Revisiting the theory of revenue diversification: Insights from an empirical analysis of municipal budgetary solvency

• Published in: Public budgeting & finance Vol. 42; no. 2; pp. 196 - 220
• Main Authors: Jimenez, Benedict S., Afonso, Whitney B.
• Format: Journal Article
• Language: English
• Published: Malden Blackwell Publishing Ltd 01.07.2022
• Subjects: Diversification; Fees & charges; Local government; Operating ratios; Policy making; Public choice; Public finance; Solvency; Tax revenues; Theory
• ISSN: 0275-1100; 1540-5850
• DOI: 10.1111/pbaf.12309

How does revenue diversification shape the budgetary solvency of city governments? Previous studies informed by the public choice/fiscal illusion perspective suggest that diversification leads to unsustainable government expansion and budgetary imbalance. In contrast, the organizational adaptation/modern portfolio theory suggests that diversification enables government to prepare for external fiscal shocks. We use different measures of revenue diversification and rely on audited financial information to develop general fund‐based and government‐wide budgetary solvency measures for more than 500 midsized and large cities in the United States from 2006 to 2012. Addressing omitted variable bias, the results of the econometric analyses indicate that the type of diversification matters. Specifically, diversifying to non‐tax sources improves budgetary solvency as indicated by higher government‐wide operating ratio and reserves, whereas diversifying within the tax structure produces the opposite effects. The contradictory results point to the need to rethink current theories of diversification, which do not recognize the different ways that revenue structures can be broadened, and how these produce distinct effects on fiscal performance. We lay out the critical first step in clarifying and further developing a more nuanced theory by proposing three causal mechanisms outlining the pathways through which the types of diversification can influence budget outcomes. APPLICATIONS FOR PRACTICE • This study examines the relationship between tax and non‐tax revenue diversification and government‐wide budgetary solvency (structural budget balance). It is the first in the revenue diversification literature to consider the total revenues and costs of operating government and incorporates a broader base of tax and non‐tax revenue sources including utilities. • The results suggest that increased reliance on non‐tax revenue sources, such as charges and fees, improves budgetary solvency. • In contrast, we find evidence that increased diversification of tax instruments leads to poor budget outcomes. • When financial managers and policymakers are considering adopting a new revenue source or expanding a current revenue stream, from a budgetary solvency standpoint, non‐tax sources may be advantageous.