Editor's Note: Alison Felix and Jason Henderson are economists with the Federal Reserve Bank of Kansas City. Below are excerpts from their report on the fiscal challenges facing rural communities. The full report can be found here.
Center for Budget and Policy Priorities In rural communities, a higher percentage of the workforce is hired by state and local governments. Since the beginning of the recession, however, state and local governments have been shedding jobs.
Fiscal challenges at state and local governments are a potential threat to the economic recovery in rural America.
Rural communities depend heavily on intergovernmental transfers from the states to provide local services. Many people in rural communities rely on the state or local government for their jobs and on Medicaid as a part of their income.
Thus, rural economies are highly susceptible to state budget shortfalls. As state governments cut spending in response to looming budget deficits in coming years, rural America’s fiscal problems may also deepen.
Although strong rural real estate markets continue to support property tax revenues, rural governments must still find ways to offset the declines in state and federal intergovernmental transfers.
Rural governments are responding by raising taxes, limiting services, cutting jobs, and improving efficiency. While many of these solutions can be painful, the challenge has a bright side for rural America―an opportunity to foster a new round of innovation in service delivery through consolidation, cooperation, and privatization of services.
Rural Property Values Hold Up
Rural local governments rely heavily on intergovernmental transfers from state governments to balance their budgets. As state governments slash their budgets, revenue streams to local governments also shrink.
During the current economic downturn, strong property tax receipts supported local tax revenues, especially in rural areas where real estate markets stayed relatively healthy.
In contrast to state government financing, property tax revenues account for a large share, roughly a quarter, of local government revenues. In 2009, property tax receipts rose more than 5 percent and underpinned an overall increase in local government tax receipts.
Thanks to the strong real estate markets in rural areas, tax revenues for rural governments could fare better than their metro peers over the next few years as new property assessments are made. By the fourth quarter of 2009, home prices in rural America had fallen a modest 0.6 percent below 2006 levels, compared to 13.7 percent declines in metro areas.
Farmland values, meanwhile, remain near record highs. After jumping more than 60 percent from 2004 to 2008, farmland continues to support rural property tax revenues. For example, in Nebraska, property tax valuations and levies on agricultural real estate rose more than 10 percent in 2009, while valuations and levies on residential real estate rose less than 2.5 percent. Most of the gains in residential property tax valuations came in rural Nebraska, which enjoyed a 3.4 percent gain compared to a 0.2 percent gain in metro Nebraska.
Meanwhile, State Tax Revenues Plummet
Unlike local tax revenues, state tax revenues fell sharply as the recession intensified, leaving almost every state with a budget shortfall. Rising unemployment slashed personal income tax receipts, while weak consumer spending cut general sales tax revenues.
As state budget problems deepen, rural governments could suffer further from reduced intergovernmental transfers. Local governments receive, on average, 31 percent of their total revenue from state governments, making them sensitive to state budget cuts. 
Federal Reserve This map shows the percentage of workers in each county hired by state and local government. Rural areas are more dependent on these jobs than are urban counties.
In rural counties, intergovernmental transfers from federal and state governments have historically accounted for roughly 45 percent of the total local government revenues, with most of the assistance coming from the states. For fiscal year 2011, the governor of Wyoming has proposed cutting state aid to local governments by more than half.
For rural counties with low employment and persistent poverty, intergovernmental transfers are even more important, accounting for 55 percent of total revenues.
Medicaid Means More In Rural America
In rural areas, Medicaid accounts for a larger share of personal incomes than in metro areas. Contractions in government spending and Medicaid could have even bigger effects on rural economies in poor rural regions, where unemployment is already high and poverty is the norm.
Cuts in Medicaid spending could have dramatic impacts on rural incomes. Over the past decade, government transfers to individuals (Social Security, Medicare, and Medicaid) have accounted for a rising share of rural incomes. According to the Census Bureau, Medicaid spending alone accounted for over 4 percent of personal incomes in rural communities in 2008, compared to roughly 2.7 percent in metro areas.
The impacts could be even larger for poorer rural communities: Medicaid spending accounted for 7.3 percent of the personal income in persistent poverty counties, double the percentage in other rural counties. Medicaid spending accounted for a larger share of personal incomes in the rural South, the Mississippi Delta, Appalachia, the Southwest, and the Great Plains, where persistent poverty and high levels of unemployment are common.
Public Employment More Important in Rural Communities
State and local governments account for a larger share of rural employment and earnings than in metro areas.
By 2008, state and local governments accounted for 14 percent of rural employment and 18 percent of rural earnings compared to roughly 10 percent of each in metro areas. These shares are even higher in rural counties in the Great Plains, the South (including the Mississippi Delta), and upstate New York, places where earnings from state and local governments exceed 30 percent of total earnings.
Overcoming Fiscal Challenges in Rural Communities
Declining tax revenues, combined with higher public expenditures, leave local governments with some tough decisions. Rural governments can deal with the fiscal challenges in one of three ways. First, they can increase revenues to pay for current spending by raising taxes and fees. 
Federal Reserve Bank Rural counties are more dependent on state and local spending, and Medicaid, than are urban communities. That's why declines in state revenues will disproportionately affect rural America.
Second, they can reduce spending by cutting services.
Or third, they can reduce costs by becoming more efficient in delivering their services. This last option provides an upside to the current fiscal challenge by potentially spurring a new round of innovation in rural service delivery.
Local governments have a number of options for increasing efficiency, and most fall into one of four categories ― consolidation, intermunicipality cooperation, internal reorganizing, or privatization. If local governments can find ways to increase efficiency, they can cope with current fiscal challenges more easily and improve their long-term fiscal health.
Consolidation―combining local governments or creating special districts to provide certain services―is perhaps the most dramatic and difficult step local governments can use to potentially increase efficiency.
This can be a lengthy process and is often unpopular with local residents who want to maintain their local autonomy and identity. The consolidation of services has been debated for decades, and in Nebraska, a local research institute recently proposed to consolidate service from 93 Nebraska counties into 20 service centers to reduce administrative duplication.
Just this year, three rural Indiana governments (Zionsville, Eagle Township, and Union Township) merged in part to streamline service delivery.
A less dramatic option for local policymakers is to cooperate or collaborate with other local governments or organizations. This can be as simple as increasing small government’s purchasing power by buying in bulk or as complex as creating contracts and boards to share resources or jointly produce goods.
Coordinating the production of goods is most likely to produce efficiency gains in capital-intensive industries where economies of scale can be achieved. Examples of these types of industries include water, electricity, waste management, and highway transportation departments.
In Pennsylvania four small, local governments (Freeland, West Hazleton, Butler Township, and Black Creek Township) started working together on road projects and were able to cut their costs by 50 percent.
In another example of a common trend in smaller rural communities, two rural school districts in Michigan recently decided to share superintendents, saving each district $50,000 annually. To save additional money, these districts also share natural gas purchasing and business and food services managers.
For some local governments, reorganizing within their existing structure may create efficiency gains. This effort could involve cooperation or consolidation among various functions or departments within the local government. Resources such as technology, personnel, training, and structures could be shared, while some redundancies might be eliminated. In addition, local governments may also be able to reduce costs by increasing their use of technology and offering online applications.
The cost savings from internal restructuring often come from eliminating some government workers, making this option a difficult one for local authorities.
Apart from deciding to provide a public good or service, a local government could also decide whether to produce the good itself or contract the production out to a private company. However, economic studies find mixed efficiency results from privatization.
Conclusion
Fiscal strains are forcing rural governments to make tough budget choices.
The recession has cut revenues and raised public service demand. Although local, rural tax revenues are performing relatively well due to a heavy reliance on property taxes, the resulting budget shortfalls at state and local governments are placing economic pressures on rural economies.
Rural economies are more dependent on Medicaid and other government spending than their metro counterparts. And, the biggest challenges could emerge in rural America’s poorest communities.
Over the next few years, rural governments may be forced to make changes in service delivery in response to fiscal pressures. Rural government authorities can choose to raise revenues, cut services, or improve efficiency of service delivery through consolidation, cooperation, or privatization.
These decisions will be difficult. Tough times present tough choices, but carefully crafted solutions may not only alleviate current fiscal strains but also create a more efficient service delivery system for rural America.