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, a local sales and use tax, a utility user tax, business license tax and hotel occupancy tax. 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/fire, 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 state or federal funding sources. 

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 is taking or borrowing local government funds in dire economic times at the same time that local government entities are also suffering economically. 
• Most recently the state has “realigned” services to counties along with some funding sources.
• The Legislative Analyst's Office (LAO) prepared a graphic dispicting the major millestones in the stat-local fiscal relationship over the past 40 years.

A Brief History of Local/State Funding

In 1910, the Separation of Sources Act determined that:

1. The State would tax railroads, telegraph and telephones. 
2. Local government would tax property. Each local government would set its own tax rate.
3. 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.

Realignment

 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)

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, a state deficit-financing bond measure was paid for by a complicated swap of taxes. The state increased the sales tax and used the funds to replace lost local revenues with ERAF funds, backfilling schools for the reduced revenues.

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 (Phase 2) effective 10-1-2011

AB 109 and AB 117 began the transfer of the responsibility from the State prisons to counties for custody of low level offenders  and monitoring of certain parolees, along with funding.  In part this was an attempt to reduce State prison overcrowding, which was under court order to reduce the prison population, and also to reduce the number of minor violators and recidivists being held in expensive in state facilities.  Funding in the amount of $5.6 billion in ongoing funding and $763 million for this shift has been provided through the current year state budget, but longer term fund transfers guarantees may be a subject of an initiative to make it permanent.

Redevelopment Agency Restructuring, effective 10-1-2011

Two measures, AB X1 26 and AB X1 2 were enacted in June 2011.  The first measure eliminates redevelopment agencies in California.  The second measure creates a way to reinstate redevelopment agencies by agreeing to make “voluntary” payments to school districts and local governments.  Lawsuits have been filed on the basis that this violates Proposition 22, at the least. (See California Redevelopment Association website for background and current status)

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