem was that it introduced an added level of complexity in administering, collecting, and understanding the tax code. When local taxes didn’t decrease and the revenue went to pension obligations for public employees, this move wasn’t a shift of tax burden but an addition to the tax burden. In fact, the tendency for spending to go to higher levels of government (local to state, state to federal) while having less than a one-to-one decrease in spending at the lower level was pointed out by Jack Osman as early as 1966.17
The developments regarding both education financing and the structure of the tax system in the state of Nebraska over the 20th century have left the state with a much more complex system of revenue collection as well as government spending. The primary justification for the increased complexity of education spending was a desire for greater equalization of education funding across school districts with different socio-economic profiles. While tax complexity and subsequently the overall level of taxation have increased, it is unclear that school district funding or outcomes are significantly more equal now than they were in 1967. Overall, the state has taken on a greater role in funding and regulating education, which used to be an exclusively local issue. This historical evidence supports the first theoretical leg of the idea of the fiscal squeeze of the states through a movement of responsibility and spending from the local to the state level. In what follows, we discuss the second part of the squeeze, which considers the fiscal dynamics between the state of Nebraska and the federal government.
Federal to State: The second part of the squeeze
Nebraska is a net recipient of federal tax dollars based on a Tax Foundation report from 1981—2005.18 The $1.10 and received per dollar spent places Nebraska squarely in the middle of the pack of states receiving federal tax transfers from other states. This is a good position to be in at the moment, but as the federal budget position weakens (increased entitlement spending like social security, Medicare, and Medicaid) the pressure on states to fund greater amounts of these expenditures increases.19 This pressure has the likely effect of lowering transfers to net tax recipient states.
Mandates are intended to create equivalent conditions for citizens between jurisdictions. This is an appeal to equity that means that a higher level of government sets standards that have to be met by lower levels of government. It makes sense that some uniformity exist between different parts of the same state or country, but mandates can be divided into two general categories depending on how they are financed. Funded mandates are specifically tied to expenditure at the level of government where the mandate is imposed. An unfunded mandate is a mandate that must be followed even without expenditure from the higher level, this could be partially funded or totally unfunded. A state which requires an after school program but does not earmark spending in the budget creates an unfunded mandate on a local government. Federal mandates for many programs including Medicaid come with funding already earmarked.
Examples of categories of mandates include: General Civil Rights, Discrimination, Emergency Aid (disaster relief), Mandatory Auditing Procedures, Homeland Security, and Social Security and Disability.
Federal programs set mandated levels of either spending or outcomes that then have to be met by states. As federal budgets decrease (either by explicit cuts or by failure to inflation adjust) the obligations for states rise. In January 2013, Gov. Dave Heineman spoke about the impact on Nebraska of one mandate in particular, Medicaid:
“The most significant challenge in enacting a biennial budget for 2013-2015 will be the financing of the Medicaid program in Nebraska. I have placed the highest priority on financing education, but the requirements presented by the current Medicaid program and the implications of new federal mandates cause an explosive demand for state resources.” – January 15, 2013 – State of Nebraska 2013-2015 Biennium Budget, p. 6.20
Until 2018, Nebraska joined other states in rejecting the Medicaid expansion that comes with the Affordable Care Act, although the issue is on the ballot for the November 2018 election. The concern in states like Nebraska which have failed to approve Medicaid expansion is whether the federal government can commit to the bargain, more standards for 90% payment, or if Medicaid transfers from the federal government will fall below this point in the foreseeable future.
Empirically, Medicaid expenditure in the state of Nebraska increased from 10.5% of state revenue in 2000 to 15% in 2016. Nebraska’s Medicaid expenditures did not deviate from the trend across the 50 states despite the fact that Nebraska chose to not expand Medicaid coverage in the wake of the Affordable Care Act. Medicaid funding from own-source revenue as opposed to federal grants and aid increased in all 50 states between 2000 and 2016 with an average increase in state revenue spending of 4.9% points. Figure 1 shows the trend for both Nebraska as well as all 50 states. Nebraska’s expenditures are, in line with the prediction of the fiscal squeeze theory that states are spending increasing amounts of their own tax resources on federally designed programs.
Infrastructure expenditures are another budget item that historically received a lot of attention and funding from the federal government, but is increasingly becoming a state issue. In an effort to get ahead of the problem, Nebraska recently raised its gas tax, which suggests the state is taking greater control of its own infrastructure and relying less on USDOT. This keeps the current federal gasoline tax in place, but looks to raise additional revenue for expanding roads internally, with the state taking more responsibility.
Nebraska faces a looming fiscal problem, as do many other US states. Nebraska has long benefited from a relatively good financial position, but the expansion in the scope of tasks the state now manages has undermined the ability of the state to set priorities and limit spending.
This is occurring everywhere as a result of two pressures. The first pressure is to accommodate more spending at the state level that has traditionally occurred at the local level. This is a response to a concern over inequality in spending between local jurisdictions, particularly with regard to schooling. The second pressure comes from the federal government, which encourages an increase in tasks that the state takes on by partially funding programs for a while and then backing off from initial funding commitments. This reduction in federal support for state spending is likely to continue as pressures on the federal budget increase due to entitlement spending increases. The way forward is to set realistic priorities for spending at the state level.
Nebraska is in a better position to manage this task than other states. Reforms that increase efficiency are possible including setting priorities in health care and exploring school choice options . These reforms will help keep Nebraska’s fiscal house in order and avoid the looming budget crisis brought on by changing budget circumstances.
Anderson, John E. and Eric C. Thompson. (2014) “Property Taxes in Nebraska: Past, Present, and Future” Platte Institute for Economic Research. Accessed August 18, 2016. http://www.platteinstitute.org/research/detail/property-taxes-in-nebraska-past-present-and-future
Buchanan, James M. and Richard E. Wagner. (1977). “Democracy in Deficit: The Political Legacy of Lord Keynes.” Indianapolis: Liberty Fund.
Dulaney, Mike. (2007) The History of the Nebraska Tax Equity and Educational Opportunities Support Act. Dissertation. Accessed September 4, 2015: http://www.ncsa.org/dr-michael-dulaney
Higgs, Robert (1987). Crisis and Leviathan: Critical Episodes in the Growth of American Government.
Oxford University Press.
Inman, Robert P. (2008). “The Flypaper Effect.” NBER Working Paper 14579.
Jargowsky, Paul A. (1966). “Take the Money and Run: Economic Segregation in US Metropolitan Areas” American Sociological Review. 61(6), 984-998.
Koppl, Roger and Steve Horwitz (eds.) (2014). Entangled Political Economy. Emerald Group Publishing Limited
Norcross, Eileen and Olivia Gonzalez. Ranking the States by Fiscal Condition. Mercatus Working paper.
June 2016 Accessed August 9, 2016: http://mercatus.org/sites/default/files/Norcross-Fiscal- Rankings-2-v2_1.pdf
Norcross, Eileen and Frederic Sautet (2009). Institutions Matter: Can New Jersey Reverse Course?
Mercatus Working Paper, Accessed September 4, 2015: http://mercatus.org/publication/institutions-matter-can-new-jersey-reverse-course.
Oats, Wallace E. (1999). “An Essay on Fiscal Federalism.” Journal of Economic Literature, 37(3): 1120- 1149.
Osman, Jack W. (1966). “The Dual Impact of Federal Aid on State and Local Expenditures.” National Tax Journal. 19(4), 362-371.
Radula, Ringa (2010) “Governing Budgetary Commons: What we can learn from Elinor Ostrom.”
European Journal of Law and Economics. (30), 201-221
Simpson, Mary Margaret. (1985) “A Profile of Nebraska’s Community College System.” Nebraska Technical Community College Association, U.S. Department of
Thomas, Michael D. and Diana W. Thomas (2018). The Fiscal Squeeze Defined. Working Paper.
Tiebout, Charles (1956) “A pure theory of local Expenditures” Journal of Political Economy. 64(5), 416- 424
US Department of Education. (2015) “Public School Revenue Sources” Institute of Educational Sciences National Center for Education Statistics. Accessed September 4, 2015: http://nces.ed.gov/programs/coe/indicator_cma.asp
Walczak, Jared. (2016) “A Twenty-first Century Tax Code for Nebraska.” Tax foundation. August 18.
Accessed August 18, 2016 http://taxfoundation.org/article/twenty-first-century-tax-code-nebraska Wagner, Richard E. (1976) “Revenue Structure, Fiscal Illusion, and Budgetary Choice.” Public Choice.
Wagner, Richard E. (1992) “Grazing the Federal Budgetary Commons: The Rational Politics of Budgetary Irresponsibility.” Journal of Law and Politics. (9), 105-119
Wagner, Richard (2007a). Value and Exchange: Two windows for economic theorizing. Review of Austrian Economics 20, pp. 97-103.
Wagner, Richard E. (2007b) Fiscal Sociology and the Theory of Public Finance: An Exploratory Essay.
New Thinking in Political economy series. Edward Elgar.
Wagner, Richard E. (2012) Deficits, Debt, and Democracy: Wrestling with Tragedy on the Fiscal Commons. Edward Elgar.