DIRECT-BENEFIT FINANCING: AN OPPORTUNITY FOR LOCAL GOVERNMENT

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DIRECT-BENEFIT FINANCING: AN OPPORTUNITY FOR LOCAL GOVERNMENTAuthor(s): LOUIS M. REA, GLEN W. SPARROW and DIPAK K. GUPTASource: Public Administration Quarterly, Vol. 8, No. 1 (SPRING, 1984), pp. 29-43Published by: SPAEFStable URL: http://www.jstor.org/stable/40861027 .

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DIRECT-BENEFIT FINANCING: AN OPPORTUNITY FOR LOCAL GOVERNMENT

LOUIS M. REA GLEN W. SPARROW DIPAK K. GUPTA San Diego State University

The recent downturn in the United States economy has rendered the fiscal condition of many states and local governments rather precarious. For example, in fiscal year 1981-82, about 30 states were expected to witness an actual decline in their own revenues. Furthermore, federal grants-in- aid monies are likley to decline from $88 billion in 1981 to about $78.6 billion by 1983. (Business Week, (1981:136) This economic predicament represents a significant contrast to the almost uninterrupted revenue growth enjoyed by state and local governments from 1948 to 1973. During this period, the total revenue raised by state and local governments through their own sources registered a substantial increase of 100 percent (Ibid.) while federal grants increased 18.5 times on a per capita basis (Maxwell and Aronson, 1977:48).

This fiscal reversal is compounded by the widespread discontent with rising ad valorem property taxes. The Jarvis- Gann Initiative (Proposition 13) in California and Proposition 2V* in Massachusetts, which severely restricted the ability of local jurisdictions to generate property tax revenue, are the most popular examples of this problem. Also, states and localities, in an attempt to maintain balanced budgets, have instituted measures which restrict the growh of expenditures. In California, for example, the passage of Proposition 4, following on the heels of Proposition 13, has limited expenditure increases



(30) PAQ SPRING 1984

to a rate which is tied to the cost of living and population growth.

It is evident that taxpayers are seeking ways to minimize the adverse effects which the sagging economy is having on their own fiscal plight. They are adamant that governments, especially at the local level, cut back expenditures and at the same time use revenues more sparingly and prudently. Underlying this philosophy is a current of "fairness" in the distribution of the municipal burden. That is, taxpayers find it quite appealing to pay for improvements and services in accordance with the benefit and enjoyment which they derive from them. Subsidization of the general public in an era of fiscal constraint is much less appealing.

Standard economic theory (Buchanan and Flowers, 1975) argues that the income elasticity of demand for public goods is greater than that for private goods. In other words, as income increases, there is a tendency to demand more of public goods as a proportion of total demand. Thus, educational services, health care, recreational services, and other types of social programs take on greater significance in the preference structures of individual taxpayers. (Musgrave and Musgrave, 1980:150-151) Similarly, it can be argued that, when real income is reduced, many of these programs may be viewed as luxuries for which a significant portion of taxpayers are no longer willing to pay. Consequently, the community in general may become increasingly reluctant to subsidize projects which will benefit only a limited segment of the populace.

Thus, municipalities and other local jurisdictions are seeking alternatives to the property tax for financing capital improvements, new development, and public services. Investors in the private sector, facing highly undesirable economic conditions, are also actively searching for alternatives to finance their projects. It is in this context that direct benefit assessments are generating lively interest and deserve careful consideration. Direct-benefit financing is a mechanism utilized by local jurisdictions to fund the acquisition of land, the making of a capital improvement, or the provision of an urban service through the assessment of property owners who directly benefit.



PAQ SPRING 1984 (31)

The purpose of this article is to review the theoretical and legal underpinnings of the direct-benefit approach to financing municipal improvements and services through a critical evaluation of the special assessment district. Particular emphasis is given to localities in the state of California which have made extensive use of the technique. Finally, it is argued that the use of direct-benefit financing in general and special assessment districts in particular is a viable means for localities to finance economic development. It is noted, however, that caution should be exercised given the prevalence of certain negative economic trends in the municipal bond market.

THEORY OF BENEFIT FINANCING

Ordinances, statutes, and case law distinguish between special and general benefits from public improvements. Although a precise distinction between these two conceptions is difficult to make, general benefits are those which are so diffused throughout a community that they cannot easily be ascribed to particular parcels of land. Special benefits tend to be identifiable as accuring to individual parcels near the improvement. It is an established legal tradition that only special benefits may be specially assessed while projects which do not produce special benefits may not be financed in this manner. (Misczynski, 1978:321)

Although the power of special assessment originated in the sovereign power of taxation, special assessments are markedly different from property taxes. Taxes may be levied for any lawful purpose of government. The taxpayer cannot object that he will not be specially benefited by the expenditure of the taxes exacted from him. On the other hand, special assessments can be levied only where the land of a property owner will be specially benefited by the expenditure of the special assessments. Property taxes are apportioned on an ad valorem basis (in proportion to the value of the taxable property) . Special assessments can be apportioned on any basis that will reasonably measure benefits. Thus, a taxpayer cannot avoid payment of fire protection taxes levied on his private lake simply because his lake cannot be benefited by the expenditure of fire




protection taxes. But, the private lake could not be specially assessed for a system of fire mains because under no circumstances could the lake be benefitted by such a system. (Hamilton, 1981:2)

Most public works which improve the use or occupation of lands result in special benefit. Curbs, gutters, sidewalks, paving, waterlines, and sewers usually present clear cases of benefit. But special assessments are not limited to tangible physical improvements. They may also be levied to pay the costs of providing services which will benefit land in some special way. Thus, street lighting districts and maintenance districts can be created to finance the lighting of streets or the maintenance of a public improvement such as a sewer system. If special benefits exist, the project must be shown to have a public purpose and general constitutional and common law standards must be met. If the assessment is by a local government, there must be a state statute authorizing the assessment project.

In a number of potential cases such as the development of off-street parking facilities and storm drains, the opening or widening of an arterial street, and the building of major highways and rapid transit systems, it is arguable whether the benefit is special or general. Courts have sometimes held that such projects are non-local in nature and produce, by definition, non-local (general) benefits. This controversy, however, is often academic because the courts invariably sustain the good faith determination which legislative bodies make upon debateable questions of benefit. (Hamilton, 1981:2) [1]

In terms of identifying projects suited to direct - benefit financing, it does seem useful to implement location-specific improvements with benefits that result in increased land value. In many states, courts have agreed that a change in the market value of real estate is a common conceptual basis for identifying special benefits. It is often asserted that only the benefits derived by an improvement in excess of those derived from the improvement of the entire community can be specially assessed. This rule, however, raises a serious question concerning where the special benefit ceases and where the general benefit begins. This matter is further complicated by the considerable evidence




which shows that property values are differentially affected by a given improvement over the life of the project. (Misczynski, 1978:322-323) The implication is that, if project costs are to be distributed in proportion to benefit, then the public, through general tax revenues, should pay the portion of project costs that general benefits are to total benefits.

Perhaps the most troublesome practical difficulty in applying these concepts of direct-benefit financing is determining how to measure benefits accurately. This is a two-pronged problem. First, as previously mentioned, it is quite difficult to identify benefits which accrue to the general community as opposed to those which accrue primarily to individual land parcels. Second, once the beneficiaries of special benefits are identified, it is necessary to utilize an equitable means of differentiating among the benefits received and then utilizing a mechanism to collect the appropriate assessments. [2] This second issue is particularly problematic because it is traditional that the amount of assessment against each parcel be determined before the public improvement is made. It is considered just that landowners know whether they will be subject to assessment and how much the assessment will be beforehand. However, it is often difficult to predict what benefits will follow from a sewer project, residential street, or similar improvement to the landscape.

Finally, it is noteworthy that no share of project costs may be assessed against exempt properties. However, exemptions from special assessments are much more restricted than those associated with the property tax. Property owned by religious, charitable, or educational insitutions as well as railroads and cerne taries, for example, is often not exempt. (Ibid., p. 332) Exemptions from the general property tax are a means of subsidizing institutions that provide some perceived benefit to the community. A theory for not exempting the same properties from special assessments is that they are benefited by the project being financed so that the assessment should work no special burden on them.

LEGAL AND ADMINISTRATIVE FRAMEWORK

The traditional administrative framework for operationalizing




the concepts of direct benefit financing is the assessment district, a specific territory within a local governmental jurisdiction, city or county, established for the purpose of financing the general benefit received by the property owners within the assessed zone. It is administered by the jurisdiction which creates it. The boundaries, functions, and administration of assessment districts are determined by the jurisdiction's legislative body. The assessment district may consist of contiguous or non-contiguous areas and the benefit may be funded through debt financing or the creation of a special fund. The cost of improvement, the provision of services, and any other incidental costs are borne by the benefiting property owners over and above their regular property taxes. Benefit assessments are not new. Their first documented use was in England in the Thirteenth Century. New York City used assessments in 1691 to pave streets and build drains. (Cal-Tax Research Bulletin, 1981:3)

Since assessment districts are initiated and controlled largely by state law, the great variation in state enabling legislation renders it rather difficult to describe in any detail the workings of an assessment district. In order to present a model of the process typical of most states, the procedures followed in California are discussed. Prior to using the assessment district to finance local projects, an administrator should carefully inspect state law as well as local charter provisions and ordinances.

California's interest in special assessments dates from the first legislature which, in 1850, authorized the use of special assessments for * 'paving the streets and the construction of sewers, making the cost thereof payable by the owners of fronting properties." Benefit assessment use peaked between 1900 and 1930. In 1913, assessments accounted for 20 percent of the total revenue of Los Angeles and Oakland. Assessment revenue increased by 175 percent between fiscal year 1978-79 and fiscal year 1979-80 in California due to Proposition 13. (Ibid., p. 4) The state has created, through specific acts, general principles that are applicable to special assessment proceedings. These procedures apply to all cities, counties, and certain special districts. Charter cities and counties may adopt




procedural ordinances of their own but for convenience most adhere to the state acts because state courts have commonly accepted these procedures. (Hamilton, 1981:3)

The major California state acts currently relevant in this area are as follows: the Improvement Act of 1911; the Municipal Improvement Act of 1913; and the Improvement Act of 1915. As amended over the years, these state acts provide the procedure, definitions, and limitations concerning the creation of assessment districts and the authorization necessary to issue bonds. The creation of an assessment district may result in the imposition of a lien against the benefitting property with yearly assessment paid by the property owner in order to fund the necessary service or improvement.

If there is a need for large front-end expenditures to acquire land or to improve property, assessment districts may decide to issue bonds. The yearly assessments against the property are used to retire the bonds over their life. The 1911 Act is both an assessment act and a bond act, the 1913 Act is only an assessment act, and the 1915 Act is a bond act. Assessment districts may be created under the 1911 or 1913 Acts (each deals with specific types of acquisition, improvements, and services; and bonds may be authorized under the 1911 Act for 1911 or 1913 districts and the 1915 Act for 1913 districts. (These bonds are not sold by the city, county, or special district but rather are presented to the contractor in payment for services rendered.)

The creation of a special assessment district is initiated by the legislative body of the jurisdiction. However, due to political concerns, many cities and counties require that the project be initiated through petition by landowners. Since the courts have been very sensitive to the requirements of due process, jurisdictions have responded by being especially cautious in intitiating or approving assessment districts. This is particularly evident in the California requirements for notice and hearing. Notice is required through publications, posting, and mailing. Hamilton (1981:12) notes that the United States Supreme Court in a series of decisions since 1949 indicates that "posted or published notice alone is not sufficient to satisfy constitutional due process requirements ." Thus, sufficient effort should be made to notify potentially affected property owners through the




mail. Further, the legislative body is required to hold one or more

public hearings before forming the assessment district and deciding upon the amount of assessment. In California, almost all of the assessment acts allow for a majority protest which must be in writing. If a protest is filed by a majority of the landowners in the assessable area, the proceedings are abandoned and the project is barred for at least one year. If no majority protest is prepared, the legislatove body may adopt a resolution to proceed but it is not compelled to do so. After legislative approval, the acquisition, improvements or services ordered by the resolution may proceed.

All benefited property will be assessed except that owned by the state and federal governments. Once the cost of the property assessment is determined, the owner is allowed thirty days in which to pay the assessment in full. If this is not done, a lien is made against the property and a bond is issued. Pursuant to the 1911 Act bond, this lien is against a specific piece of property rather than a personal liability of the landowner. When the 1915 Act bond is used, there is an indirect lien on all affected properties; that is, if there is a default, the governmental jurisdiction covers the payment and conducts foreclosure proceedings to recover its money.

The difference in foreclosure proceedings can affect the decision of bond buyers. In the case of 1911 Act bonds, the buyer is likely to feel more secure having property available in the event of foreclosure. According to the procedures of the 1915 Act, the "good faith and credit" of the local jurisdiction secures the bond. If foreclosure takes place, payment is made from a bond redemption fund. Given the massive reduction in local tax revenues in recent years, bond buyers may have little faith in the ability of local governments to back up their investment.

USE OF DIRECT-BENEFIT FINANCING: THREE EXAMPLES

As discussed above, the assessment district has been used by local jurisdictions for many years as a means of financing




improvements or services to benefit a specific geographic area. In the face of tax limitation measures and various pressures to reduce municipal expenditures, local jurisdictions have begun to use this type of financing more extensively and in more innovative fashions. The following examples briefly describe three schemes in which direct- benefit financing is used either alone or in coordination with other financing mechanisms. Each of the examples demonstrates the flexibility of this method of financing when utilized by innovative local government officials.

Faire hild, California is a general law city with approximately 60,000 inhabitants. It is located on the major interstate highway about halfway between San Francisco and Sacramento. In recent years, an aggressive city manager, finance director, and city council have used assessment districts both alone and in combination with other financing mechnisms to fund over ten million dollars in improvements.

In one situation, the use of the assessment district is associated with a 75-acre parcel earmarked for a regional shopping center. This case [3] is especially innovative because the assessment district is utilized in tandem with tax increment financing, the developer's cash deposit, and loans from the city to structure an attractive package which has induced the developer to invest in Fairfield.

The assessment district was created to finance three major undertakings: the road work surrounding the shopping mall; an interchange to the interstate highway system including on and off ramps; and a bridge across the interstate. In return for the financial package offered by the city, the developer agreed to a profit sharing plan. The developer will pay the city from net sales revenues derived by the shopping center on a sliding scale ranging from 10 to 15 percent yearly based upon the amount of sales. Additionally, the developer has agreed, in the event the shopping center is sold, to provide the city with 15 percent of any increase in property value. This agreement is in effect for 99 years.

While the Fairfield example does not apply exclusively to assessment district financing, it does show how this device can be used as part of a financial package which enables a jurisdiction to maximize its financial leverage to encourage




economic development. It also illustrates how the creative use of assessment financing can help to develop a public/private partnership that produces long-term financing for the city in a time of fiscal constraint.

Fresno County is a charter county of approximately one-half million persons situated in the center of California's rich central valley. Over the years, the county has evolved an ambulance service that now serves all areas of the county. Fifteen providers of service including public, private, not-for-profit, and volunteer organizations are engaged in providing varying degrees of ambulance service. Each of the providers depends upon the county for financial assistance. Given the inability of Fresno County to raise tax rates (due to Proposition 13), a higher and more sophisticated level of paramedic services could not be provided. Thus, in 1982, the provision of ambulance service reached a crisis in Fresno County.

The County Administrative Officer has presented the following proposal to the county board of supervisors. [4] (At the time of this writing, the final decision of the board had not been made.) A County Service Area (CSA) would be formed with boundaries coterminous to the county boundaries. Since it is assumed that ambulance service is a benefit that would be enjoyed equally by everyone in the CSA, an assessment is proposed for each "living unit" in the county to fund the ambulance service or "Advanced life Support System." Living units comprise approximately 194,000 units in the county and are defined as single and multiple family residential, mobile homes, apartments, condominiums, motels, and hotels. The assessment would therefore cover not only residents of the county but also visitors who would be eligible to take advantage of the service. Visitors would undoubtedly pay in the form of higher motel and hotel room rates. It should be emphasized that this scheme is still a proposal and there may well be problems involving state enabling legislation. However, the proposal is a most innovative attempt in the use of direct-benefit legislation.

A final example of direct-benefit financing is found in the city of San Diego. [5K San Diego is a charter city in the South- western corner of California having a land area of 320 miles and a population of over 850,000. In accordance with the city's




planned growth program, an area of 4200 acres, known as North City West, in the Northwestern section is scheduled for major development. Due to serious reductions in the revenue-raising capacity of the city, precipitated by Proposition 13, the city does not have the financial capability to develop the infrastructure necessary for the proposed development. To obviate these problems, the city is working with two developers who own most of the land in this area on a direct-benefit financing scheme that would create municipal capital projects.

Since San Diego is a charter city, state law permits the city council to create a Facilities Benefit Act (FBA). This FBA incorporates many of the procedures found in the State 1911 and 1913 Acts but does not use bonds for financing. The financing for such projects as parks, libraries, water, sewers, and police and fire stations is generated through a lien against all of the parcels in the project. When a particular parcel or group of parcels is developed, the contractor pays a fee which varies in amount according to the parcel's land use designation. When the fee is paid by the developer, the lien is lifted and the cost is passed on to the purchaser of the property. An assessment district type of benefit financing has also been created within the school districts of the area; that is, an assessment of about $5000 per residential unit will be used for the construction of schools. Streets and transportation-related construction com- bine assessment district financing and exactions under the State Subdivision Map Act.

The San Diego North City West project, which will include 14,000 mixed residential units for 40,000 people, an industrial park, and a regional shopping center, is scheduled for completion in 2006. Using the three direct -benefit financing mechanisms, mentioned above, approximately $125 million in infrasctucture cost will be generated with little or no cost to those who do not reside or own commercial property in the development area.

RECENT BORROWING TRENDS: A WORD OF CAUTION

The dwindling revenue sources and expenditure limitation measures are two reasons why direct -benefit financing has




become increasingly popular in recent years. However, the deepening economic recession has made it more and more difficult for local governments to borrow money in the bond market. This, of course, raises serious questions concerning the continued success of a financing mechanism which relies so heavily on municipal bonds.

The average interest rate on local bonds has doubled since 1977. Municipalities now have to borrow at a rate which represents an almost 22 percent increase over just a couple of years ago. (Business Week, 1981:136) In fact, the state of California has recently rescinded its law prohibiting local governments from borrowing at higher than 11 percent. Facing this new fiscal dilemma, many financially sound state and local governments have had to halt new bond offerings.

This rapid increase in bond rates has been caused by a number of factors. First, in reacting to the economic problems faced by many municipalities throughout the country, Moody downgraded more city credit ratings than it upgraded. Second, tax-free municipal bond holdings are becoming less and less desirable as an alternative to other investment opportunities such as the tax-free All Savers Certificate and other tax-free savings and retirement pleins. The desirability of holding municipal bonds is further decreased by the proposed cut in the personal income tax by 23 percent in 1984. Also, the planned reduction from 70 to 50 percent of the tax in the top rate for unearned income has narrowed the gap between the yields of non-taxable bonds and competing taxable investments such as money market mutual funds and other tangible assets such as real estate. (Lutkovitch, 1977:2) Thus, with this decline in the capital gains tax, the municipal bond market is likely to experience a severe setback.

During the 1970s, the ownership of municipal bonds by households has increased both relatively and absolutely. (Lamb and Rappaport, 1980:18) This increase can be largely attributed to the entry of the middle-class into the municipal bond market. This type of investment was viewed as a hedge against rising inflation which placed them in higher tax brackets. With a slowing of the inflationary trend, this pattern is likely to change resulting in a further weakening in the demand for tax-free




municipal bonds.

CONCLUDING STATEMENT

The use of direct- benefit financing (especially through the administrative framework of the assessment district) establishes a mechanism for administering and funding public improvements or urban services that benefit specific property within the jurisdiction. Some salient advantages of direct financing which have been discussed in this article are summarized as follows. First, it is required that the benefits deriving from the public improvement be direct and localized. Thus, the beneficiaries and not the taxpayers in general pay for the improvements. This concept of fairness has considerable intuitive appeal. Along this same line, properties ordinarily exempt from property taxes (not including federal and state owned property) may be assessed to pay their "fair share/'

During an era of economic austerity in general and expenditure limitations in particular, special assessments may be advantageous in providing improvements and/or services which otherwise could not be provided through the general fund. Municipalities in California are using this mechanism in innovative ways and in combination with other tools such as tax increment financing. Developers are particularly attracted to this type of financing as a means of avoiding the otherwise prohibitive cost of constructing infrastructure through more traditional financial routes. The cases of Fairfield, Fresno, and San Diego illustrate the possible alternatives.

Potential disadvantages of direct-benefit financing can also be identified. If the bulk of improvements and services currently provided from the general fund become financed through special assessments, these improvements are likely to become vastly differential among the communities. Consequently, it is possible for some communities (predictably those at the lower end of the income scale) to suffer extreme inequity under such a system. Another problem is that an overdependence on special assessments is likely to eliminate projects whose positive externalities will not be contained within any one differentiated community. In other words, the projects which tend to benefit a




large section of the city and whose beneficiaries are difficult to identify will probably have a low funding priority.

With the proliferation of assessment districts comes the possibility of administrative confusion and, hence, mismanage- ment or inefficiency. A large number of overlapping or duplicative assessment districts can create citizen confusion, especially when taxpayers attempt to specify the nature of complaints and dissatisfaction.

One final problem involves the use of municipal bonds in assessment oriented financing. Although the use of municipal bonds can be crucial to the success of direct-benefit financing, the high borrowing rates which municipalities must pay coupled with the decreasing desirability of municipal bonds as an investment opportunity have put this type of financing in some jeopardy. This problem should not be overstated, however, largely because bonds are not necessary for all direct -benefit financing schemes. The Fresno and San Diego schemes, for example, require no bonds.

In sum, direct-benefit financing is a viable alternative at the disposal of local jurisdictions to generate economic development. If used extensively, however, the technique requires careful coordination in order to minimize duplication, inefficiency, and community imbalance.

NOTES l.In California, the courts have taken a closer look at the application of benefit

assessment. In a decision rendered by the California Second District Court of Appeals on November 25, 1980, the court stated the following warning: "Ordinarily, levies to meet general expenses of the taxing entity and to con- struct facilities to serve the general public, such as fire stations, police stations, and schools, may not be transformed from general ad valorem taxes to special assessments by a mere change in the name of the levy..." Solvang Municipal Improvement District v. Board of Supervisors , 112 Cal.App. 3d 545 (1980).

2. There are several methods used for apportioning costs to the benefited properties. The front foot method is the most simple and most commonly used. Under this method, the total cost of the project is expressed in terms of total frontage feet facing the improved zone. Then, individual assessment is made by multiplying each property's front footage by the per foot cost. This method is most appropriate where the frontage length is the best indicator of benefits received. An alternative such as the benefit zone method is utilized when the benefits to the properties are directly related to their distance from the development project. Flood control projects, for example, may appropriately use this method.

3. Interview with Charles Long, Finance Director, City of Fairfield, California, March 11, 1982.




4. Interview with Bill Brian, Assistant City Administrative Officer, County of Fresno, California, April 2, 1982.

5. Interview with Michael Stepner, Deputy Director of Planning, City of San Diego, California, March 26, 1982.

REFERENCES Assaf, Philip D. (1980). Outline of Legal Procedures for Special Assessment and

Assessment Bond Financing . San Mateo: Wilson, Morton, Assaf, and McElligott (attorneys at law).

Buchanan, J.M. and M.R. Flowers (1975). The Public Finances: An Introductory Textbook. Homewood, II.: Richard D. Irwin.

Business Week (1981). Special Report. "State and Local Governments in Trouble." October 26.

Cal-Tax Research Bulletin (1981). Benefit Assessments: A Born Again Revenue Raiser. Sacramento: Cal-Tax.

Hamilton, Franklin T. (1981). Guide to California Special Assessment Acts. San Diego: Stone and Youngsberg (attorneys at law).

Lamb, Robert and Stephen P. Rappaport (1980). Municipal Bonds: The Comprehen- sive Review of Tax Exempt Securities and Public Finance. Toronto: McGraw-Hill.

Lutkovitch, Joan (1977). Statistics on State and Local Government Finance. New York: The Bond Buyer.

Maxwell, James and J. Richard Aronson (1977). Financing State and Local Govern- ments. Washington, D.C.: Brookings Institution.

Misczynski, Dean J. (1978). "Special Assessments," in Donald G. Hagman and Dean J. Misczynski (eds.). Windfall for Wipeouts. Chicago: American Society of Planning Officials.

Musgrave, R.A. and P.A. Musgrave (1980). Public Finance in Theory and Practice. New York: McGraw-Hill.



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DIRECT-BENEFIT FINANCING: AN OPPORTUNITY FOR LOCAL GOVERNMENT