The recession-induced budget shortfalls pummeling various governments illustrate the difficulties in crafting a tax system that is both effective and fair.
By trying to make state and local taxes fairer, revenues have become more volatile. And the way taxing and budgeting cycles are structured these days, the administration of local government—especially school districts—has become much more difficult.
A century ago, local government finance was much simpler.
Townships, cities, school districts and counties got virtually all their money from property taxes. Local boards and councils decided what programs they wanted, how much money they needed and they set property tax rates accordingly. The state set out general rules for the system, but local government had broad control over tax levels and spending.
Property taxes, however, especially the personal property tax that hit my grandparents’ bedstead, sewing machine and three sows, are often unfair. It was repealed here some four decades ago.
But the real estate tax remains, and its inequities are well-known.
The value of a house, farm or business often is not related to the disposable income of its owners. Young farmers, for example, whose land is heavily mortgaged pay the same taxes per acre as the well-capitalized 60-year-old down the road.
Frail retirees living in a house purchased many decades earlier pay the same tax as a two-earner household in a comparable house down the block. And property taxes aren’t cut when someone gets a pink slip and income drops to near zero.
Government finance based solely on real estate taxes also generated inequities between different localities. Cities with a high tax base could afford a high level of public services, those with a smaller base had much less per capita to spend.
Recognizing these problems, many states acted a generation ago to reduce city, county and school district reliance on the property tax. Minnesota famously led the way in devising state credits to reduce real estate taxes. It also structured state aid for education that reduced the inequities between rich and poor districts.
But even at the state level, money has to come from somewhere. As transfers to local levels of government formed a larger and larger fraction of state-level spending, state sales or income taxes had to be raised.
These taxes are generally acknowledged as fairer than the property tax, particularly when necessities such as food and clothing are exempted from sales taxation as in Minnesota. If you don’t spend money, you don’t pay sales tax; if you don’t have income, you don’t pay income tax.
Effectively replacing higher real estate taxes with sales and income taxes helped low-income but property-rich households, largely the retired and farmers. But it made government budgeting much more problematic at all levels. Sales and income taxes are subject to the business cycle. When the economy is booming, incomes and spending are high and money rolls into state coffers. But when the economy sours, both taxes shrivel.
At the same time, federal and state mandates have increasingly tied state and local spending to the business cycle. When economic activity slackens, states and counties have to spend more on unemployment and welfare programs precisely when revenues are shrinking.
Minnesota, like most states, has a two-year legislative cycle. Taxing and operational spending changes often are made in the first session after each biennial election with the “off-year” session restricted to bonding for capital improvements and miscellaneous matters that may have arisen.
When we go into recession immediately following the major session, as in 2001, it is hard to make fiscal changes before the next scheduled one two years down the pike. But in that time the state can dig itself into a major financial hole.
At the same time, school districts and other local governments find it hard to budget when they don’t reliably know how state aid will fluctuate in the medium term. The relief to local taxation embodied in state-paid real estate tax credits and education aid has the unintended effect of introducing much greater uncertainty into local financial planning.
(This column is part one in a two-part series. Part two, “Nonpartisan group could monitor state coffers,” discusses how to soften the effect of the business cycle on state and local government finance.)
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.