Financial and Regulatory Considerations for State and Local Governments When Establishing Levies

Years later, in law practice, I discovered that such theories and, sometimes, misconceptions about the use of funds were common. This article addresses these ideas by exploring common financial, regulatory, and political considerations at play when establishing “levies” to fund government expenses, and it offers advice for lawyers advising government bodies regarding such levies.

Vetting Funding Needs: Three Questions to Ask

To make the topic more accessible, this article is based on a simple hypothetical: Your government entity client needs more funding for one or more particular uses and asks for help in determining a funding source. Your initial response is to ask three questions of the entity’s leadership or administrative officers.

First Question: When Does the Entity Need the Funding, and for How Long Is It Needed?

In other words, over what period of time must the funding be available? You’re looking for information on whether the need is long-term or short-term, whether it is emergent and critical or really for some future time and perhaps contingent. Your client’s responses to this question need to include information on your public body’s finances, particularly on its budget (such as related allocations and revenue projections).

Second Question: How Much Funding Does the Entity Need?

This second question is more straightforward than the first, but it still requires some unpacking. Naturally, you’re interested in the total sum needed. But you’re also interested in whether the funding is needed at once and over a short time period or over a longer time period. And if the latter, how are the payments broken up or distributed?

The assessment of how much funding your client needs will also be informed by the answer to the third question (below). If, after reviewing your client’s responses, you still can’t determine whether the funding will be adequate to meet the goals, then there’s a problem. If you have such doubts, you may need to drill down more into the entity’s expectations and advise it or its staff about the apparent disconnect.

Third Question: How Will the Funding Be Spent?

The planned use for funding is key in this analysis because you need to evaluate whether, based on the financial information provided to you, your client’s spending goals—the project, services, etc., on which the entity wants to spend the money—will be met.

This question reflects structural limitations and common administrative goals influencing funding decisions. The most common structural limitations influencing funding decisions are restrictions placed on the use of certain funds under state and local laws. Accordingly, you should help your client select a funding type that is most appropriate—one that is financially and administratively efficient, such that it maximizes the value of funding received and minimizes compliance requirements.

Regarding compliance, you should note that the use of such funds can be idiosyncratic. For example, Oregon law limits how certain types of taxes, such as on vehicle use and fuel sales, can be used (i.e., only for certain road infrastructure projects). Another example: If the funds will be used to support a private enterprise, then the Oregon Constitution, Article XI, Section 9, likely prohibits relying on borrowings for that funding. As these examples illustrate, sometimes the plan for how to spend the funding should significantly inform where you look for the revenue.

Regarding value, consider whether your client’s proposed use for the funds raises legal opportunities or challenges. For example, if the planned use is for a capital project, then the best course may be borrowing because bond laws accord such uses special treatment (e.g., the related offering may be eligible for general obligation funding and be tax-exempt, which reduces the entity’s capital cost and makes the offering more enticing for some investors). Another example from Oregon: Oregon Revised Statute 801.041 places conditions on counties enacting new vehicle registration fees, including a required revenue split with all cities within the county (and a requirement that new vehicle taxes be approved by voters, which—as we’ll see below—isn’t always required). Think of the foregoing analysis as something like a return-on-investment assessment. As this illustrates, the funding purpose may activate or eliminate different otherwise viable funding options.

Your client’s answers to these questions should provide you with the context you need for the next phase of discussions.

First, you should know whether the funding will be used for an expense serving a long-term need and represent an investment in an asset or facility, or whether the funding will be used for refinancing existing debt (such as a previous bond offering), unfunded actuarial liabilities, or operating deficits or for new or ongoing operations and services.

Second, you should understand whether your client is trying to address a cash flow problem (good) or an insolvency problem (trickier). Cash flow problems tend to arise because there is a large, unbudgeted, and one-time expense, such as a capital construction project. Insolvency problems arise when there is not enough money to meet all funding needs due to a structural problem—namely, mid- and long-term costs surpassing available funds (from all sources).

For example, consider a city with terrible, road-destroying winters. Every year, the city spends $50 million on road projects. And at the end of every year, the city auditor finds that deferred road maintenance grows by $50 million over the funds allocated for roadwork. Imagine you are counsel to this government. The governing body has expressed an interest in floating a $100 million bond offering, paid over 15 years, to pay for road projects—something the city does every handful of years to try to catch up on roadwork, so the city is near its debt limit. On those facts, the offering sounds like an incomplete solution. Yearly, the city has $100 million in needed road fixes, and for years they haven’t been able to pay for all the needed work with available funding. This mismatch points to an inadequate revenue base for maintaining the city’s infrastructure. The city’s problem isn’t cash flow; it is insolvency.

Third, you should understand which of the different types of funding options are a fit for your public body’s needs—and there are a number of needs to be addressed. Can the funding be obtained in a timeframe that works for your client under a particular option? Can you use the funding source on the spending need—are the two matched? Would the funding impose an unreasonable administrative hurdle? Is the revenue source efficient? Last, is the funding a political match?

Politically, you should keep in mind that the choice of funding type is a policy statement and can be interpreted to express one or another value. For some communities, the choice of funding type is as much an issue of ideology as it is financial. You should have a sense of the politics in your government on funding types. For example, with borrowing comes more outside regulation (bonds are securities regulated by the Municipal Securities Rulemaking Board, which is subject to oversight by the U.S. Securities and Exchange Commission). Counsel should explore whether such additional oversight itself may be a deal-breaker for their government.

Your client’s responses to these questions should provide you with a better foundation for evaluating whether the best fit might be borrowing, new income, or both.

Practice Tips

This brings us to a few practice tips for public body counsel reviewing funding issues.

First, be curious. Counsel who understands the funding landscape well enough to have a general sense of the funding “lifecycle” and why other governments’ funding projects missed the mark can at least help their client avoid others’ mistakes and, ideally, put them on the right path—often with the aid of outside counsel. Accordingly, you should collect anecdotes about funding projects that were successful and ones that failed. Be sensitive to the politics and values that can impact support for a particular funding option. Last, ensure that your public body has policies and practices that support different funding options, such as written financial and debt management guides.

Second, as counsel to new income projects—which in this article are limited to establishing new taxes or fees collected by public bodies under law rather than agreement—you must learn about the other taxes and fees collected by your government (past and present), know when a new income type must be submitted to voters (new taxes frequently must be voter-approved), and look out for limitations under state or local laws on how different income types may be spent.

Last, and specific to projects involving borrowing, such as via bonded obligations, your role as public body counsel starts with ensuring that the government entity has a solid foundation of written, vetted financial policies and practices. Counsel must also be ready to answer bond counsel’s questions regarding the public entity’s governance documents and system, events (such as certain litigation) that must be disclosed, other income sources, and governance issues.

Is the Proposed Levy a Tax or a Fee?

Generally, a tax is a levy on an activity, property, income, or other resource that is imposed by government on parties (individuals and entities), to raise revenue for one or more government uses. Taxes are authorized by voters and by legislative act. Taxes are broadly imposed and broadly beneficial. Unless otherwise limited by law, taxes can fund any lawful public body expense (i.e., flow into a public body’s general fund).

A fee is a levy related to a particular government service that is imposed on persons who apply for or receive a benefit from that government service. Fees are often imposed by public agencies and used to fund a particular and related regulatory activity. Accordingly, fees—particularly licenses, which are a type of fee—are established to regulate activity and/or generate income to pay for the related service(s). As such, fees burden a limited class of individuals and benefit only that same limited class (i.e., payment of fees is essentially voluntary). There must be a close, clear nexus between the parties burdened by a fee and the parties benefited by that fee.

Although many state laws treat a fee’s income-generating and regulatory components as distinct, the two, in practice, are inseparable. Fees imposed primarily for regulatory purposes still may not materially exceed the cost of government’s regulatory activities and may only be used for their intended purpose.

But the above definitions don’t necessarily yield a definitive answer when trying to determine whether a levy is a tax or fee. Often, courts conclude that a “fee” is still a tax and vice versa. For a more dispositive assessment of whether a levy is a fee or a tax, apply the prevailing test in your jurisdiction. For example, in the Ninth Circuit, the prevailing test is found in Bidart Bros. v. California Apple Comm’n, 73 F.3d 925, 930 (9th Cir. 1996). The Bidart test focuses on three primary factors:

1. the entity that imposed the levy,
2. the parties upon whom the charge was imposed, and
3. whether the charge was expended for general public purposes or used for the regulation or benefit of the parties upon whom the assessment was imposed.

When the first two Bidart factors are not dispositive, courts emphasize the third factor—the way in which the income was ultimately spent. Generally, if the fee income is spent for general purposes, then the fee is considered a tax.

Common Types of Taxes

Let’s examine common types of taxes. A nationwide survey of local option taxes (taxes levied by state municipalities that are not required by state law and that are generally voter approved) showed that the most common types of taxes levied by state and local governments were income and sales taxes. Increasingly, many governments are also taxing transactions involving particular goods and services, such as transient lodging (i.e., lodging for fewer than 30 nights), motor vehicle fuel, vehicle rental and ride services, and the sale of products containing THC (marijuana) and tobacco.

Many local option taxes are subject to state-imposed restrictions. For example, in Oregon, all taxes on the use of vehicles (cars, motorcycles, etc.) are subject to the Oregon Constitution, Article IX, Section 3a, which limits the use of these taxes to “construction, reconstruction, improvement, repair, maintenance, operation and use of public highways, roads, streets and roadside rest areas in this state” (and for bond repayment and some administrative expenses).

Generally, unless otherwise restricted (e.g., Oregon Revised Statute 320.350), taxes may fund any lawful public body expense, so they generally flow into general funds and are appropriated to pay for a range of costs and services.

Common Types of Fees

Next, let’s look at common types of fees. A recent survey of fees levied by state and local governments suggests that many public bodies rely significantly on fines and fees to fund their services. Consistent with the limitation that fees must benefit and burden the same parties, most fees levied are user fees and charges for municipal services, such as water treatment and electricity production and transmission. Additional common types of fees include vehicle registration fees, recording and assessment fees, animal services fees, and public safety fees (e.g., alarm response).

Remember, fee incomes are largely restricted to supporting expenses that are closely related to the activities levied. The rule of thumb for assessing whether the use of fee income is lawful asks whether the individuals burdened by a fee are also the people who benefit from how the income is spent. However, rate-based charges funding utility services may generate income in excess of the government’s actual cost for services if the profit, as applicable, is “reasonable and consistent with amounts received by a private enterprise in the operation of similar facilities” or “does not exceed a proportionate part of the amount reasonably necessary to finance the [system] expansion and is earmarked for that purpose.”

As noted above, from a spending standpoint, the restrictions on the use of fee income are fairly clear. If your client tells you that the public body wants to use pet licensing fees to pay for fireworks for a Fourth of July show, then you should advise your client to look for an alternative funding source. Unless the entity can present a compelling argument that connects pet licensing fees to fireworks, the use of those fees is likely unlawful.

Is the Proposed Levy Lawful?

Next, we explore a framework for assessing whether a levy and use of its income is permissible. As signaled above, a state or local government’s ability to impose levies flows from the U.S. and state constitutions, as well as local laws. State and local restrictions on levies often place limits on the activity, status, property, income, or other resource or characteristic on which governments may lawfully impose levies. The limitations on levies can be structural, administrative, and often idiosyncratic.

Reduced and generalized, the four most common limitations on levies are that they must be authorized by voters and by legislative act, be uniformly imposed, state their purpose (dedication), and be consistent with federal and other relevant (state and local) laws. Each limitation is explored below.

Authorization

Levies must be authorized by voters and legislative act. How to meet this requirement varies between different state and local governments. For example, some states enable their municipal subdivisions to enact charters that set forth how the government is structured and governed, including the process of establishing new levies. Counsel reviewing new income transactions should begin their diligence by reviewing such charters to determine whether a levy is authorized and, if so, whether voter approval or ratification is required. Even if approved by voters, enacting levies generally still requires a legislative act by the entity’s elected officials.

Uniformity

The second structural limitation on levies, uniformity, requires that all members within a targeted class be treated alike (inherent uniformity) and that the levy operate uniformly within the territory in which it applies (territorial uniformity).

This requirement is applied differently to taxes versus fees. A tax must be assessed uniformly “on the same class of subjects within the territorial limits of the authority levying the tax.” Yet, fees are “exempt from constitutional limitations requiring that taxes be uniformly imposed so long as the financial burden and the private benefit are closely related.” However, fees and taxes both must uniformly apply to members in a particular or targeted class.

Many uniformity challenges focus on how a levy treats members of a particular class. Generally, public bodies may create classifications for the purpose of levying particular individuals (i.e., a class) and not levying other particular individuals. Classifications must be based on inherent, qualitative, genuine, rational differences between the classes of property to be accorded different treatment. A classification is constitutionally permissible if some real and substantial distinction is present. However, classifications may not be based on suspect categories or fundamental rights.

For example, for ad valorem taxes, the legislature may divide different property subjects into different classes on a rational basis, and different classes may be treated differently. However, valuation methods and tax rates must be uniform within “the same class of subjects” of ad valorem taxation throughout a taxing authority.

Last, courts have found in the inherent uniformity requirement the principle that taxes must account for the taxpayer’s ability to pay.

Dedication

The third structural limitation on levies, dedication, is surprisingly straightforward. Every law imposing a tax must state the purpose for which the tax is imposed (i.e., how collected taxes will be spent). On fees, the limitation’s application is only slightly more involved. Public bodies may spend fees only on costs related to the properties, activities, and parties burdened by the fee. Whether a fee use is related to its enumerated purpose is determined on a case-by-case basis.

As noted earlier, unless otherwise provided for under relevant law, taxes are broadly imposed and may be broadly beneficial, whereas fee use must be narrowly beneficial. There must be a proximate nexus between the ways fee incomes are used and their source. Using levied incomes only for their authorized purpose(s) is critical. For example, Oregon law prohibits public officials from spending moneys “for any other or different purpose than provided by law.” Public officials who spend money for a purpose “other or different” than provided by law may be civilly liable for return of those funds.

Consistency

The last structural limitation, consistency, requires that laws imposing levies must be consistent with relevant federal and state laws. Most “consistency” cases explore whether a levy is preempted or otherwise in conflict with another federal, state, or other relevant local law. Such conflicts of law can arise in a number of ways. For example, a local law establishing a levy may be preempted when the federal government or state clearly expresses its intent to preempt local legislation in a particular area or when the federal government or state imposes requirements on local governments on how those governments may use a particular tax or fee, or when two laws promulgated by different governing bodies cannot operate concurrently.

Last Words

This article offers practical guidance on common financial and regulatory issues that arise when public bodies establish new fees and taxes. The big-picture takeaways are:

• If your government entity client needs new funding, ask:
  • When is it needed?
  • How much is needed?
  • How will it be spent?
• When confronted with a funding need, consider whether there is a cash flow issue or an insolvency issue.
• When considering borrowing, make sure the entity’s financial house is in order and start working with bond counsel early to ensure the foundation is, in fact, there.
• The new funding need may entail borrowing and new income.
• When considering new income, ask whether a new or increased fee or tax is the best fit and make sure that the entity’s associated spending plans match the income to a permissible use.