By THERESE J. McGUIRE
Property tax relief mechanisms:
Property taxation and property tax relief have risen to the top of the political agenda in Illinois. State lawmakers have placed new restrictions on property taxes in the Chicago suburban counties and have talked about capping property tax increases statewide. At the same time, lawmakers have provided more state funds to local governments. The 1989 income tax surcharge, and to a lesser extent its 1991 extension, provided state money that local governments (cities, counties and school districts) could use to replace or to augment property taxes.
During the 1980s state governments became increasingly involved in setting U.S. domestic policy. One reason for the increased state involvement in domestic issues was that during this period the federal government decreased real federal aid to state and local governments. At the same time, the federal government loosened the reins on state governments through changes in regulations and grant formulas.
The changes in fiscal responsibility and the difficulties encountered in many areas of social policy turned the 1980s into a decade of uncertainty and turmoil for state budgets and for state revenue flows. Many states undertook special tax studies or set up commissions to advise policymakers on the fiscal options. The goal was to reform the state fiscal system. In each case it soon became apparent that the strong fiscal link between state and local governments could not be ignored. Through grants-in-aid, mandates, regulations and restrictions, state governments are heavily involved in the fiscal affairs of local governments.
To evaluate a state fiscal system, it is necessary to evaluate local fiscal systems and the link between the two. Property tax relief mechanisms are key components of the fiscal link between state and local governments. Political arguments for state-provided property tax relief are easy to come by, but economic justifications for many forms of state-provided property tax relief are harder to come by. In many cases property tax relief cannot be justified using economic principles.
The traditional forms of property tax relief include homestead exemptions and credits, circuit breakers, classification of property, and tax deferral programs. A broader focus would extend relief to include any state action that could result in lower local property taxes, such as increased state aid to local governments or state-granted authority to impose non-property taxes.
Under the broadened definition, at least nine property tax relief mechanisms can be identified. They differ from one another in many important ways. Some of the mechanisms are costly to the state; others are not. Some automatically result in lower property tax burdens for certain taxpayers. Some only provide a potential means for reducing tax burdens. Others simply redistribute a given total property tax burden among types of property.
Most states utilize one or more of the mechanisms described below.
• Homestead exemptions/homestead credits. Under a homestead exemption, a certain amount of the value of the property of homeowners is exempt from taxation. The exemption removes property value from the tax rolls. It does not result in state reimbursement to local governments; it does result in a redistribution of total property taxes away from owner-occupied residential property to other types of property, in particular, to commercial and industrial property. Because the exemption is usually for a flat amount, the exemption is of proportionally greater value to individuals with homes of relatively low market value — that is, to lower income individuals.
A homestead credit involves state assumption of a portion of the taxpayer's liability. For example, a state might provide a credit of 40 percent of the homeowner's property tax bill. Under such a credit, the state reimburses the local unit of government in the amount of the credit, and the taxpayer is responsible for the remaining portion (60 percent in this example) of the tax bill.
• Circuit breakers. Circuit breakers are often implemented through the personal income tax as refundable income tax credits. The credits are targeted to lower income individuals and often to elderly homeowners and renters. The rationale for including renters is that landlords pass at least a portion of prop-
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erty taxes on to renters through higher rents. The amount of the credit for property taxes paid falls as the taxpayer's income rises.
• Classification. Through different assessment ratios or different nominal tax rates, the tax burdens on different types of property are reduced. The classification systems in many states were implemented in recognition of de facto classification that had resulted through the assessment process.
Many states assess owner-occupied residential properties and farmland at lower rates than other types of property. Like the homestead exemption, classification does not result in lower overall property taxes. Instead classification redistributes the property tax burden away from favored types of property and towards other types of property.
• Tax deferral. Under tax deferral programs, certain types of taxpayers are allowed to defer their tax liabilities to a specified time in the future. Deferral programs do not reduce taxes. Instead, they allow the taxpayer to accomplish a better match between income flows and tax payments.
• Property tax limitation measures. State governments have imposed limits or constraints on property tax rates, property tax assessment increases, property tax revenues and local government spending. Whether state-imposed limitation measures are costly to the state government depends on how the state reacts to the changed fiscal circumstances of the local governments.
• State-shared revenues and state aid. State aid and state-shared revenues provide local governments with an alternative to the local property tax as a source of revenue. State aid is obviously costly to the state, but it does not necessarily result in lower local property taxes.
• State-granted authority to impose nonproperty taxes. Like state aid, local nonproperty taxes provide local governments with a viable alternative to the property tax, thereby giving local governments the financial means to lower property taxes if they so desire. There is no cost to state government. The new taxes can overlap with others, and their imposition can raise questions about which level of government should impose a particular tax.
• State assumption of local spending responsibilities. In recent years, many states have assumed responsibility for health care, welfare, public justice and other services previously provided by local governments. This shift in responsibility is costly to the state and enables local units of government to reduce property taxes if so desired.
• State income tax deduction for local property taxes paid. Many states allow state income taxpayers a deduction for local property taxes paid. Net income taxes are thus lower for the taxpayers who take the deduction. Because many states have graduated personal income tax rates and because higher income individuals are more likely to pay higher property taxes, this form of property tax relief is of greater value to higher income taxpayers.
In Illinois property tax relief measures include: a homestead exemption of up to $3,500 on principal residences; circuit breaker relief for senior citizens; classification of property in Cook County and assessment of farmland based on its ability to produce income, not its selling price; tax deferral for the elderly; statutory limitations on non-home-rule government property tax rates; a limit on the growth rate of property tax extensions (total property tax payments) in DuPage, Kane, Lake, McHenry and Will counties; a one-year easing of reassessment-driven tax increases in Cook County; sharing with local governments of state income and sales tax receipts; authority for home-rule governments to impose non-income taxes; a state income tax credit of 5 percent of property taxes paid.
An economic evaluation of the mechanisms included in a broad definition of state property tax relief mechanisms raises a pair of issues:
1. Why should states be involved in local property tax relief? What are the economic justifications for such actions?
2. How effective are property tax relief mechanisms? What are the economic effects?
To answer the first set of questions, it is useful to review the two basic models of government behavior that economists rely on to explain and evaluate government decisions. The median voter model assumes that the decisions made by elected officials reflect the wishes of the resident-voters, or at least of the median or swing resident-voter. According to this model, the chosen levels of government expenditures and taxes are the desired levels of expenditures and taxes. If this model closely approximates the behavior of local governments, there would appear to be no need for state involvement in local fiscal decisions.
The implications of the second model of government behavior are quite different. The budget-maximizing bureaucratic model assumes that elected officials are primarily interested in their own well-being and that the bigger their budgets the happier they are. If local governments are better described by this model, the expectation is that the levels of local expenditures and taxes will be higher than the levels desired by the resident-voters. In this case, limits or controls on the fiscal behavior of local bureaucrats may be justified.
Which model is more appropriate for local governments? The answer is not clear. On the one hand, it is often argued that local governments are more responsive to the desires of voters than are higher levels of goverment, that competition among local governments provides a natural restraint on undesirable spending and that information on public expenditures and services is better at the local level, enabling voters to make better decisions that restrain elected officials. On the other hand, the evidence on the effect of state grants on local government spending decisions indicates that local elected officials may spend more than is desired by the resident-voters (the so-called flypaper effect).
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It is likely that there is a little bit of both models at play. In tying to justify state involvement in local fiscal affairs the question becomes: Are local governments more or less likely than state governments to be held in check by voters? Put another way: Are state or local governments in greater need of outside controls or limits on fiscal behavior? A plausible case could be made that the excessive-spending culprit is more likely to be state government than local government.
When states engage in the various forms of property tax relief, the property tax can lose its ability to be the major source of local revenue. To be fiscally responsible and to be accountable for local fiscal decisions, local governments need a viable source of revenue over which they have substantial control. The two main competitors to the local property tax are local general sales taxes and local income taxes. There are problems with both.
Local general sales taxes are regressive because they impose a relatively high burden on low-income taxpayers. Different sales tax rates in nearby jurisdictions can result in "border effects," when shoppers/taxpayers cross borders to avoid the tax. Income taxes are a primary source of revenue for both federal and state governments; adding a third level of taxation may place too heavy a reliance on one tax base. The bases of both sales taxes and income taxes are likely to be unevenly distributed among local jurisdictions, resulting in fiscal inequities among local governments if a heavy reliance is placed on either tax. When such pros and cons are weighed, the property tax stands up to scrutiny.
In other words, when states get involved heavily in property tax relief and limitations on the use of property taxes, they cripple one of the more viable means of fiscal empowerment for local governments. Thus, there would appear to be little economic justification for state involvement in local fiscal affairs generally and for certain property tax relief mechanisms specifically. To complete the economic evaluation of property tax relief mechanisms, the last set of questions posed above must be answered: What are the economic effects of property tax relief mechanisms?
An examination of five of the nine mechanisms described above provides a taste of the myriad of likely effects. Homestead credits designed so that the state picks up a significant share of the homeowner's property tax bill act like matching state aid. If the credit were 40 percent, each extra dollar of local property tax would cost the taxpayer only 60 cents. The taxpayer gets an increase in local expenditures (and presumably local services) of one dollar at a price of only 60 cents. This type of "matching aid" tends to stimulate local spending and breaks the link between marginal benefit and marginal cost to the taxpayer. This type of property tax relief is likely to lead to inefficiently high levels of local spending; paradoxically it can lead to higher rather than lower property taxes if the stimulation effect is strong enough.
Circuit breakers tend to be good mechanisms for providing targeted relief. As long as the set of taxpayers who qualify for the credit is small, the potential inefficiencies associated with the program — the same inefficiencies identified with homestead credits — are also likely to be small. As a corollary, because they are limited, circuit breakers are not an appropriate tool for general property tax relief.
The economic effects of state aid to local governments were mentioned above. The empirical evidence confirms that the flypaper effect (that grant money sticks where it hits) exists and may be large, suggesting that state aid tends to end up as increases in local spending rather than as decreases in local property taxes.
Classification of property results in a redistribution of the overall burden rather than a reduction in the overall tax burden. Many classification systems redistribute the burden away from owner-occupied residential property, where resident-voters tend to live, and toward commercial and industrial property, where nonresidents tend to work. An argument is sometimes made that classification results in local officials setting higher property taxes than they would choose if all the property owners were resident-voters. This source of inefficiency is a potential concern whenever governments rely on taxes that are exported to nonresidents who do not have voting rights in the jurisdiction imposing the tax.
The final property tax relief mechanism to be evaluated here is property tax limitation measures. The effectiveness of these measures depends very much on their specific design. For example, those limitations that apply only to property tax rates tend not to be effective at limiting property taxes because the property tax base grows as property increases in value. Property tax limitations can be the source of inefficient spending and taxing behavior as local elected officials try to circumvent the limits.
Property tax relief mechanisms are just one part of a large mosaic called the state and local fiscal system. From this systemic viewpoint, the most important question is: Do the costs of state provision of local property tax relief outweigh the benefits? As state spending pressures and tax burdens increase, the answer to this question is likely to be in the affirmative for many states.
There appears to be no magic solution to high property tax burdens. Each property tax relief mechanism has its imperfections, and economic models challenge the very concept of state involvement in the fiscal affairs of local governments. As states continue to evaluate and reform their fiscal systems, the link between state and local governments provided by property tax relief mechanisms will be an important area of potential reform.
Therese J. McGuire is an assistant professor at the University of Illinois' Institute of Government and Public Affairs (IGPA) and has a joint appointment at the School of Urban Planning and Policy, University of Illinois at Chicago. This article is adapted from IGPA's quarterly publication, Policy Forum (volume 4, number I).
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