Public Finance Seminar Spring 2013, Professor Yinger

1. Public Finance SeminarSpring 2013, Professor Yinger State Aid

2. State Aid Class Outline • The Education Finance System • Types of State Aid • Research on State Aid

3. 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).

4. Authority Revenue Local Property Taxes Local Voters School District State Aid State Regulators Federal Aid State Aid EDUCATION FINANCE IN THE U.S.

5. State Aid 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.

6. State Aid The Role of the Courts • 1971: Serranodecision 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: Rodriquezdecision by the U.S. Supreme Court ruled out education claims based on U.S. Constitution.

7. State Aid 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 majorreforms without a court mandate, including Kansas, Maryland, and Michigan.

8. State Aid Educational Disparities • What the courts are responding to are enormous disparitiesin 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.

9. Demand Supply Disparities in Income & Wealth Poverty, Limited English, Wages Gaps in Education Resources Gaps in Student Performance Gaps in Education Costs State Aid Sources of Student Performance Gaps

10. State Aid

11. State Aid 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?

12. State Aid 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

13. State Aid 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

14. State Aid Educational Adequacy • Adequacyis 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).

15. State Aid 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.

16. State Aid The Foundation Aid Formula • 40 states use afoundation aid formula, designed to achieve educationaladequacy. • 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.

17. Spending Above Foundation Level Spending per Pupil Foundation Spending Level E* Required Local Taxes Aid Vmin Vmax Tax Base per Pupil State Aid The Foundation Aid Formula, 2

18. State Aid The Foundation Aid Formula, 3 • 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.

19. State Aid The Foundation Aid Formula, 3 • 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?

20. Spending Above Foundation Level Spending per Pupil Foundation Spending Level E* Spending Lost without Required Minimum Tax Rate Local Taxes Aid Vmin Vmax Tax Base per Pupil State Aid Foundation Aid without Minimum Tax Rate Requirement

21. State Aid 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.

22. State Aid Power-Equalizing Aid, 2 • To determine the associated aid formula, note that • Combining this with the GTB formula leads to:

23. State Aid Power-Equalizing Aid, 3 • 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.

24. mi = (1 – Vi /V*) Matching Rate = State Share Recapture 0 Vmin V* Vmax Tax Base per Pupil State Aid Power-Equalizing Aid, 4

25. State Aid Power-Equalizing Aid, 5 • 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.

26. State Aid 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

27. Initial Spending Spending with Foundation Aid Spending with Power-Equalizing Aid Spending per Pupil With Required Min. Tax Rate Recapture E* Small Impacts Due to Small Price Elasticity Vmin V* Vmax Tax Base per Pupil State Aid Comparing Foundation and GTB Aid, 2

28. State Aid 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.

29. State Aid 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.

30. State Aid 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.

31. State Aid Research on State Aid, 3 • Matching aid • The community budget constraint • The household budget constraint • Tax Price

32. State Aid Research on State Aid, 4 • 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:

33. State Aid Research on State Aid, 5 • 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:

34. Budget Line with Cash Grant Tangency Point with Cash Grant Clothing Tangency Point with Price Subsidy I3 Budget Line with Price Subsidy I2 I1 F1 F3 F2 Food Cost of Both Programs (in Units of Food) State Aid Cash vs. Price Subsidy

35. State Aid Research on State Aid, 6 • 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.

36. State Aid Research on State Aid, 7 • The flypaper effect applies only to lump-sum aid. • The price elasticity may be high because the service is a government service, but the theorem applies regardless of the price elasticity. • The theorem assumes no flypaper effect. • Hence, a large flypaper effect could reverse the theorem.

37. State Aid Research on State Aid, 8 • 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.

38. State Aid Research on State Aid, 9 • 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.

39. State Aid Subject • Entry 1