A strong economy, a stock market boom, and a red-hot real estate market have spelled good news for Virginia state and local government finances. Growth of tax revenue has been especially robust for state government because of its reliance on the individual income tax. In recent years tax collections have exceeded forecasts. So far, the state government has had the money to finance the reduction of the car tax, the lowering of the sales tax on food for home consumption, increased state aid to localities for law enforcement, and lower tuition for Virginia students in state-supported colleges.

Will the good times last? Skeptics about the sustainability of the economic expansion and the stock market boom have been wrong. On the other hand, history teaches us that not everything always works out favorably. There are real risks of a slower economy, inflation, a stock market dive, a jump in unemployment, and other unwelcome events. With these risks in mind, I shall review basic information about state and local government finance and identify important issues that we may face.

STATE AND LOCAL GOVERNMENT EXPENDITURE

Public education tops state and local government spending: 25.6 percent in FY 1996, the most recent year available from the Census Bureau (Figure 1).¹ Welfare ranked second and higher education was third. Highways accounted for 8.7 percent of spending and health and hospitals, 7.3 percent. Police and fire protection accounted for 5.1 percent of the total, interest on general debt used 4.9 percent, and sewerage and waste management used 4.2 percent. Corrections accounted for 3.8 percent of outlays. "All other," a category including such functions as financial administration, judicial and legal affairs, housing and community development, and parks and recreation, accounted for 17.8 percent of the spending dollar.

From 1986 to 1996 state and local spending in Virginia grew at an average annual rate of 7.1 percent. Although outlays increased for all major functions, growth rates varied (Figure 2). Spending on welfare and corrections grew most rapidly. Since 1996 welfare reform and a strong economy have worked together to reduce welfare outlays. The rate of growth of expenditures for public education, police and fire protection, interest payments, sewerage and waste management, and the "all other" category was close to the average rate. Outlays on highways, health and hospitals, and higher education grew at annual rates well below the average.

With the exception of the late 1980s and the early 1990s, the past 13 years have been free of any significant inflation. Over the 1986 to 1996 period as a whole, prices paid by state and local government rose at a 3.1 percent average annual rate.² Thus, adjusted for inflation, government outlays grew at a 3.9 percent average annual rate.

STATE AND LOCAL GOVERNMENT REVENUE

Total general revenue consists of three sources: taxes, federal aid, and charges and miscellaneous fees. In FY 1996 taxes accounted for 59 percent of the total. From 1986 to 1996 the share of taxes declined after reaching a high of 63.7 percent in 1988. Federal aid accounted for 14 percent in 1998. The federal share fell from a high of 17.2 percent at the beginning of the period and was stable in the last five years. Offsetting the declining shares of taxes and federal aid was the category of charges and miscellaneous revenue, which rose sharply from 21.4 percent at the beginning of the period to 27 percent in 1996.

Recently, the state individual income tax has been the leader of state and local tax revenue growth. The tax, which is the most important single source of tax revenue in the commonwealth, accounted for 28.9 percent of total taxes in FY 1998, its highest share over the 13 years from 1986 to 1998. The real property tax was second in importance with a 19.3 percent share in 1998, far below its peak share of 23.8 percent in 1992. The relative contribution of the sales and use tax (state and local combined) declined consistently, ending with 15.4 percent. The personal property tax, also known as the car tax because of the importance of motor vehicles in the personal property tax base, rose from 6.2 percent of tax revenue in 1986 to 7.3 percent in 1998. This share will decline in the future as state aid replaces much of the local personal property tax under the car tax repeal adopted by the 1998 General Assembly.

Motor fuel taxes furnished 4.1 percent of tax revenue in 1998, the lowest share since 1991. Unlike most other state and local tax sources, state motor fuel taxes are not ad valorem taxes, i.e., they are based on gallons sold rather than the value of the sale. ³ Consequently, falling gasoline prices in recent years have not adversely affected motor fuel tax revenue. In fact, the opposite has been true because the lower price has spurred consumption. Other taxes make up about a quarter of total tax revenue. Among these other taxes are the state corporate income tax, local consumer utility taxes, the state insurance premiums tax, and local property taxes on public service corporations. The share of other taxes was similar to what it was in 1986. However, in the intervening years this share dropped to a low of 21.2 percent in 1992 before returning to its earlier levels.

The individual income tax is the mainstay of Virginia state and local government. Although it is reserved for the state government, the tax is a major source for state aid to local governments. Because of its importance, the income tax warrants further discussion. The most current data cover tax year 1996. From 1990 to 1996 there was a $3.9-billion cumulative increase in tax collections. About four-fifths of this increase was due to personal income growth and roughly a tenth was due to a rise in the effective tax rate. The effective rate is computed by dividing tax liability by net taxable income. As more taxpayer income moves into the higher rate brackets, the effective rate rises. In Virginia, the effective rate rose from 4.76 percent in 1990 to 4.96 percent in 1996. The remainder of the growth was due to a rise in the ratio of taxable income to personal income and the interaction of the identified factors. Thus, by far the largest source of growth was the increase in personal income, accounting for a gain of $3.2 billion. Nonetheless, the other factors added a not insubstantial $693 million.

What about the role of capital gains in income tax collections? Because of the booming stock market, taxable capital gains have grown rapidly. Since most capital gains are declared by wealthy taxpayers, the bulk of income from this source is taxed at Virginia's top rate of 5.75 percent. According to Internal Revenue Service data on federal returns filed in Virginia, net income from capital gains constituted 4.8 percent of adjusted gross income in 1996, a seven-year high. Because of the continued rapid rise in the stock market, it is very likely that capital gains' share is even higher today. Growth of capital gains does not stem solely from regular stock trading; it also arises when taxpayers exercise stock options that have been given in lieu of wage and salary compensation. In high-tech Northern Virginia, a number of Internet entrepreneurs and employees have benefited from large stock options.

In the future, two aspects of the tax should be addressed. First, the tax rate structure is an anachronism. The tax now has four brackets: 0 to $2,999.99 at 2 percent; $3,000 to $4,999.99 at 3 percent; $5,000 to $16,999.99 at 5 percent; and $17,000 and over at 5.75 percent. In 1926 when the commonwealth adopted the modern day income tax under the sponsorship of Governor Harry Byrd, the brackets were 0 to $2,999.99 at 1.5 percent, $3,000 to $4,999.99 at 2.5 percent, and $5,000 and over at 3 percent. Thus, although the rates were increased, the first two brackets have not been changed since the Byrd Administration. Adjusted for the nine-fold increase in prices since then, the first two brackets in 1926 were equivalent to 0 to $27,523 and $27, 523 to $45,871 in 1998 dollars. In the early days, few returns had taxable incomes above the top of the first bracket. Today, nearly all returns exceed the top of the second bracket, and many are subject to the top rate. Either we should dispense with the charade of a progressive rate structure by adopting a flat rate tax or the current brackets should be made much wider.

The U.S. Supreme Court decision that forced Virginia to stop taxing federal retirees while exempting Virginia state and local government retirees caused the General Assembly to revisit the taxation of elderly taxpayers. The result was a large tax break for middle and upper income elderly taxpayers that was implemented in 1990 and fine-tuned in later years. Virginia now provides taxpayers aged 65 or older with a $12,000 deduction from the adjusted gross income reported on federal returns. Taxpayers aged 62 through 64 are eligible for a $6,000 deduction, a significant break for the elderly. A married couple age 65 receives a deduction of $24,000 plus extra age exemptions of $1,600. Rewarding the elderly may be good politics, but from a public policy standpoint it makes little sense to provide tax relief based solely on the age of a taxpayer. Such relief will grow increasingly costly as the baby boom generation begins to retire.

STATE AND LOCAL GOVERNMENT DEBT

One way governments can finance outlays is through debt. Of course, eventually taxes or charges and miscellaneous fees must be used to cover interest and debt redemption. With respect to debt, Virginia has a reputation for conservativism. Under the guidance of the Byrd organization, the state government was noted for its "pay as you go" policy of shunning debt in favor of financing capital outlays from current revenue.

At the close of FY 1996 Virginia's state and local government long-term debt outstanding was $24.1 billion. Of this amount, 36 percent was state and 64 percent local. Only one-third of the total was guaranteed with the full faith and credit of the issuing governments. The remainder was in non-guaranteed bonds whose interest and principal payments were tied to specific revenue sources. Very little of the state government debt was guaranteed, perhaps one reason why the state receives the best bond ratings possible. Virginia local governments rely upon both general obligation and revenue bonds. In general, Virginia local government bond issues receive very favorable ratings.

Two measures can be used to compare Virginia state and local government debt with other states: per capita debt outstanding and debt outstanding per $1,000 of personal income. By either measure, Virginia falls below national averages. In FY 1996 Virginia state and local government per capita debt was 83.7 percent of the national average. Debt in relation to income was 80.7 percent.

THE CONNECTION BETWEEN VIRGINIA STATE AND LOCAL GOVERNMENT

State and local government finances are intertwined and must be looked at together. The two levels of government jointly serve residents of the commonwealth, share many functions, and offer alternative ways to raise revenue and spend it. Table 1 provides information on Virginia state and local government finances in FY 1996. The table shows (1) the large amount of aid provided by the state government to local government. About 85 percent of the aid is financed from state tax sources; the remainder comes from federal Òpass-throughÓ aid--federal aid to state government that is redirected to local governments; (2) state government raises more in taxes than local government; the state government raised 57 percent of state-local tax collections. Nationwide, state governments raised 60.7 percent, and in Virginia's most competitive neighbors, Maryland and North Carolina, the state share was 57.8 percent and 72.1 percent, respectively; (3) one-fourth of state expenditure was for aid to local government (shown as intergovernmental expenditure). Nationwide, intergovernmental expenditure accounted for 29.3 percent of state expenditures. In Maryland and North Carolina the shares were 30.8 percent and 31.4 percent. Virginia's share will rise as aid in lieu of the car tax increases; (4) local governments spend more on current operations than state government; and (5) assistance and subsidies (e.g., welfare payments) are mainly a state activity.

More detail on state aid is contained in the Virginia Auditor of Public Accounts' report on FY 1998 local government finances. In that year, 39 percent of local maintenance and operation expenditures was financed with intergovernmental aid. With a few exceptions, most of the aid was state categorical funds, i.e., aid for categories of spending, such as public education. The exceptions were federal pass-through funds for health and welfare and for education. Intergovernmental aid for public education dwarfed all other forms of aid. Nearly half of local outlays for education was financed with intergovernmental aid, and the bulk of it was from state categorical programs.

TAX BURDEN

Taxes, the compulsory payments that are the most important source of revenue for state and local government, are a crucial element in state and local government finance. How does Virginia measure up in terms of tax burden?

The best broad measure of tax burden relates total state and local tax collections in relation to personal income. Using this measure, Virginia's FY 1996 tax burden was $98.48 per $1,000 of personal income. By national standards, property taxes and general sales taxes in Virginia are low. The other principal tax, the individual income tax, is high. The state's overall tax burden was one of the lowest in the nation. Virginia's burden was well below the national average of $112.99 per $1,000 of income, and only Alabama, Tennessee, and New Hampshire had lower rankings. The burden in Virginia was lower than in any of its major neighborsthe District of Columbia, Maryland, and North Carolina.

These data reflect conditions in FY 1996. Since then there has been a general wave of tax cutting and strong growth in personal income. In particular, Virginia and Maryland have adopted major tax cuts, and the District is considering one. Because of the size of the car tax cut ($1.2 billion in FY 2003 when it takes full effect), Virginia is likely to remain a low tax state relative to others.

As previously observed, Virginia state and local government general expenditures rose at a 7.1 percent average annual growth rate from 1986 to 1996. If expenditures had grown only at the rate allowed by population (1.4 percent) and price increases (3.1 percent), the average annual growth rate of expenditures would have been 4.5 percent.⁴ Why did Virginia spend more? One argument is that this extra spending was the result of a revenue system that generated extra revenue that politicians and bureaucrats chose not to return in the form of tax cuts. A 1987 econometric study based on data for a nationwide sample of municipalities found that local spending in the short-run was explained by past revenues rather than past expenditures.⁵ A different argument would be that expenditures reflect voter preferences and that the electorate opted for higher levels of public spending. There is truth in both arguments, but I assign more weight to the second. Generally, state and local expenditures are for goods and services that as real income grows, citizens demand more. With rising incomes, consumers can afford better homes and cars, and they demand better schools and roads. Also, income growth tends to be concentrated in metropolitan areas where government intervention is used to mitigate such problems as congestion, crime, and pollution. Thus, it is no surprise that voters may approve more public spending as income rises.

FINAL THOUGHTS

In conclusion, several observations about Virginia's state and local government finances are warranted.

1. Piecemeal fiscal policy is not good policy. State and local finances are intertwined. For example, more state aid for local government must be financed from state revenue. Focusing on the benefits of the aid without examining the effect on state programs provides an incomplete picture.
2. Taxes are the biggest source of state and local government revenue. They should be designed to minimize possible negative effects on economic growth and distortions in a market economy. Full attention should be given to making government more efficient, relying on the private sector as much as possible, imposing user fees when feasible, and borrowing when appropriate. But even though taxes are a last resort, they should not be ruled out as a source of new revenue.
3. Borrowing does not supplant taxes. It simply defers costs. Later generations will have to pay higher taxes to cover debt service (interest and redemption) and to cover upkeep of capital facilities financed with debt.
4. The Virginia constitutional prohibition on two consecutive terms for a governor has financial repercussions. Governors serve for only 18 months with a budget of their own devising. Tax and expenditure policies with phase-ins will fall upon the next administration.
5. There is a need for regularly updated long-range expenditure forecasts. It is impossible to accurately forecast what will happen six years ahead, but it is better to make some effort to gauge the future. Forecasts should not be made solely by one or two organizations. There is room for projections by commissions appointed by the governor, legislative commissions, business groups, and others. It is important that assumptions and data be made available.
6. There are several studies of Virginia state and local government finances that have been recently completed or are underway. The Virginia Business Council financed a study scheduled for release in the fall of 1998 that was never published due to criticism from the governor. The study, Virginia's Fiscal Future: A Long-term Perspective, is available on the website of another business group, Virginia Forward. In addition to the full study, the site contains an exchange of correspondence between Governor Gilmore's office and the council. Virginia Forward published its own study in September 1999. The study, Projection of Virginia's State and Local Expenditures and Revenues, was conducted by the Barents Group LLC, a subsidiary of KPMG LLP.⁶ The 1999 General Assembly established under Senate Joint Resolution 401 a commission to study Virginia's state and local tax structure for the 21^st century. The commission is required to complete its work by December 2000. Two studies are underway to examine transportation finance. The General Assembly's Commission on the Future of Transportation in Virginia issued an interim report in 1998,⁷ and the commission is required to submit its final report prior to the 2000 session. Governor Gilmore created the Governor's Commission on Transportation Policy, which is supposed to report its findings by the end of the year.
7. Virginia has a long history of earmarked revenue for highways. Resort to borrowing with debt service from general fund sources of revenue would mark a new direction. Reliance on user taxes, fees, and tolls may be a better idea.
8. Caution in making assumptions about the future is important in fiscal policy. Miss Rosey Scenario may not be a permanent resident of the state. We live in a prosperous time, but it will not continue indefinitely. Virginia's rainy day fund (the Fiscal Stabilization Fund) provides a safety net, but it does not erase the need for caution in making fiscal decisions that could create future problems.

Endnotes

¹ More recent data are available from Virginia's Department of Accounts (state data for FY 1999) and from the auditor of public accounts (local data). Unfortunately, it is difficult to consolidate the state and local data into a format similar to the one developed by the Census Bureau because of accrual versus cash accounting and because of the high level of aggregation used in reporting state expenditures. ² Chain-type price index for state and local government expenditures, fiscal years.>
³ §58.1-1720 of the Virginia Code permits certain localities in a transportation district to impose a 2 percent tax on the retail price of fuels sold. Currently, only selected localities in Northern Virginia impose the tax.
⁴ The 4.5 percent rate allows for compound growth so it is more than the sum of the two components.
⁵ Douglas Holz-Eakin, Whitney Newey, and Harvey Rosen, "The Revenues-Expenditures Nexus: Evidence from Local Government Data," National Bureau of Economic Research Working Paper Series, Paper No. 2180 (March 1987)
⁶ This study and the earlier Virginia Business Council study may be viewed at: www.virginiaforward.com
⁷ Interim Report of the Commission on the Future of Transportation in Virginia, House Document No. 12 (1998 session).

Table 1
Virginia state and local government revenue and expenditure, FY 1996 (Millions of Dollars)

Percent of Total

Item	Total State and Locala	State	Local	State	Local
Revenue	31,666.6	20,186.6	15,933.3
General revenue	26,476.7	16,731.2	14,198.9
Intergovernmental revenue	3,813.2	3,514.8	4,752.1
From federal government	3,813.2	3,377.1	436.1	88.6	11.4
From state government	0.0	0.0	4,316.1
From local government	0.0	137.7	0.0
General revenue own sources	22,663.5	13,216.4	9,446.7	58.3	41.7
Taxes	15,626.5	8,900.4	6,725.7	57.0	43.0
Charges and miscellaneous
general revenue	7,037.0	4,316.0	2,721.0	61.3	38.7
Utility revenue	1,057.1	0.0	1,057.1	0.0	100.0
Liquor store revenue	249.0	249.0	0.0	100.0	0.0
Insurance trust revenue	3,883.8	3,206.5	677.3	82.6	17.4
Expenditure	29,029.9	17,832.9	15,709.6
Intergovernmental expenditure	0.1	4,462.7	50.0
Direct expenditure	29,029.8	13,370.2	15,659.6	46.1	53.9
Current operations	21,517.0	9,131.3	12,385.8	42.4	57.6
Capital outlay	3,627.6	1,521.4	2,106.2	41.9	58.1
Assistance and subsidies	1,067.2	975.4	91.7	91.4	8.6
Interest on debt	1,398.4	549.9	848.5	39.3	60.7
Insurance trust	1,419.7	1,192.2	227.5	84.0	16.0
Direct general expenditureb	26,135.2	11,959.8	14,175.4	45.8	54.2

aAdjusted to exclude double-counting bAll expenditure other than outlays for utilities, liquor stores, and employee-retirement or other insurance trusts.

John L. Knapp is research director for business and economics at the University of Virginia's Weldon Cooper Center for Public Service. He was deputy director of the former Tayloe Murphy Institute, which was part of the Darden School. Prior to joining the institute he served as deputy director of the Commonwealth of Virginia's Division of State Planning and Community Affairs. Earlier he was an economist with the Virginia Division of Industrial Development and Planning, assistant economist with the Federal Reserve Bank of Richmond, and a budget analyst with the U.S. Department of Agriculture. For many years he served on the Governor's Advisory Board of Economists. He is a member of the Virginia Employment Commission's Trust Fund Advisory Committee, Virginia Highway Revenue Advisory Board, and Virginia State Chamber of Commerce Tax Policy Committee. He is a former president of the Council of Professional Associations on Federal Statistics, the Association for University Business and Economic Research, and the Virginia Association of Economists. He has written numerous articles and study reports, many on public finance topics.