8
Achieving Goal 3: Raising Revenue Fairly and Efficiently

Most of the policy discussion related to the fairness of school financing systems focuses, as it should, on the pattern and level of educational spending or outcomes. However, another aspect of equity should not be ignored: How fair is the distribution of the burden of the taxes or fees used to generate revenue for schools? Some aspects of this revenue perspective on equity are obviously intertwined with the spending and outcome issues embobied in the concepts of school finance equity and adequacy discussed in Chapters 3 and 4. However, many other aspects are not. Moreover, the basic principles typically used to evaluate the fairness of revenue sources differ from the standard equity principles underlying the school finance literature.

In addition to equity, other aspects of the revenue system are also important, such as how much it costs the government to administer the system, how stable the revenue sources are over the business cycle, and how extensively the tax system distorts taxpayers' decisions in undesirable ways. Policy makers who are striving to achieve the goal of raising revenues in a fair and efficient manner need to pay attention to all of these issues. In addition, they need to consider any tradeoffs or complementarities with the other two goals of a good financing system: increasing achievement for all students and reducing the nexus between achievement and family background.

Two main aspects of revenue raising should be distinguished—the particular revenue source that is used (i.e., property, income, or sales taxes) and the level of government (i.e., school district, state, or federal government) that is responsible for raising revenue. Table 8-1 displays the main options for the United States.

In this chapter we argue that the local property tax remains the best way to



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Making Money Matter: Financing America's Schools 8 Achieving Goal 3: Raising Revenue Fairly and Efficiently Most of the policy discussion related to the fairness of school financing systems focuses, as it should, on the pattern and level of educational spending or outcomes. However, another aspect of equity should not be ignored: How fair is the distribution of the burden of the taxes or fees used to generate revenue for schools? Some aspects of this revenue perspective on equity are obviously intertwined with the spending and outcome issues embobied in the concepts of school finance equity and adequacy discussed in Chapters 3 and 4. However, many other aspects are not. Moreover, the basic principles typically used to evaluate the fairness of revenue sources differ from the standard equity principles underlying the school finance literature. In addition to equity, other aspects of the revenue system are also important, such as how much it costs the government to administer the system, how stable the revenue sources are over the business cycle, and how extensively the tax system distorts taxpayers' decisions in undesirable ways. Policy makers who are striving to achieve the goal of raising revenues in a fair and efficient manner need to pay attention to all of these issues. In addition, they need to consider any tradeoffs or complementarities with the other two goals of a good financing system: increasing achievement for all students and reducing the nexus between achievement and family background. Two main aspects of revenue raising should be distinguished—the particular revenue source that is used (i.e., property, income, or sales taxes) and the level of government (i.e., school district, state, or federal government) that is responsible for raising revenue. Table 8-1 displays the main options for the United States. In this chapter we argue that the local property tax remains the best way to

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Making Money Matter: Financing America's Schools TABLE 8-1 Tax Options for the United States Type of Tax District State Federal Property X possible   Sales   X   Income   X X raise local revenue for education. That is, provided a decision is made to lodge significant responsibility for raising revenue at the local level, the local property tax is preferred to other local taxes for that purpose. That analytical conclusion is depicted in Table 8-1 by the designation of property taxes as the single revenue source for local school districts. While local sales and income taxes are potentially feasible and are currently used in some states, the property tax is the preferred option. At the state level, the relevant major revenue sources are state income and sales taxes, with 41 states using income taxes and 45 using sales taxes. States traditionally have not made much use of state-level property taxes to finance education. However, several states have recently shifted toward statewide property taxes or their equivalent, and other states could do so as well. Hence, along with state income and sales taxes, we identify statewide property taxes as a larger potential source of revenue for education than in the past. Although the federal government now provides only about 7 percent of the revenue for K-12 education, in principle it could do a lot more. In the absence of major tax reform at the federal level (in the form, for example, of a shift away from the federal income tax to a value-added tax or other form of consumption taxation), the relevant revenue source for education at the federal level is the federal income tax. After evaluating the property tax in some detail, this chapter addresses four questions about the revenue system. The first question is whether the mix of local taxes should be altered by reducing reliance on the property tax and increasing reliance on other local taxes or a modified version of the property tax. The second is what state revenue source would be best if heavier reliance were to be placed on state revenue sources. The third is whether it would make sense to shift away from local revenue raising in favor of much greater reliance on state revenues. And the fourth is whether it would be desirable to increase significantly the federal role in revenue raising for K-12 education. EVALUATION OF THE PROPERTY TAX Evaluating the local property tax as a source of funding for local schools is significantly more complicated than evaluating a state or national tax because of the close relationship between the revenues collected and the amount of spending

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Making Money Matter: Financing America's Schools in each school district. This close relationship suggests to some people that the property tax should be evaluated as a benefit tax—that is, as a tax that is specifically paid for the services provided by a community, rather than in more standard ability-to-pay terms, which examine the distribution of the tax burden separately from what the funds are used for. When looked at as a benefit tax, the local property tax appears to perform better on efficiency grounds and, according to some people, also better on equity grounds than when it is looked at through the lens of the more traditional tax literature. In the following sections we refer to both perspectives. Efficiency Most taxes induce some inefficiency by encouraging taxpayers to alter their behavior in ways that would reduce their tax liability. In the case of the property tax, the standard concern is that households will respond to the tax by investing less in housing or that firms will respond by investing less in property subject to the property tax or by shifting their investments to areas with low property tax rates (Mieszkowski and Zodrow, 1989). In contrast to this emphasis on the inefficiencies of the tax, the benefit-tax approach emphasizes that the local property tax may generate efficient decisions, especially with respect to the level of education services. Particularly in large suburban areas where households can choose among many small, relatively homogeneous school districts, households gain access to the education services provided by a district in return for paying its local property tax. Presumably, people will have a tendency to sort themselves among districts in line with their preferences for education, so that those with stronger preferences for education will end up in districts with more education and higher property taxes than those with weaker preferences. In effect, the property taxes act more like prices that consumers willingly pay for education than compulsory taxes. This analogy is particularly apt, according to the advocates of this perspective, when local zoning regulations ensure that residents in each school district end up in houses that are similarly valued, so that they pay similar property taxes for their uniform public education (see Hamilton, 1975; Fischel, 1992; Hoxby, 1996b). This view, which is generally consistent with the well-known strand of public finance literature initiated by Charles Tiebout in 1956, draws attention to the efficiency benefits that accrue from local provision and financing of public goods. Significantly, however, the benefit-tax approach would apply to any local tax, not just to the local property tax. That is, the efficiency claims for the property tax relate more to the governmental level at which revenues are raised than to the desirability of the property tax or any other specific local tax. For this reason, we defer to later in the chapter a fuller discussion of the potential trade-offs between efficiency and equity that might arise with a shift to a larger state role in education finance.

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Making Money Matter: Financing America's Schools Furthermore, the benefit-tax argument applies most directly to small, relatively homogeneous suburban districts only when local zoning enforces housing uniformity within districts, and it is not particularly pertinent to central-city or rural districts. In light of these limitations, it seems reasonable to treat the property tax like other taxes and to recognize that it will induce some distortions in behavior. Because all taxes induce distortions, the relevant question from this more traditional perspective then becomes how the distortions associated with the property tax compare with those associated with other potential local taxes, such as the income or the sales tax. Fairness There is little doubt that many taxpayers view the local property tax as unfair. In 1978, for example, voters in California shocked the nation by supporting Proposition 13, a statewide initiative to reduce drastically the level and rate of growth of local property taxes. Massachusetts voters followed with their own stringent tax limitation measure two years later. While the motivation for these and other measures to limit property taxes are obviously mixed and complex, voters appear to have been motivated in part by their perception that the local property tax was unfair.1 Acting on concerns of this type, legislators in many other states did not wait for statewide referenda to reduce property taxes, but instead jumped on the anti-property-tax bandwagon and introduced policies designed to provide property tax relief to all or to specific groups of taxpayers. Further evidence of continuing taxpayer dissatisfaction regarding the property tax emerges from annual surveys administered between 1972 and 1994 by the U.S. Advisory Commission on Intergovernmental Relations. During that period, between 25 and over 30 percent of the respondents consistently rated the property tax as the least fair tax (compared with federal and state income taxes and the state sales tax) and typically much less fair than the main alternatives to property taxes for financing education, state income and sales taxes. Taxpayers have lots of reasons for believing the property tax is unfair. Many of these relate to the way the tax is administered (e.g., see Netzer and Berne, 1995, for examples specific to New York State). Compared with other taxes such as income and sales taxes, the property tax is more difficult to administer fairly because it requires that property be assessed. Ideally, the assessed value of a property should reflect its market value. However, where there are few market transactions, the value of the property must be approximated by one of several imperfect methods. It is not surprising that the assessment of property is subject 1    These and other factors are explored by Citrin (1979) in California, Gramlich and Rubinfeld (1982) in Michigan, and Ladd and Wilson (1982) in Massachusetts.

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Making Money Matter: Financing America's Schools to error and to political influence in some states and, consequently, frequently departs from market value. Another complicating factor is that any given parcel of property is likely to be subject to taxation by several local authorities, such as a county government, a municipality, a school district and perhaps several special-purpose districts. Such complexity may well confuse local taxpayers and make them view the overall burden as unfair. Finally, the fact that property taxes are typically levied only once or twice a year makes them more visible than income taxes, which are largely collected through withholding, or sales taxes, which are collected in small amounts at the cash register. Other reasons for concern about the fairness of the property tax arise in particular circumstances. In California in the late 1970s, for example, part of the concern arose from the rapidly rising housing values and the three-year assessment cycle, which combined to produce huge increases in property valuations and tax burdens in a single year, increases that bore no relationship to the taxpayer's ability to pay as measured by current income. In Massachusetts, the high levels of property tax burdens made the tax difficult for some taxpayers to accept. Beyond some of these taxpayer concerns, many of which are clearly valid and reflect underlying problems with how the tax is administered, experts in public finance also have much to say about the fairness of the property tax based on the two basic principles of tax equity. However, as the committee discovered, not all economists agree. Those economists who emphasize that the local property tax is like a benefit tax would typically defend it on fairness grounds by appealing to the benefit principle of tax equity. According to this principle, a tax is fair if the burden of the tax is distributed among taxpayers in line with the benefits they receive from the services funded by the tax. However, in the committee's view the benefit principle is not very applicable in this context, largely because it is based on an unacceptable ethical foundation. Because the demand for education is highly correlated with parental income and education, this approach to equity would accept as fair differences in education levels across jurisdictions that correspond to differences in preferences and family ability to pay for education. Although such a pattern increases the efficiency with which education is provided (in the sense that those who have greater willingness to pay for education get more) compared with a uniform state-wide level, the committee sees no reason to assert that such an outcome is fair, especially given the acknowledged significance of education to a child's life chances. An additional complication arises in using the benefit principle to evaluate the equity of property taxes because of the phenomenon of tax capitalization. For example, if two school districts provide similar education services but one does so at a lower tax rate (perhaps because of the presence of a power plant in the district), homeowners are likely to have bid up housing prices in the low-tax

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Making Money Matter: Financing America's Schools district enough so that new homeowners would receive no net financial benefit from living in the district with the lower tax rate. Thus what may appear as an inequity—the fact that households in one community pay a lower tax rate than those in the other for the same services—turns out not to be an inequity if one takes into consideration the fact that the households paying the lower tax rate pay more for their housing.2 More useful and appropriate for evaluating the equity of the property tax, in the view of the committee, is the ability-to-pay principle. From this perspective, the key question is: How regressive is the property tax? It turns out that there is no simple answer to this question. The incidence of the property tax has, in fact, been one of the most controversial topics in the field of local public finance. The controversy centers around the so-called old view and the new view of the incidence of the tax. Those who apply the old view argue that the tax is regressive on the grounds that landlords and business firms are able to shift much of the burden of their real estate taxes onto renters and consumers in the form of higher prices. The new view, in contrast, emphasizes that the property tax is a tax on wealth, so that the ultimate burden of the tax is distributed in line with earnings from wealth. Since those earnings rise disproportionately with household income, the tax burden, according to this view, could be progressive—that is, the tax would place a heavier burden on higher-income households than on lower-income ones. Fortunately, as noted by McLure (1977), the two views can be reconciled by interpreting the old view as one component of the new view. In particular the old view is most applicable to differences in property tax rates across jurisdictions. This reconciliation leads to the general consensus that what makes the property tax regressive is the differences in tax rates across jurisdictions. Regressivity emerges to the extent that higher property tax rates are levied in districts with above-average proportions of poor households and lower rates in districts with richer households. However, a different conclusion emerges for property tax rates that cover a broad geographic area like a large state. In this case, the new view would be more applicable, which would mean that the burden of an increase in the property tax rate is likely to be proportional or even relatively progressive. This observation suggests that a shift away from reliance on local property taxes (with their tax rate differentials that make the tax regressive) to a statewide property tax could well make the tax system fairer. 2    This phenomenon of capitalization has implications not only for the equity of the existing system but also for changes in the system. Any policy that would change property taxes, such as increased reliance on alternative revenue sources, will generate windfall gains in housing values to those whose taxes fall and losses to those whose taxes rise. Similarly, the positive effects on poor people of equalizing aid that allows poor jurisdictions to lower tax rates or increase the quality of their education services could be offset in part by a rise in housing costs. However, if the low-income residents are homeowners, they also benefit from the higher value of their houses (see Wyckoff, 1995).

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Making Money Matter: Financing America's Schools This discussion generates two conclusions about the fairness of the property tax. First, from an equity perspective, the administration of the property tax leaves a lot to be desired and inevitably leads to the unfair treatment of some taxpayers. The committee would support ongoing efforts to administer the tax as fairly as possible. As spelled out by Netzer and Berne (1995:39), a property tax system should be: (1) ''transparent and straightforward," so that it is comprehensible to voters and property owners; (2) it should be "systematic," in the sense of having few internal contradictions; and (3) it should be "reasonably related to the policy objectives that animate the various provisions." Second, the property tax is not so regressive—and hence unfair—a tax as some people make it out to be.3 Its major failings are (1) the regressive elements that emerge because it is a local tax and (2) the inequities in spending that result from the wide variation across districts in the property tax base. However, these latter inequities result more from the fact that many states place such heavy reliance on local—in contrast to state—revenue sources rather than to the property tax itself. This conclusion about regressivity implies that converting the local property tax with its variation in tax rates across jurisdictions to a statewide uniform-rate property tax could well improve the fairness of the revenue system. It would eliminate most of the regressive element that arises from the differential tax rates across jurisdictions and would eliminate the spending disparities that arise from the variation in local property tax bases.4 A logical next question would then be whether further gains in equity could be obtained by shifting away from the property tax completely to other statewide taxes, such as income or sales taxes. However, the committee is well aware that some people would argue that any gains in equity (either in the fairness of the revenue system or in the form of a more even pattern of spending across districts) from a shift to statewide taxes could come at a potentially large cost, namely the loss of local control and more efficient decision making that flows from local school districts having access to their own source of revenue. In light of the concern about local control and efficiency, it is worth examining first how the property tax stacks up against other local taxes that might be used by local school districts. 3    Throughout this discussion we have defined regressivity with respect to a household's current income. An alternative approach would compare tax burdens across households as a proportion not of their current income but rather of their lifetime or "permanent" income. Such an analysis would make the property tax look less regressive and more proportional, given that household spending on housing is typically found to vary in line with a household's permanent income. It is worth noting, however, that if one is going to look at the incidence of property taxes in terms of permanent income, one must also examine the incidence of other taxes in similar terms. For a discussion of these issues in the context of excise taxes, see Poterba, 1989; Lyon and Schwab, 1995). 4    At the same time, it should be noted that such a change in tax system could well lead to short run windfall gains and losses that could be quite arbitrary in their distributional effects. Hence, any change in tax structure would require attention to these arbitrary gains and losses.

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Making Money Matter: Financing America's Schools SHOULD THE MIX OF LOCAL TAXES BE CHANGED? The two major candidates to replace the local property tax are the local income tax and the local sales tax. Alternatively, one could imagine modifying the local property tax by applying it to residential property alone or by sharing the revenues across communities within a metropolitan area. Local Income or Sales Taxes A somewhat stronger case can be made for replacing the local property tax with a local income tax than with a local sales tax, but even here the argument is not compelling. Strauss (1995) tries to make the case for a local income tax with particular reference to New York State. His starting point is that because education represents an important form of income redistribution, it should be financed out of broad ability-to-pay taxes, such as income or consumption broadly defined. The property tax is unfair, he argues, because it does not allocate burdens in line with any reasonable concept of ability to pay. For example, it often imposes heavy burdens on the elderly who are property wealthy but income poor, and it treats taxpayers in districts with a lot of business property favorably relative to those in districts that are primarily residential (with no reference, however, to the potentially offsetting impacts on housing prices that occur when differences in property taxes are capitalized). Few would disagree with the argument that the income tax is the superior tax judged in terms of ability to pay. Unlike the property tax, it applies directly to households and hence can be adjusted to take into account the circumstances of the family, such as the number of dependents. Furthermore, provided one accepts the view that current annual income is the appropriate measure of ability to pay, tax burdens will inevitably be more in line with household ability to pay than they would be with the property tax. Of course, in practice, in order to minimize administrative and compliance costs by taking advantage of the existing state administrative structure, the definition of income for a local income tax would most likely follow the state definition. Consequently, the fairness of any local income tax would depend on the fairness of the state income tax. Although from an ability-to-pay perspective a local income tax could well be a fairer way to raise revenue within a district than the local property tax, the income tax may well be less desirable on other grounds. First, it could well lead to even greater disparities across school districts than those associated with the local property tax. This outcome would occur, for example, if the amount of business property (which is included in the property tax base but not the income tax base) were larger in areas with lower-income residents than in areas with wealthier residents, a pattern that would tend to mitigate the effects of large differences in household income or property wealth across districts. In practice,

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Making Money Matter: Financing America's Schools which tax base varies more is an empirical question and the outcome is likely to vary from one state to another. As Oates (1991) has pointed out, the unequal distribution of the tax base is likely to be a problem for any local tax whether it be a property, income, or sales tax, and the problem could well be less for the property tax than for other taxes. Second, there are likely to be greater behavioral distortions with the income tax than with the property tax. If a redistributive local income tax and expenditure package is weighted toward lower-income individuals and families, then inmigration of the poor into the local jurisdiction raises the cost of redistribution and may cause out-migration of wealthier families. The property tax generates fewer distortions because the mechanism of tax capitalization through which differences in tax burdens are reflected in the prices of housing makes it more difficult for taxpayers to avoid the burden of the tax by movement from one jurisdiction to another. Other possible advantages of the property tax over the income tax include the fact that it is potentially more stable over the business cycle because of the relative stability of housing values (but offsetting this is the possibility of increasing tax arrears during recessions) and its broader tax base, which includes business as well as residential property and means that tax rates can be lower for any amount of revenue. Finally, in contrast to the income tax, for which the marginal tax rate for a local income tax could be quite high because the same base is used by the federal government and most state governments, the property tax has the advantage of not being used by higher levels of government. The local sales tax is an even less promising alternative than the local income tax. Shifting away from the local property tax to a local sales tax is unlikely to make the revenue system more fair. First, the sales tax itself is generally a very regressive tax. Although many states have moderated the regressivity of their state sales taxes to some extent by choosing not to tax food, the state sales tax typically remains quite regressive. There is no reason to believe that a local sales tax would be any less regressive. Whether it is more or less regressive than the property tax is a more complicated question, but one on which there is no clear presumption in favor of the sales tax. Moreover the local sales tax has some other significant disadvantages. The disparities across districts in sales tax bases are likely to exceed the disparities in property tax bases because of the uneven distribution of large retail shopping centers across school districts. Local sales taxes are relatively easy for taxpayers to avoid and hence can distort the shopping behavior of local shoppers in significant ways. Revenue from sales taxes is typically quite unstable over the business cycle, and finally, sales taxes are not deductible under the federal income tax. Thus, the property tax appears to dominate the other main alternative broad based local taxes—income and sales—as a revenue source for school districts based on standard evaluation criteria for revenue sources such as equity, effi-

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Making Money Matter: Financing America's Schools ciency, and stability. However, one final criterion remains—the effect of the tax on the willingness and ability of voters to raise funds for education. Various constraints have recently been imposed by state governments on the local property tax, in the form of property tax caps and other limitation measures. Many of these constraints have been binding, and they would appear to be a serious indictment of the property tax as a source of revenue for education. Dye and McGuire (1997) and Rueben (1997) provide empirical evidence that these property tax limitation measures are effective at limiting the level and growth of property taxes. The evidence on the effects of these restrictions on school outcomes, such as student test scores, is more mixed. Downes et al. (1998) do not find strong evidence of a short-run effect of the Illinois tax cap on test scores, while Downes and Figlio (1997) find evidence that mathematics test scores are lower in states with binding limitation measures, and Figlio and Rueben (1997) find evidence that teacher quality is lower in states with strict property tax limitation measures. Typically, when tax limitation measures are imposed, the affected jurisdictions are allowed to circumvent the restrictions if they receive voter approval. The effectiveness of voter referenda as an escape valve for jurisdictions hard hit by limitation measures is in question. However, one must be careful not to assume that taxpayers are revolting against the property tax per se. They may, instead, be concerned about the overall level of taxes and have chosen to protest against the one that is closest to them, the one at the local level. One particular characteristic of such a local tax provides some support for this view. In many jurisdictions, the local property tax is treated as the residual tax, in that its rate is the easiest one to increase when a jurisdiction finds that it has a shortfall between its planned expenditure and the revenue it will receive in the form of state or federal aid or from other tax bases subject to fixed tax rates. The rising property tax rates may well induce local voters to view the property tax as the culprit when the real problem is that expenditure demands are outstripping the growth in other sources of revenue. By this reasoning, one might expect to see limitations imposed on other forms of local revenues, should they become much more broadly used. Possible Modifications to the Local Property Tax Given that the reasons for shifting away from the local property tax to another broad based local tax are not compelling, it is worth considering whether various modifications of the local property tax might be desirable. The two most commonly discussed alternatives are shifting the taxation of nonresidential property to the state level and the introduction of local tax base sharing, as in Minneapolis-St. Paul. The fact that the property tax applies not only to residential but also to business property raises a variety of policy issues for the financing of education. Ladd and Harris (1995) examine the case for shifting the nonresidential portion

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Making Money Matter: Financing America's Schools of the local property tax base to the state level, with the funds redistributed back to local districts for education. Such a shift might be justified on the following grounds. First, it would recognize the fact that it is residents who receive the primary benefits of locally provided education services, either directly in the form of education services or indirectly through the capitalization of education services into house values. In contrast, because they typically recruit workers from a region larger than the local school district, firms generally receive fewer benefits from local education than do residents. Second, the inclusion of business property in the local tax base could distort local spending by lowering the tax price of education to residents and thereby inducing districts with large amounts of local business property to overinvest in education, relative to the local benefits received by residents. Third, locally differentiated taxation of business property could distort firms' location decisions, as firms seek the districts with the lower tax rates, thereby creating inefficiencies in production. Fourth and more speculative is that shifting to statewide taxation of business property for education with the proceeds channeled back to school districts could generate a fairer pattern of education spending across the state. Whether this outcome would occur depends on the location of the business property and the formula by which the state distributed the revenue back to the local districts. Ladd (1976) and Ladd and Harris (1995) observe that the impact on distribution as a result of statewide taxation of business property depends on the location of the business property and the structure of the aid system. Ladd (1976) simulates the results of this type of policy change on resource equity in Massachusetts. She concludes that the state would need to provide additional redistributive aid to poorer districts to make up for the lost revenue from the smaller tax base. If business property is disproportionately located in poorer school districts and the state aid system does not compensate, then equity would be reduced by such a proposal. Ladd and Harris (1995) consider the impact of this policy in New York State. They concluded that in order to improve the distribution of resources, the revenues would have to be distributed to the 75 percent of the school districts with the lowest income or property wealth. They noted, however, that such a redistribution program would drain a considerable amount of revenue from the New York City schools. The results from these studies highlight the limitations of these statewide property tax programs. A variation of this approach is a system in which the tax base generated from new business investment within a metropolitan area is shared among the local communities. Such an approach has been used in the Minneapolis-St. Paul area for the financing of general public services since 1975 (Luce, 1998). Under that program, 40 percent of the new property tax base is put into a regional pool, which is then distributed among municipalities in line with their population and inversely with the market value of their property relative to the rest of the region. While this approach appears to have reduced fiscal disparities in the Minneapolis-St. Paul region, its failure to offset the higher costs of providing services in

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Making Money Matter: Financing America's Schools 1992 dollars) while decreasing significantly within-state spending inequality. Their results also suggest that the highest-percentage increase in spending would be in the poorest school districts and spending in the wealthiest districts would remain constant. Overall, they found that the state's share of total spending rose as a result of court-ordered reform, with funding for this increase in the poorest districts coming from higher taxes. Contrary to these results, Hoxby (1996b) estimated that the average level of per-pupil spending fell with more effective equalization, as a result of the large disincentives on high-demand school districts that are contained in these plans. In light of this mixed evidence, the committee itself looked at the patterns of spending over time in all of the states that have had court-ordered reforms. Instead of following the Joondeph approach of picking a selected set of years, the committee examined annual average growth rates of spending in each state relative to the national average for specified numbers of years since the state's court case. We believe this approach better answers the question of how a court case affected spending, say, 5, 10, or 15 years after the court case. The results for all the states experiencing court-ordered reform are shown in Table 8-2. Up to three entries are provided for each state. The first one shows the difference in the average annual growth rate in per-pupil expenditures in that state from the U.S. average five years after the state's court case. The second entry for each state is the difference after 10 years, and the third is the difference after 15 years. The dates cited for the court cases are relatively straightforward except for California, for which we could use the 1971 date of Serrano I or the 1976 date of Serrano II, TABLE 8-2 Annual Average Growth Rates (Relative to National Average) in Per-Pupil Expenditures Following Court-Ordered Reform State and Case Year Average Annual Growth Rate, 5 Years After Case Average Annual Growth Rate, 10 Years After Case Average Annual Growth Rate, 15 Years After Case California, 1976 -0.0077 -0.0082 -0.0101 New Jersey, 1973 0.004 0.0068 0.0137 Connecticut, 1977 0.0268 0.0312 0.0189 Washington, 1978 0.0031 -0.0136 -0.005 West Virginia, 1979 0.0201 0.0035 0.0125 Wyoming, 1980 0.0276 -0.0101 -0.0103 Arkansas, 1983 0.0001 0.0052 NA Kentucky, 1989 0.0294 NA NA Montana, 1989 -0.0002 NA NA Texas, 1989 0.009 NA NA NA = Not applicable. NOTE: Calculations based on data from National Center for Education Statistics, State Comparisons of Education Statistics: 1969–70 to 1996–97, Table 39.

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Making Money Matter: Financing America's Schools which led to the virtual equalization of spending across districts. 9 For the table we have used the 1976 starting date. Had we used the 1971 starting date for the California figures, the first entry for California would have been a positive number. That is, for the five years after the first Serrano case, per-pupil spending on schools in California grew faster than the national average. The table shows that for the 10 states for which data are available five years after the court case, only two (California and Montana) experienced rates of spending growth that were below the U.S. average growth rates. For the seven states with reforms early enough for there to be 10 post-reform years, the results are more mixed: spending in three states (California, Washington, and Wyoming) grew more slowly than the U.S. average, and spending in four states (New Jersey, Connecticut, West Virginia, and Arkansas) grew faster. Finally, after 15 years, three states exhibited faster spending and three states slower growth. In summary, the committee believes that there is sufficient evidence to reject the conclusion that greater equalization of spending across local school districts will necessarily reduce spending on education. While spending in California did indeed fall relative to the spending in the nation (at least after 1976), the case for attributing that to the Serrano decision is not compelling. Moreover at least half of all states experiencing court-ordered reform have increased their spending relative to the national average over time. Greater equalization of spending is not incompatible with higher state spending for education. Impact on the Responsiveness of the Tax Base An additional consideration regarding a greater state role in education finance is what it will do to the stability of revenues over the economic cycle and to the growth potential for revenues over time as the economy grows. The flexibility of the base matters from a political perspective because it is politically much easier to raise revenue through growth in the tax base than through increases in tax rates. In general, the property tax base is quite stable over the business cycle and its growth over time depends heavily on assessment practices. Sobel and Holcombe (1996) find the personal income tax base to be fairly stable over the course of a business cycle and that, of all the main taxes, it appears to respond the most to growth in state income. This responsiveness is beneficial when a state's economy is growing but could be harmful during periods of slow state economic growth. According to Sobel and Holcombe (1996), the variability and growth of sales tax revenue depend on what items are included in the tax base. Retail sales taxes, including food purchases, vary over the business cycle in a manner similar to the personal income tax, but they vary much more when food 9    Serrano v. Priest (Serrano I), 487 P.2d 1241 (Cal. 1971), and Serrano v. Priest (Serrano II), 557 P.2d 929 (Cal. 1976).

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Making Money Matter: Financing America's Schools items are exempted. In general, sales tax bases (with or without food) are not as responsive to state income changes as the personal income tax, largely because they exempt spending on most services, which are the fastest growing part of the economy. Thus, in states like California, and more recently Michigan, where the state has become the primary financier of local school districts, local school districts find that their fortunes are tied to revenue sources that are arguably more sensitive to the business cycle than the property tax, and to revenue sources that they do not have control over. This consideration is not inconsequential in weighing how best to design a financing system that raises revenues fairly but also generates sufficient revenue to foster the goal of facilitating high learning for all students. While a shift to a larger state role is likely to enhance equity, the increased responsiveness of the revenue system to changes in the economy could present serious problems in the event of an economic downturn. The absence of a serious economic downturn in the past 8–9 years provides little basis for prediction, but given that downturns in the economy are inevitable, one should not ignore their potential effects on the education finance system. The lesson from the research is that shifting away from a local property tax to a narrowly defined state sales tax (one with many exemptions including food) would put education revenues in the most jeopardy. Impact on Cost-Efficiency and Student Outcomes Independent of the impact on funding levels, would we predict that a larger state role in financing would increase or decrease student outcomes? At least two conceptual arguments can be made that a larger state role will decrease the cost efficiency of the system. Fischel (1996) and Hoxby (1996b) argue that because school quality is capitalized into higher home values, all homeowners (even those without children) are interested in improving their local schools when schools are financed locally. As a visible outcome of schools, test scores serve as a measure of school quality. Local homeowners can hold school administrators accountable for using higher property taxes (which will reduce housing values) effectively to improve local public schools (which will raise housing values) when improvement is measured by higher test scores. With a shift to a greater reliance on state revenue or if local control over spending is otherwise reduced, the incentives for this monitoring by all homeowners are removed and test scores may suffer.10 A second argument is that greater state involvement in financing will bring with it greater state control over the mix of inputs to be used by local school districts. For example, states may require districts to have certain class sizes, to 10    We focus here on the cost-efficiency of production rather than the broader concept of overall efficiency discussed in Hoxby (1996b) because of the way we have stated goal 1. While goal 1 could be consistent with the economist's definition of efficiency, it need not be.

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Making Money Matter: Financing America's Schools hire certain types of teachers, or to have libraries of a certain size. Given our conclusion in Chapter 5 that knowledge about the education production process is imperfect and that the effectiveness of certain inputs may vary with the specific context, such central directives might well keep schools from producing education in a cost-efficient manner. Working in the other direction, however, is the possibility that the shift to a greater state role in financing could be accompanied by changes in school governance that give the state more authority to hold schools accountable for high achievement standards while giving them more flexibility to manage themselves. Such would be the case, for example, if the shift to greater state financing were part of an overall standards-based reform strategy. In that case, the greater state role (in financing and governance) could well lead to greater student achievement. In practice, how much control states exert over local schools and the form of that control varies greatly from one state to another. Some states (such as California) control the total amount of spending by imposing spending restraints. A number of recent state education finance reforms have included some type of maximum per-pupil spending level or some type of limit on the growth rate of spending. Alternatively or in addition, state governments impose various regulations such as mandating a particular curriculum that students must complete, setting a minimum number of days and/or hours that students must spend in school, requiring specific treatments for some groups of students, granting teacher certification, imposing work rules for teachers and other school employees, setting standards for the provision of transportation and meals, and influencing or limiting capital investment decisions through controls on borrowing or debt. All of these regulations reduce the autonomy of local schools and, in most cases, influence the financial decisions of the schools. In evaluating the following evidence, it is important to bear in mind that to the extent that a larger state role is associated with more state control, it is difficult to sort out empirically the effects of centralizing finance from centralizing of governance. Several researchers have investigated the relationship between the state role in financing and student outcomes by including various measures of centralization as explanatory variables in a standard educational production function regression. They typically find that a larger state share reduces student outcomes. In two regression studies, Peltzman (1993) found that an increase in the state's share of education revenue lowered state SAT scores in the 1970s, but these variables were unrelated in the 1980s. In his examination of the performance of noncollege-bound students, Peltzman (1996) found that an increase in the state expenditure share was associated with a decline in scores on the Air Force Qualification Test. Fuchs and Reklis (1994) found that math scores are higher in states in which the state share in education revenues was lower. Hoxby (1996a) argues that the state revenue share is an inaccurate proxy for state control. For example, even though local governments in California collect property

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Making Money Matter: Financing America's Schools tax revenue, the Serrano decision took away local control over how much they spend. Irrespective of that lack of local control, California's state share in 1995 is listed at only 56 percent (Table 2-2). Rather than state share, Hoxby included a measure of the local government's tax price for an additional dollar of education expenditure (where the local tax price in California would be infinite since the spending of local districts is fully constrained). She found that an aggressive power equalization plan (i.e., higher tax price) had undesirable impacts on student outcomes in that it raised the student dropout rate by 3 percent and that a move to fully state-financed schools raised the dropout rate by 8 percent. Husted and Kenny (1998) included a measure of state education spending inequality in their educational production function and conclude that the mean SAT score is higher in those states with greater within-state variation in spending. A second approach to exploring the relationship between a larger state role and student outcomes is to look at changes in outcomes that follow court-mandated reform. This second approach is more general in that it captures the effects not only of finance reform but also of any accompanying changes in governance. The disadvantage of this approach is that the effects of the finance changes cannot be separated from those of the governance changes. In some cases (for example, Kentucky after its recent court case that declared unconstitutional not only its school finance system but also its governance system), both changes were large. Downes (1992) looked at the California experience following Serrano and found that greater equality in spending was not accompanied by greater equalit in measured student performance. Using individual-level data from the National Longitudinal Survey of the High School Class of 1972 (NLS-72) and the National Educational Longitudinal Survey (NELS), Downes and Figlio (1997) estimated that court-mandated school finance reforms did not result in significant changes in either the mean level or the distribution of student performance on standardized tests of reading and mathematics. They do find, however, those legislative reforms that are not a result of a court decision lead to higher test scores in general; the estimated effect was particularly large in initially low-spending districts. In sum, there is no reason to think that a shift to a greater state share of funding (with no change in average funding level) will lead to greater achievement unless it is connected with policy changes designed to encourage that end. If state funding is not connected with such changes, the shift to a greater state share of funding may reduce the productive efficiency of the system, as local school districts may have less incentive to use their resources carefully given that fewer of those resources are coming directly from local taxpayers. The bottom line is that states that shift to more state funding in the name of fairness need to ensure that they do not inadvertently reduce the productivity of their education system in the process. Only with appropriate policy changes can they avoid that outcome.

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Making Money Matter: Financing America's Schools Considerations Related to Goal 2: Breaking the Nexus Many of the considerations related to how increasing the state role would affect goal 1 also apply to goal 2: breaking the nexus between family background and student achievement. Here we consider more directly the extent which a larger state role in financing can help ensure both equitable and adequate funding for disadvantaged students, particularly those who are concentrated in districts with limited resources relative to their educational needs. One of the major justifications for a larger state role in education finance is that the state revenues can be used to offset what otherwise might be undesirable disparities in education spending across school districts. Court-ordered education finance reforms have frequently increased the state financial role and led to a more equitable distribution of spending than would have occurred in the absence of the reform. Assuming that money can make a difference in student achievement, this redistribution of resources to low-spending districts could potentially increase their students' achievement. Current state aid is often not designed to compensate fully for the differences in the costs of providing education across school districts. This observation suggests that states that increase the role of the state in the financing of education must work hard to ensure that the funds are distributed across school districts in ways that take account as fully as is technically possible any differences in the costs of educating students. Failure to do so will be detrimental to the districts serving disproportionate numbers of difficult-to-educate children and will hinder efforts to reduce the nexus between family background and student achievement. A second consideration is the political economy of grants-in-aid and its implications for the state's ability to ensure adequate funding for all districts, particularly those that are unable to supplement state funds from local sources. As Courant and Loeb (1997) describe, the extent to which centralization of school finance permits local districts to supplement the state funding has potentially significant implications for the likelihood that the state funding will be adequate for the poor districts. Consider a situation in which local districts are free to supplement the state funds in an unlimited way. One possible outcome is that many high-demand voters in rich districts will try to keep state spending on education relatively low. They do so out of their own self-interest. The higher the level of the state funding is, the greater is the proportion of their tax dollar that goes to pay for the education of children in other districts. Hence, they prefer a lower state amount so that they can direct their taxes to providing services in their own local district. According to Courant and Loeb, whether there is support for a state foundation grant at a level that would truly provide an adequate level of basic education depends on the number of voters in high-demand school districts and their political influence. This problem is alleviated when local supplementation is limited so that voters from high-demand school districts are restricted in their ability to substitute greater local revenue for general state grants.

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Making Money Matter: Financing America's Schools A more extreme reaction by high-demand families who are restricted by state financing programs designed to equalize spending across districts is to opt out of the public school system altogether and send their children to private schools. As Brunner and Sonstelie (1997) explain, such equalization plans restrict the variation in public school spending across districts and they keep some families from obtaining their preferred level of education through the public sector. The only way for families to achieve their preferred level of education is by choosing a private school. Since these families no longer use the public school system and the statewide financing system eliminates benefits in the form of rising housing values, their support for the public education system is likely to shrink. The empirical evidence on this question is mixed. Most of the research has focused, once again, on the experience in California after Serrano . The raw data suggest that Serrano has not led many families to choose private schools. Brunner and Sonstelie (1997) observe that about 9 percent of California schoolchildren were enrolled in private schools in 1973–74, compared with roughly 10 percent in the rest of the country. By 1992–93, private school enrollment had increased to about 10 percent in California and 12 percent in the rest of the country. They conclude that private school enrollment in California basically followed the national trend. Downes and Schoeman (1998), however, come to a different conclusion. They argue that even if the supply of private schools did not increase, Serrano could account for nearly half of the actual movement from public to private schools in California over the 1970–80 period. These considerations highlight the importance of variation in individual demands for education and the fact that families with high demands for education are able to behave in ways that may be beneficial to them but potentially harmful to the goal of raising sufficient revenue to promote higher levels of achievement for all children, and particularly for disadvantaged students. To minimize the negative side-effects of the decisions of high-demand families on the overall level of support for education, states could (1) prohibit or severely limit local districts from supplementing state aid from local taxes (as was done in California) and (2) prohibit families from opting out of the public system in favor of private schools. However, such policies would run counter to some deeply rooted values in American education related to freedom of choice. Hence, the challenge is to design a system that ensures adequate funding for disadvantaged students but does not run roughshod over other values that people hold dear. SHOULD A GREATER SHARE OF FUNDING FOR EDUCATION COME FROM THE FEDERAL GOVERNMENT? A larger state role in financing primary and secondary education will only partially address education resource inequities in the United States. A case can also be made for a larger federal role in revenue raising for education, based on either an equity or an adequacy rationale. The two rationales lead to two alterna-

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Making Money Matter: Financing America's Schools tive policy options for the federal government. (A third rationale for a larger federal role is reserved to Chapter 9 and Appendix A, which discuss research and data needs.) Equity Arguments for a Greater Federal Role Since enactment of the 1965 Elementary and Secondary Education Act (ESEA), the federal government has played a significant role in funding schooling for specific groups of at-risk students. The case for targeted support for such students rests largely on a redistributive or equity rationale. In such instances, the highest level of government is most appropriate as the source of revenues. In part, the argument for this is simply practical. It is much more feasible for the federal government to play that role than it is for lower-level governments because of the possibility of movement of households among subnational jurisdictions. For example, consider a large city school district with a large percentage of economically and educationally disadvantaged students. Given that it costs more to provide a given level of education to those than to other students, the city would have to spend significantly more per pupil than other school districts. This condition is likely to lead to higher tax burdens. Those high taxes would provide an economic incentive for middle-and upper-income households as well as businesses to move out of the city (or to choose not to move there in the first place). Consequently, the city school district would become increasingly impoverished and unable to do much redistribution of funds away from wealthier residents to the disadvantaged students. In the extreme, there would be no nonpoor residents in the city to support educational services for the poor. This behavior is likely to occur at the state level as well as the local level, but is much less common at the federal level given that taxpayers would have to move out of the nation to avoid the burden of paying higher taxes to support needy students. Related to this practical position is the ethical argument that poverty and its associated education characteristics are national problems that deserve national attention. While some districts would be wealthy enough to fund additional programs for disadvantaged students within the district, one can ask whether it is fair to make the people who happen to live in those districts or states bear the financial burden while others have opted out of such payments by moving to areas with low proportions of at-risk students. To the extent that poverty and other measures of educational disadvantage are national problems, the fair way to fund their alleviation is with a national tax, such as the federal income tax, which would spread the financing burden among all U.S. residents in line with their ability to pay, regardless of where they live. This federal equity rationale is already reflected in categorical programs for specified groups of students, that is, students who need additional educational services in order to achieve to acceptable levels. Largely developed during the

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Making Money Matter: Financing America's Schools second half of this century, these programs often were initiated at the federal level in part because the students involved were not being served sufficiently by states and local school districts. Such programs include Title I, focused on low-achieving students from economically disadvantaged backgrounds; the Individuals with Disabilities Act (IDEA), concentrating on students with physical and mental disabilities; ESEA Title VII, directed at students whose native language is other than English; and several other related programs. Today, these programs for students with special needs permeate education strategies at the school, district, state, and national level, nearly always complemented by additional state and local funding. For most professionals in education today, these federally funded programs are simply a part of the infrastructure. However, as discussed in Chapter 7, funding of these programs is still problematic. Although the federal government took the lead role in creating these programmatic emphases, it has never funded them at their fully authorized level. For IDEA in particular, this underfunding has created large financial burdens for states and local school districts. Thus one option for the federal government is to assume a larger share of this particular educational burden. Another would be to fund Title I at the full amount authorized by Congress, $24.3 billion annually (Independent Review Panel on the Evaluation of Federal Education Legislation, 1999:12). These additional federal funds could be used to expand school services for students with special needs and would free up state and local funds to expand the overall level of school services to all students. Adequacy Arguments for a Greater Federal Role A second argument for a greater funding role for the federal government emerges directly from analyses of funding inequities (Chapter 3). In their examination of 16,000 school districts, Evans et al. (1997) found that while within-state inequality fell slightly between 1982 and 1992, between-state inequality rose sharply. State government policies that are designed to improve intrastate inequality are not likely to improve interstate spending inequality. Only if education finance reform in states that is intended to reduce intrastate variation also raises the state average spending level and if the states pursuing such policies are those with relatively low per-pupil spending levels, would state-specific reform efforts reduce interstate differences. But these conditions are not always satisfied. Serious proposals to correct interstate inequality are most likely to require an increased federal role in financing education. Thus, this second rationale leads to an alternative policy option for a larger federal role, namely ensuring that all states can adequately fund their schools. The federal government will face the same challenges (described in Chapter 4) in determining an adequate level of per-pupil revenues for a district or school with the typical mix of students. Nevertheless, there are proxy measures that could be used in the meantime. Odden and Busch (1998), for example, suggest the na-

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Making Money Matter: Financing America's Schools tional median level of basic education revenues per pupil. Although whatever measure is used at this point would be imprecise, it would represent an acknowledgement that only an enhanced federal role can address interstate funding inadequacies. Especially in an era when the nationwide education goal is to teach students in all states to high standards, the time may have come to consider a new federal role in education on the basis of educational adequacy. Such an approach would call for a new federal foundation program. An adequacy rationale at the state level leads to a foundation type of school finance structure; the state ensures that each district has an adequate level of education revenues so a district can educate an average student to specified performance standards and then would adjust this foundation amount by a factor that accounts for the higher costs of both students with special educational needs and geographic price differences for the educational inputs purchased. Each district would need to contribute financially to such a foundation base by making a required maximum tax effort. Districts that could not generate an adequate level of resources with the required tax effort would receive state aid to subsidize the difference. A new federal role could be similar. First, federal policy makers would have to define a federal foundation level of spending that would be adequate for the state or district with the typical student. They would then need to adjust this base level by a factor that accounted for differences in pupil needs as well as in educational input prices across states. The federal government could ensure that each state could generate the foundation level of funding by giving each state federal aid equal to the difference between the foundation level and the revenue that the state would generate based on a minimum tax effort. Provisions would also be needed to ensure that states distributed revenues to districts and schools so that they too had an adequate amount of revenues per pupil. To be sure, considerable analysis would be needed to determine nationwide, cost-and price-adjusted revenue per-pupil amount for each state and district and how the minimum tax effort would be defined. Nonetheless, the basic approach should be clear. Either of these policy options would require a substantial increase in federal revenues. Because of the existence of large federal surpluses at the current time, these ideas might have arrived at a fortunate time. Nevertheless, the politics for funding such new initiatives can be expected to be contentious. CONCLUSION Increasing the fairness with which revenues are raised for education will almost certainly require a greater revenue-raising role for states and the federal government. However, as with any change, there are trade-offs to be considered. The good news from our analysis is that, in some cases, the trade-offs are not so stark as some people have suggested. For example, the concern that increased

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Making Money Matter: Financing America's Schools centralization of financing at the state level will inevitably lead to lower state spending on education, an inference drawn from the California experience, is not supported by the evidence from other states. Nonetheless, some trade-offs remain. Of most importance for harnessing education finance to the broader goals of education policy is the need for policy makers to pay close attention to ensuring that changes in financing mechanisms do not weaken the incentives for districts or schools to be vigilant about the productive efficiency of the system and that intergovernmental aid programs are carefully designed to promote the goal of reducing the nexus between family background and student achievement.