Indiana Tax Reform: History and Solution

August 13, 2007

Editors: The following is a contrasting perspective to the joint statement on tax reform issued last week by the governor, the Senate president pro tem and the House majority leader. The author, whose conclusions challenge the leadership’s public interpretation of events leading up to this summer’s tax protests, is an independent financial consultant to Indiana local government.

Indiana Writers Group column for Aug. 15 and thereafter
490 words at op-ed cut

By Paul Speer

In shifting from a fractional valuation replacement cost system to an estimated market value assessment system, the state of Indiana took an excellent first step into the 21 century. That brave move, however, caused, as it must, a sense of uncertainty in taxpayers’ minds as to the burden they would be expected to carry. This uncertainty was compounded by evidence that the residential sector would be carrying a greater share of the tax burden than before.

The state sought to limit this burden through the institution of a “circuit breaker” system, limiting the taxes that would be paid by any residential parcel to two percent of the gross taxable valuation. At the same time, it instituted a trending system, increasing the valuation of all parcels by the increase in valuation of the sold parcels of like kind. It was thought that trending would permit local tax revenues to grow to cover increases in expenditures, but limit the growth to that permitted by the circuit breaker.

The state made an unfortunate assumption under this new system that the Municipal Cost Index (MCI) would grow in parallel with the increase in property values. The circuit breaker would limit the growth in municipal costs and force economy upon the local units of government. The problem is that property values and costs do not rise in tandem.

In the past, property values have risen at a higher percentage than the Consumer Price Index (CPI) and the MCI. They rose at a greater rate than the increase in individual pay. That last was what put taxpayers in a bind. As long as replacement costs were used to assign valuations, there was some protection.

Owners were aware, of course, that the gap between replacement costs and property values as measured by current sales was widening. Evidence is clear that they took advantage of increasing values on the books by diving into home equity loans.

Taxpayers viewed the trending as a means by which local units could raise additional taxes within the two percent circuit breaker, but if trending increased all values by, say, 10 percent that left leeway for taxes to go up more than two percent. The uncertainty of it all left the taxpayers who were on fixed income or whose income increased less than the trending percent in a bind.

Today, the MCI and the CPI move upward at different but perhaps parallel rates of inflation. Wages, a more personal matter to the taxpayer, lag. Housing values are for much of the economy flat or declining.
We are seeing, anecdotally high rates of foreclosure even in the higher valued property; sellers, instead of receiving money at the closing table from the buyers, are having to pay the buyer for their negative equity. Trending, a gross measure, no longer works well and is becoming politically unpalatable.

Finally, when taxpayers lose faith in their government on such a basic measure as taxation, systemic long-range change must be made.

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A Solution

Property taxes are the traditional method by which local taxpayers are cognizant of the efficiency of their local government in the provision of municipal, school and other services.

More to the point, it is the traditional way in which debt of the local unit is financed. Each issuance of bonds, lease purchase agreements and other forms of debt bears the pledge of the issuer to pay the holder from a dedicated revenue source. For general obligation bonds, the full faith and credit is pledged and that security includes a property tax levy for that and for no other purpose. Interfering with that levy or substituting another revenue stream has implications regarding the unit’s ability to pay when due interest and maturing principal and thus the value of the security in the holder’s portfolio. Further brought into question is the unit’s future borrowing ability.

Indiana attempted to assuage market fears regarding the security of local bonds. It limited local spending and the ability to raise additional revenue from property taxes but placed debt service payments in a prior lien position with respect to property tax revenues.

The revenue raising limitations, however, raised questions regarding the sufficiency of the property tax to pay for the day-to-day operations of the local unit. It attempted to patch over this problem by permitting counties with the approval of the major municipalities to raise a local option income tax by a limited amount. This did not sway the Bond Insurance industry or the municipal rating services — the primary governors of the cost of municipal credit. These independent arbiters are perhaps the best judges of the state-enacted solutions on the feasibility and, most important, the sufficiency of local-government revenue raising.

The present situation in Indiana has brought to the fore certain factors adversely affecting the cost of borrowing for all local units of government:
1. No municipal or county government has access to bond insurance. Only school corporations, which have built-in state distribution intercept mechanisms, are being considered. For everybody else, this increases the cost of borrowing to the taxpayer.
2. In addition, the rating services are waiting in the wings, threatening to lower municipal and county debt one notch. The income tax solution (COIT, CEDIT, LOIT or whatever) does not have the same weight as the traditional property taxes. Relying on a sales tax (if one were available) has even less weight. Property taxes are viewed as a 1:1 tradeoff with the debt they support. That is, the rating services and the market view that one dollar of levied property taxes can be expected, after collections, to pay of one dollar of debt service. Other taxes are more problematic. To receive the same treatment, pledged sales taxes require a 2:1 to receive the same perception of security. For example, look at the hotel-motel tax bonds. They have a huge coverage ratio but not an equivalent bond rating.
3. Underneath it all, Indiana was relying on continued high inflation in real property values to be the saving grace. Those days are gone — if not forever, then in the short to medium term. Meanwhile, increases in the Municipal Cost Index and inflation in the general economy do not slow down. The two-percent circuit breaker becomes ever more binding and the tweaking by the Legislature must continue with the desired result being a moving target.
The circuit breaker was the wrong solution at absolutely the wrong time. Tweaking the present set of laws is not the best solution.

It is often said that the best solutions are the simplest. It is time that Indiana simplified the tax-raising oversight of local units of government with a three-step rectification.
1. Remove the State from the Assessed Value business.

Now that the state has properly changed the valuation method to a full-market value basis, it is appropriate to freeze all valuations at the current post appeal level, with increases only when improvements are constructed or upon sale. Homestead and other exemptions would remain in place.

This will provide open, simple and transparent relief for property owners, save counties and their taxpayers millions of dollars in reassessment costs as well as the legal expenses incurred in appeals and save the DLGF (the Indiana Department of Local Government Finance) a similar amount.

It will provide those on fixed income protection against the vagaries of general reassessment.

It is equitable in that the additional taxes to be expected as the result of the construction of improvements will be clearly evident. Purchasers will have a clear indication of the additional taxes due as the result of the purchase and adjust their purchase price accordingly.

2. Concentrate DLGF efforts in the area of budget certification and tax levy approval.

Permit increases in the taxing unit’s levy for all Funds except Debt Service to a fixed percentage based on the greater of 2.5 percent or the increase in the Municipal Cost Index, subject to the following modifications:

  a. additional taxes to be collected against the value of new construction, which will require municipal or school services;
  b. the cost of funding unfunded state mandates;
  c. the levy increase occasioned by the passage of referenda by units of government for levy increases as well as debt service..

3. Make debt service once again an independent levy.
These suggestions will place the onus of local spending back upon each taxing unit. Such a system, similar to that in California, would place local taxpayer closer to the units of government to whom he will pay his taxes and provide him with a basis for participation in periodic elections.

Paul D. Speer, of Municipal Finance Consulting Services, Inc., has been a financial advisor to local units of government in Indiana for 30 years.



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