Investor Alert

Nov. 4, 2021, 11:30 a.m. EDT

‘Trying to strangle local governments’: What happens when states and their cities become adversaries?

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Andrea Riquier

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Two years before Detroit, what was then the largest municipal bankruptcy in American history took place in Jefferson County, Ala. The state Supreme Court ruled a county occupational tax unconstitutional — “pointlessly,” in Fabian’s words — a step that ushered it into insolvency.

Starving the beast

Napoleon Wallace and Activest, a research firm he co-founded, are working to price what it calls “fiscal justice risk” in the municipal market.

Read: A new investing strategy aims to influence racial justice, from the ground up

“When state legislatures limit the agency and capacity of local government to meet the demands of their residents, the result is generally a broken fiscal environment that harms communities of color and restricts [cities’] ability to operate in the best interest of their residents,” Wallace said in an interview.

He pointed to not just the high-profile fiscal blowups of Detroit and Flint , but also Ferguson, Mo., and Louisville. And he doesn’t agree, he said, that state-level policy has what’s often called “unintended consequences.”

“In a lot of areas, the role of state pre-emption and the ability to limit taxing at the local level is a very well-constructed apparatus that allows for gerrymandered state legislatures to impose their will on diverse cities,” he said. When states limit cities’ policy-making abilities, “you make it hard for progressive interests even when they have support among residents. You hamper their ability to finance progress.”

The conservative notion of “starving the beast” — limiting taxation both for its own sake and so that governments don’t have revenue to spend on programs –– isn’t new . But it gained a foothold on the state level in the past decade or so, perhaps most notably when supply-side crusader Arthur Laffer began advising Kansas Gov. Sam Brownback.

Kansas tax cuts enacted in 2012 blew a hole in the state’s budget, its economy and its bond rating, as the legislature cut funding to higher education, public schools, transportation and more. As Wallace noted, more often than not, the stripping away of social safety nets has a disparate impact on communities of color.

Don’t miss: Wisconsin Gov. Tony Evers clawing back Foxconn state tax breaks

The fault lines of inequality exposed by the COVID-19 pandemic have also thrown the pre-emption issue into starker relief. A 2020 report from the left-leaning Economic Policy Institute notes that legislative moves are “disproportionately harming the same communities that have been pre-empted from taking local action, limiting their ability to effectively combat the public health crisis.”

The report, which focuses on the South, characterizes pre-emption as “embedded in a racist history.” Pre-emptive laws “are passed by majority-white legislatures and tend to create barriers to economic security in cities whose residents are majority people of color.”

Throughout the pandemic, state lawmakers have pre-empted local measures, like masking policies or shutdown orders, that would help keep vulnerable people safe, even as people of color were more likely to be “frontline” workers or employed in jobs that didn’t allow them to work from home, the report notes.

A just-released report from the Pew Charitable Trusts looks at the limitations states impose on local taxation through the lens of the COVID economic downturn.

“The pandemic has created significant economic uncertainty for local leaders, with many experiencing large revenue shortfalls that make balancing budgets all the more difficult,” the Pew report notes.

“When local governments struggle, states pay a price, too — because of lost jobs, reduced tax collections, diminished services and, in extreme cases, costly state bailouts. To minimize harm during economic downturns and support localities’ financial stability over the long term, states could review any policies that restrict local budget flexibility.”

See: In one chart, how U.S. state and local revenues got thumped by the pandemic — and recovered

But to Barrett it’s ironic that Wisconsin finished fiscal 2021 with a $2.6 billion surplus , and expects an even larger surplus in 2022, yet legislators can’t find a way to share any of that with locals. And lawmakers don’t seem any more inclined to “review” their restrictive policies than they were before the pandemic.

“They have a surplus, and they won’t throw us a bone,” Barrett told MarketWatch. “They’ve won. They strangled us. We don’t have much left.”

Read on: What good is a commuter tax in a work-from-home world?

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