Public Finance Seminar Spring 2015, Professor Yinger State Aid

Public Finance SeminarSpring 2015, Professor Yinger

State Aid

State Aid

Class Outline

The Education Finance System

Types of State Aid

Research on State Aid

State Aid

The U.S. Education Finance System

State elected officials make the rules for elementary and secondary education.

State elected officials also design the education finance system:◦ State aid (~50% of total in average state)◦ Property taxes and perhaps other local taxes◦ Compensation for homestead exemptions

The federal government provides a little funding (< 10%), tax breaks for property taxes, and some incentives (through NCLB).

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EDUCATION FINANCEIN THE U.S.

School District

Local Property Taxes

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Federal Aid

Local Voters

State Regulators

Authority Revenue

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The Education Finance System, 2

The broad rules are laid out in a state constitution, which has phrases such as “a system of free public schools’ or “a sound, basic education.”

Elected officials design a system that meets their objectives, which usually (but not always!) do not involve much re-distribution.

People in low-performing districts bring suits into the state courts, and the state courts rule on the constitutionality of the system designed by elected officials.

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The Role of the Courts

1971: Serrano decision by California Supreme Court rejected California’s education finance system based on U.S. and California Constitutions.◦ It is unfair, the court said, for a child’s education

to depend on the wealth of his school district.

1972: Rodriquez decision by the U.S. Supreme Court ruled out education claims based on U.S. Constitution.

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The Role of the Courts, 2

Since 1971:

◦ 43 state courts have heard challenges to their state’s education finance system.

◦ 20 more education finance systems have been declared unconstitutional by a state supreme court.

◦ Court decisions have led to major education finance reforms in many states, including California, Kentucky, New Hampshire, New Jersey, Texas, Vermont.

◦ Several states have implemented major reforms without a court mandate, including Kansas, Maryland, and Michigan.

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Educational Disparities

What the courts are responding to are enormous disparities in both resources and student performance across school districts within a state.

This disparities arise because districts vary widely in both available resources and educational costs.

Large cities, which often contain many poor families, have particularly low student performance.

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Sources of StudentPerformance Gaps

Poverty, Limited English, Wages

Disparities in Income &

Wealth

Gaps in Education Resources

Gaps in Education

Costs

Gaps in Student

Performance

Demand Supply

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8th Grade Test-Score Gaps

Between Big Cities and States, 2001State City Reading Math

California Los Angeles 38.0% 42.9%

Oakland 44.0% 44.9%

Colorado Denver 44.4% 64.9%

Illinois Chicago 27.3% 50.0%

Louisiana New Orleans 58.0% 63.6%

Maryland Baltimore 63.0% 70.2%

Massachusetts Boston 38.8% 41.2%

Michigan Detroit 48.3% 44.4%

Minnesota Minneapolis 35.4% 41.7%

Missouri St. Louis 67.6% 60.0%

New Jersey Newark 43.9% 61.4%

New York Buffalo 48.9% 59.0%

New York City 26.7% 41.0%

Rochester 44.4% 71.8%

Ohio Cleveland 18.7% 53.4%

Pennsylvania Philadelphia 61.7% 68.6%

Wisconsin Milwaukee 49.3% 79.5%

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NYC Buffalo Rochester Syracuse Yonkers Rest of State0

10

20

30

40

50

60

70

80

90

Proficiency and Graduation Rates in New York, 2013

Grades 3-8 ELA Grades 3-8 Math Graduation Rate

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Key Questions in Education Finance Reform

1. What is the best way to measure the education provided by a school district?◦What do we want schools to provide?

2. What is the appropriate equity standard?◦How would we recognize a fair outcome if

we saw it?

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Measuring Education, 1

Spending per pupil is a poor measure of education ◦Easy to measure, but hard to interpret◦Rejected by most courts

Spending ignores variation in the cost of education due to◦Concentrated disadvantage among students◦The high cost of attracting teachers to some

districts

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Measuring Education, 2

Pupil performance, such as test scores and drop-out rates, provides a better measure of education◦ It corresponds with what parents want◦ It is consistent with the trend toward setting higher

standards◦ It is consistent with accountability programs (discussed

next class)

An education cost index provides a bridge between performance and spending◦ An equivalent approach is using higher “weights” for

disadvantaged students

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Educational Adequacy

Adequacy is the equity standard emphasized in most recent court decisions and by most policy makers:◦ Every student should be in a school that delivers an

adequate average student performance.

An adequacy standard does not eliminate all disparities:◦ Districts are allowed to provide above-adequate educations

if they can.

Adequacy is achieved by a foundation aid program (discussed below).

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Other Equity Standards

Access Equality◦ The education provided by a district should depend only on its

property tax rate.◦ Refers to fairness for taxpayers, not students. ◦ Is achieved by power-equalizing aid (discussed below)◦ Was the main issue in Serrano.

Wealth Neutrality◦ Educational outcomes should not be correlated with school

district wealth.◦ Difficult to achieve.

Equality◦ All school districts should provide the same level of education.◦ May require state provision, as in Hawaii.

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The Foundation Aid Formula

40 states use a foundation aid formula, designed to achieve educational adequacy.

The foundation aid formula is

◦ Aj = aid per pupil to school district j.

◦ E* = foundation spending per pupil (state-selected; the same in every district).

◦ t* = minimum required property tax rate (state-selected; the same in every district).

◦ Vj = actual property tax base per pupil in district j.

* *j jA E t V

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The Foundation Aid Formula, 2

E*

Spending per Pupil

Tax Base per Pupil

Vmin Vmax

Required Local Taxes

FoundationSpendingLevel

Spending Above Foundation Level

Aid

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A foundation aid formula can easily be adjusted for educational costs (that is, focused on performance):

◦ S* = foundation spending level per pupil in a district with average costs

◦ Cj = educational cost index for district j.

Pupil weights can also be used.

This formula is equivalent to offsetting fiscal disparities across schools.

* *j j jA S C t V

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A foundation formula must address four issues:

◦1. How much spending is “adequate”?

◦2. Should the foundation level be adjusted for variation in education costs across districts?

◦3. Should a minimum local property tax rate be required?

◦4. How should burden of funding an adequate education be distributed?

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Foundation Aid without Minimum Tax Rate Requirement

E*

Spending per Pupil

Tax Base per Pupil

Vmin Vmax

Local Taxes

FoundationSpendingLevel

Spending Above Foundation Level

Aid

SpendingLostwithoutRequiredMinimumTax Rate

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Power-Equalizing Aid

Power-equalizing (or guaranteed tax base, GTB) aid, is the main program in 3 states and a supplementary program in 10 others.

The idea behind GTB aid is that a district’s spending should depend on tax effort, not tax base:

where V* is a policy parameter set by the state.

*j jE t V

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Power-Equalizing Aid, 2

To determine the associated aid formula, note that

Combining this with the GTB formula leads to:

*1 j

j j

VA E

V

* *or ( )j j j j j j j jE A t V t V A t V V

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GTB is matching aid; the state share of spending decreases with Vj.

If V* < maximum Vj, then matching rates are negative in rich districts.◦ This is called recapure.◦ Vermont is an example.

Raising V* raises the cost of GTB aid.◦ To offset this effect, set matching rates at a fraction of

the value in the above formula◦ That is, flatten the line in the following picture.

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0

MatchingRate =StateShare

Tax Base per Pupil

Vmin Vmax

Recapture

V*

mi = (1 – Vi /V*)

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GTB aid can be adjusted for costs (but rarely is):

Using GTB as a supplement to foundation aid is misguided:◦Foundation aid already requires poor districts to

set tax rates above their desired level.◦Adding GTB aid will not induce any further tax

rate increases.

*

* * *

j j jj j j j

S C V VA E E C

S C V V

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Comparing Foundation & GTB Aid

GTB aid is often thought to be more equalizing than foundation aid.

In fact, however, price elasticities are small, so the response to GTB aid is small, even for poor districts. (See D/Y, NTJ, 1998.)

So:

◦ Foundation aid is much more equalizing at the bottom of the property value distribution (and is the only way to ensure adequacy).

◦ GTB aid is more equalizing at the top of the property value distribution—at least if it includes recapture

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Comparing Foundation andGTB Aid, 2

E*

Spending per Pupil

Tax Base per Pupil

Vmin Vmax

Recapture

Initial SpendingSpending with Foundation AidSpending with Power-Equalizing Aid

V*

Small Impacts Due to Small Price Elasticity

With RequiredMin. Tax Rate

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Wealth Neutrality

Wealth neutrality is defined as a zero correlation between property wealth and performance outcomes.

◦ This is the same as a flat regression line for performance as a function of wealth.

When it was first proposed, many people thought GTB aid would lead to wealth neutrality.

But a famous paper by Feldstein (AER 1975) shows that this would be true only by coincidence because outcomes depend on the behavioral responses to the matching rates.

◦ A low response by low-wealth districts (which seems to be the case) would lead an upward sloping line.

◦ A high response by low-wealth districts would lead to a downward sloping line.

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Research on State Aid

The Oates Equivalence Theorem

Recall that

The Oates theorem says that the impact of these two components of augmented income on demand should be the same.

Other equivalence theorems arise in other models.

A VY Y A

V

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Research on State Aid, 2

The Flypaper Effect

Empirical studies find that the Oates theorem does not hold.

In the D/Y equations, f ≠ 1:

There is no consensus about why this is true.

* *

1* * *V VS K Y f A C e

V V

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Matching aid

The community budget constraint

The household budget constraint

Tax Price

{ } 1C Se mA tV

1 1{ }e

m mV V

C SV VY A Z PH

1VTP MC mV

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The matching rate

Note that in this formulation, the matching rate is the state share

Some studies use the state match per dollar of local or

This leads to:

Sm

S L

*S

mL

1

1 *

{ }e m

C S A tV

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Matching vs. lump-sum aid

There is a well-known theorem that matching aid has a more stimulative effect than equal-cost lump-sum aid.

This is an application of the classic microeconomic theorem that price subsidies have larger effects (per dollar) than cash grants.

The relevant graph follows:

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Cash vs. Price Subsidy

Food

Clothing

F1 F3 F2

Budget Line with Cash Grant

Cost of Both Programs(in Units of Food)

Tangency Pointwith Price Subsidy

I3

I2

I1

Budget Line with Price Subsidy

Tangency Pointwith Cash Grant

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This theorem fails to consider three key elements of the demand for public services

Lump-sum aid has a flypaper effect.

Matching aid alters the value of existing lump-sum aid (and, to be specific, makes it less stimulative).

Both matching and lump-sum aid may alter efficiency, but these effects are not well understood.

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The flypaper effect applies only to lump-sum aid.

Even if the price elasticity is high for a government service, the theorem applies regardless of the price elasticity.

The theorem assumes no flypaper effect.

Hence, a large flypaper effect could reverse the theorem.

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Matching and lump sum aid

With matching and lump-sum aid the household budget constraint is

Matching aid affects the value people place on lump-sum aid (because it alters their tax price),

This effect could reverse the standard theorem because it lowers the stimulative impact of matching aid.

1 1{ }e

m mV V

C SV VY fA Z PH

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Aid and Efficiency

Both types of aid appear in augmented income.

Matching aid appears directly in tax price and both types of aid affect tax price through e.

Hence both type of aid may alter efficiency—and this effect may reverse the standard theorem.

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Documents

Public Finance Seminar Spring 2015, Professor Yinger State Aid