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

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.