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Indiana University

Once and Future Taxes

April 14, 2010
Bloomington, Indiana --

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When a recession hits, it’s a double whammy for state and local governments. Demand for social services goes up, while revenue that supports such services goes down. And during our current recession, says John Mikesell, “the declines have been particularly substantial. So you have the demand for spending rising right when revenue resources are scarce.”

Mikesell is Chancellor’s Professor of public and environmental affairs at the Indiana University School of Public and Environmental Affairs in Bloomington and a nationally recognized expert on retail sales taxes. The author of the standard public finance and budgeting textbook used in graduate public administration programs, Mikesell is currently studying the impact of the present recession on state taxes throughout the country. The outcomes, he says, have been grim.

John MikesellState budgets rely heavily on taxes from income and sales, the very sources that are hit hardest when the economy is struggling. As states scramble to meet the needs of out-of-work residents and failing businesses, they face budget shortfalls due to the lost tax revenue that otherwise would have been paid by those same citizens and companies.

Many of the effects of the current recession are the same as in earlier ones, but this recession is deeper and longer than any other since the end of World War II. That makes current fiscal impacts both more interesting for research and more difficult for those expecting necessary services from state and local governments.

No bright spots

“The major state taxes have all been devastated by the recession,” Mikesell says. “Across the country, there are virtually no bright spots. What we are experiencing in Indiana is more or less what other states are also having to face.”

Local government tax revenues haven’t been hit quite so hard, yet, because of their historic reliance on property taxes, but political decisions have left many municipalities vulnerable at just the wrong time.

“The one reasonably reliable, reasonably stable source that local governments have had is the property tax, but local governments all over the country have been constrained in their authority to use the tax,” Mikesell explains. These constraints usually come from state legislatures and are not driven by any particular party or political philosophy.

“There’s a saying that, ‘Nobody ever lost an election running against the property tax,’” says Mikesell. “Everyone does it: Republicans, Democrats, liberals, conservatives. Even people who support strong, autonomous local government will run against the property tax even though, logically, that is the one thing they should preserve.”

Although property taxes are not the only means for local governments to obtain funding, Mikesell says they are a major and reliable revenue source.

“Local sales tax, local income tax, local property tax, user charges, and transfers from the state or federal government —only one of those sources is reasonably stable,” he says. “Even with foreclosures and all the problems in the property market, property tax continues to be the most stable revenue source overall.”

Failure to thrive?

Local governments without a property tax often face difficult 
finances. Cities that rely on local sales tax without a property tax to support continuing operations often leave themselves completely susceptible to economic fluctuations. Any time a major retailer shuts down, “it’s a public catastrophe,” Mikesell says.

This kind of economic impact is an important public issue because local governments are responsible for providing critical services, including public safety and education.

“Local government budgets are primarily for wages and salaries. The big cost area is personnel, and where are the big personnel costs for cities? Police and fire, and there aren’t many technological solutions that allow maintenance of service when cuts are made. Some cities are starting to feel the pinch in terms of their ability to deliver services,” Mikesell says.

Municipal fee-for-service strategies have become more common, such as charging residents for trash pickup or for specialized parks and recreation programs, but it’s logistically impossible to have residents purchase the services that police and fire departments provide (to say nothing of the moral and social arguments some may raise against such a system).

“Police and fire departments give a protective blanket to an area,” Mikesell explains. “When a property is on fire, the firefighters come to put the fire out to keep it from spreading. Police patrols protect everyone because the bad guys don’t give you a list of exactly who should sign up to be protected.”

Because these services must be delivered at the neighborhood level, permitting residents to voluntarily opt-in to police and fire coverage would give everyone an incentive to decline the service and let their neighbors pay.

Billing after the fact is equally problematic. “If the fire department has already put out the fire, why would I voluntarily pay their bill?” Mikesell asks. “Collection rates for emergency ambulance runs, unless covered by insurance, aren’t very high. The same logic goes for fire runs.”

Because their services are oriented to the community at large, police and fire departments — as well as sanitation, road maintenance, and many of the other responsibilities of local governments — can be reasonably maintained only through tax dollars. A robust property tax makes protecting those services much easier.

Just say no

Local governments in Indiana are not immune to the movement away from property taxation as a foundation for their finances. Recent state legislation placed dramatic restrictions on municipal capacity to levy property taxes, and school districts no longer rely on the property tax for support of their operations (payments by the state have become the source for this revenue). One of those legislative restrictions, House Bill 1001 passed in 2008, took property tax rate-setting out of the hands of local voters and capped taxes at 1 percent for residential property, 2 percent for commercial property, and 3 percent for industrial property.

Media attention helped win the sympathy of the legislature. “In many respects, the controls were the product of a revolt by wealthy property owners who knew how to mobilize for political clout,” Mikesell says. The Evansville Courier and Press reported that the caps are likely to cost local governments $465 million in 2010 and $488 million in 2011. “Some cities have felt the pinch pretty severely already,” Mikesell notes.

Property-owner complaints were precipitated by a revaluation of residential property that aligned tax values more closely with actual property values (many high-value properties had been paying artificially low property taxes for years). The newly assessed taxes were made even higher by the fact that non-residential property values were not corrected, and many businesses remained exempt. High-value homes were left with a large share of the tax burden that “produced shocking increases in some property-tax bills,” Mikesell says. “Rather than reform the root causes, the response was strict limits on local use of the tax.”

In another element of the new fiscal arrangements, school budgets are no longer financed through local property taxes but are dependent on the state, whose finances have been severely affected by the recession.

“The problems of the state now immediately translate into fiscal problems for the schools,” Mikesell explains. “They have few options for adjusting to the reduced funds and even fewer that do not mean reduced educational service.”

Overall, though, the state of Indiana has been spared the disasters that many states have had to confront. “Indiana went into the recession having cleaned up some unpaid bills and without the spending increases that had occurred in some other states,” Mikesell says. “When the recession hit, we didn’t have quite the problems or ticking time bombs that some states had. And we had the advantage of a significant rainy-day fund as an important backstop against the greatest disasters.”

Mikesell praises the Indiana government for being “terribly willing to say no,” in contrast to other states that resorted to “various kinds of financial tricks to close gaps in their budgets, like moving paydays around, altering the timing of revenue flows, and delaying projects.”

Despite this careful planning, however, it wasn’t possible for the state of Indiana to overcome the shortfalls caused by the recession. Back in 2008, when Mikesell sat down with the other members of Indiana’s revenue forecast committee to produce a revenue baseline for 2010 – 11, the depth and persistence of the economic problems ahead were not foreseen. “The big three taxes — individual income, corporate income, and retail sales — have been affected more than we expected,” he says.

"Unless a hint of economic recovery starts showing up in state revenues, there will be more reductions ahead. It will not be pleasant." When the committee reconvened in December 2009, they had to revise projections downward by about $1.8 billion, or approximately 7 percent. The Indiana state constitution forbids the state from going into debt, so the Hoosier state government had no choice but to start cutting back expenditures.

Mikesell describes Gov. Mitch Daniels’s unpleasant task of determining where those cuts were going to come from: “He rescinded appropriations to general state agencies first, then to state universities, and, most recently, to primary and secondary education. Unless a hint of economic recovery starts showing up in state revenues, there will be more reductions ahead. It will not be pleasant. There is some evidence of recovery, but not yet enough in state revenues to allow the conclusion that the bad times are behind us.”

Indiana University itself is grappling with close to $59 million in budget cuts from this revision, which Gov. Daniels announced in December 2009. “[IU] is vulnerable because we are a nontrivial part of the state budget,” Mikesell explains. “You have to think like a bank robber — they rob banks because that’s where the money is. When you’re making cuts, you go where the money is.”

As Indiana’s biggest state-funded institution, IU got the largest share of the cuts, with runner-up Purdue University losing about $45.5 million. State funding accounts for approximately 19 percent of IU’s budget, and the cuts are necessitating reductions across all campuses in areas such as administrative services and travel spending. In addition, some positions may be left vacant through the remainder of the budget cycle.

A sliver of a silver lining

Amid all the bad news, there is one small but potentially beneficial development in the state’s method of tax collection. A recent referendum transferred property assessment duties from Indiana’s townships to its counties. This consolidation gives local governments a “better shot at quality and uniformity” in distributing their tax burden across property owners, according to Mikesell.

“Under the old system, some of the townships were assessed by trustees who had other kinds of government functions. Many of them had no particular interest in doing property assessments, so there was considerable variation in the quality of assessments being done,” he says.

Assessments done at a larger level increase the chances of a more professionally done job and more consistent valuations. Indeed, even before the legal change in the system, a number of trustee assessors actually had the county assessor do the valuation work.

Although the change may seem minor, Mikesell reiterates that there is nothing more important for local government budgets than property taxes. Improving the means of determining tax liability can spell only good things for municipalities and may avoid the type of drastic revaluation that led to the present tax caps.

Still, Mikesell is hoping to see even greater changes in the way the government determines what property owners must pay. He says that electing assessors makes it too easy for popularity contests and conflicts of interest to damage this single most important factor in municipal finance.

“Some assessors are capable, diligent, and exactly who ought to be hired for the job, but that is not uniformly the case,” he says. “The ultimate reform, of course, would be to appoint assessors based on their qualifications and evaluate them on the basis of their performance. We wouldn’t dream of having IRS auditors elected!”

Elisabeth Andrews is a freelance writer in Bloomington, Ind.

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