The Local Option Inventory Deduction

Introduction
The tax restructuring bill of June 2002 eliminated property taxes on business inventories (that’s the “inventory tax” that the auto dealers advertise about each February).  They did this by allowing a 100% deduction from the assessed value of inventories, starting with assessments in 2006, for taxes payable in 2007.

In addition, though, the legislature gave counties the option to eliminate property taxes on inventories immediately, by adopting a local 100% inventory deduction.  To offset the resulting shift in tax payments to homeowners, counties can increase the homestead credit.  To offset the loss in revenue that a higher homestead credit would cause, counties can adopt a higher Economic Development Income Tax (CEDIT or EDIT) rate.  As of May, 2003, 14 counties have taken the plunge.

Contents

Inventory Tax Elimination in Three Steps
Effects on Local Government Budgets
Effects on Taxpayers
Economic Development
Adoption Dates
Constitutional Amendment

Inventory Tax Elimination in Three Steps
For property tax assessments in 2006, taxes in 2007, Indiana will adopt a statewide 100% inventory deduction.  This will remove business inventories from property taxation.  Counties can act sooner, if they choose. The County Option Inventory Deduction involves three steps:

• A 100% inventory deduction.  Inventories will still be assessed for the property tax, but the new deduction subtracts all of this assessed value from the taxpayer’s assessment.  That will raise property tax rates for everyone else, if local governments continue to collect the same amount of property tax revenue from the reduced tax base (IC 6-1.1-12-41). 
• Local Homestead Credit.  Counties can add a local homestead credit to the statewide 20% credit, enough to make sure homeowners don't pay more taxes.  An added percentage is subtracted from each homeowner’s tax bill, enough to prevent the average homeowner’s tax bill from increasing.  Local government will collect less in property taxes if the credit is adopted (IC 6-3.5-7-25).
• Local Income Tax (EDIT). The lost property tax revenue from the added homestead credit can be made up with an added income tax.  Counties can adopt or increase their Economic Development Income Tax (EDIT), with a rate high enough to make up for the lost revenue from the higher homestead credit.  The county auditor distribute income tax revenues to local governments based on their homestead credit losses, before distributing remaining EDIT revenues in the usual fashion. The maximum added EDIT rate for this purpose is 0.25%.  Most counties would have to raise their EDIT rates less than this, in the 0.1% to 0.2% range  (IC 6-3.5-7-5(p)).

As of January 1, 2003, 14 counties had adopted the county option inventory deduction.  For these counties, the inventory deduction applied for the assessment of March 1, 2003.  Inventories will be exempt from taxation in 2004.  The counties are:

The Indiana Legislative Services Agency has estimated the EDIT rates that would be required to replace revenue lost from the higher homestead credit.  This information is available on this website, with the third link in the following box. 

As an example, consider the calculation for Adams County (one of the early adopting counties).  The estimated property taxes paid on business inventories in 2004 in Adams County is $1,943,510.  However, the tax restructuring of June 2002 provided a new deduction for inventories of manufacturers destined for out-of-state shipment.  There is as yet no data available about the value of this deduction.  In Adams County, 65.6% of inventories are owned by manufacturers, which implies that $1,274,491 of the inventory taxes are paid by manufacturers.  If none of these inventories are covered by the new deduction, then the total inventory tax will be the full $1,943,510 in 2004.  If all of these inventories are covered by the new deduction, then the total remaining inventory tax will be the non-manufacturing portion, $669,019.  The actual figure will most likely be between these two.  These two figures give the range of possibilities.

Suppose inventory taxes are eliminated, and total tax levies are maintained through higher rates.  About 49.3% of property taxes in Adams County are paid by homeowners.  This means that 49.3% of the taxes that were paid by owners of inventories will be shifted to homeowners.  If inventory taxes are the larger $1.9 million figure, that means $958,203 is shifted to homeowners.  If inventory taxes are the smaller $670 thousand figure, $329,845 is shifted to homeowners.  This is the range of taxes that the higher homestead credit would offset, and the range of revenues which local governments would lose to the higher homestead credit.

A one percent local income tax in Adams County raises $5,506,115.  Dividing the larger revenue loss figure by this amount gives 0.17%.  That's the added EDIT rate required to replace homestead credit losses if no manufacturing inventories benefit from the out-of-state shipment deduction.  Dividing the smaller revenue loss figure by this amount gives 0.06%.  That's the added EDIT rate required to replace homestead credit losses if all manufacturing inventories benefit from the out-of-state shipment deduction.  In other words, it is estimated that the higher homestead credit would require an EDIT rate of between 0.06% and 0.17% to replace lost revenue.  The maximum rate allowable under the inventory deduction option of 0.25%, so homestead credit losses could be fully replaced.

Effects on Local Government Budgets
Local governments do not have to raise their tax rates when the local option inventory deduction is adopted.  If they do not, their revenues will decline, because the lost revenues from taxes on inventories are not replaced by higher payments by other taxpayers.  Local governments that do not raise their rates need not adopt the higher homestead credit nor higher EDIT rate, because there would be no tax shifts to offset.

The June 2002 tax restructuring assumes that local units will raise their property tax rates in order to collect the same tax levy as would have been collected without the inventory deduction. Rates for funds under the property tax controls, and debt service rates can automatically adjust upward.  Senate Enrolled Act 464, passed by the 2003 General Assembly, requires the Department of Local Government Finance to adjust maximum rates on cumulative funds and school capital project funds to allow local units to raise these rates to maintain their property tax levies. 

This implies that

• Local governments need not lose property tax revenue when inventories are exempted.  All tax rates can increase to maintain levies.  Local governments can choose to raise their rates less, in order to reduce the size of the tax shift to taxpayers who do not own inventories.
• Local governments need not lose tax revenue if the added homestead credit is adopted.  The added EDIT rate is intended to raise income tax revenue to replace the lost property taxes.

Effects on Taxpayers

Eliminating inventories from assessed value means property tax rates will rise, assuming local governments maintain their property tax levies.  Adopting the added homestead credit offsets added property taxes for homeowners.  Adopting the added EDIT rate means county residents pay more in income taxes.

• Businesses that own substantial inventories will see tax reductions.  The reduction in their assessed values will more than offset the higher property tax rates.  Some small businesses that do not pay the corporate income tax are subject to EDIT.  Businesses with substantial inventories will still see an overall tax break.
• Businesses that do not own substantial inventories will see tax increases.  They will pay the higher property tax rates on their existing assessed value, and higher EDIT taxes if they are not subject to corporate income taxes. 
• If the added homestead credit is adopted at a uniform county-wide rate, homeowners in tax districts with substantial inventories will pay higher property taxes, and those in districts with few inventories will pay lower property taxes.
• Senate Enrolled Act 464 allows the homestead credit to vary by taxing district.  If the added homestead credit is pro-rated by the shares of inventories in each taxing district, all homeowners will break even on their property tax bills.  The higher property tax rates will be offset by higher homestead credits.  Pro-rating homestead credits would increase the complexity of the tax calculation and billing process for the county auditor and treasurer.
• Homeowners will pay more in local taxes overall because of the higher EDIT rate on their incomes.  (With a uniform homestead credit, some homeowners in tax districts with few inventories may pay lower taxes overall.)
• Renters will pay more in local taxes.  Their landlords will pay the higher property tax rate, without much benefit from the inventory exemption.  Rental property is not eligible for the homestead credit.  Some of these higher taxes will be passed on in higher rents.  Renters also will pay the higher EDIT rate on their incomes.
• Farmers’ property is dominated by land, which will be subject to the higher tax rates, and so would pay higher property taxes.  Any farmers with substantial inventories would pay lower property taxes.  Farm homesteads are treated the same as those of other homeowners.  Under a uniform homestead credit, many farmers would see their homestead property taxes fall, because rural areas are likely to have a smaller share of inventories.

Note that the higher homestead credit and higher EDIT rate can continue after 2007, when the statewide inventory deduction becomes effective. 

Economic Development

The property tax on inventories is a direct business tax.  Generally, it is thought that reductions in direct business taxes encourage new business location and investment. 

Research for Indiana provides evidence that property taxes do affect the amount of inventories held in Indiana.  Lower property taxes are associated with a greater amount of inventory assessments, with each 10% reduction in inventory taxes raising the assessed value of inventories about 4%.  Elimination of property taxes on inventories would likely increase the quantity of inventories held in Indiana.  (See DeBoer, “Taxing Inventory:  An Analysis of Its Effects in Indiana,” Indiana Business Review, Fall 1999). 

If such development occurs, jobs will be created and employee incomes will rise.  In effect, some of the property tax cut businesses receive is passed on to employees in higher wages.  Added competition from new and expanded firms would increase the variety of products available to consumers, and reduce prices.  In effect, some of the property tax cut businesses receive is passed on to customers in lower prices.  The long run effect on taxpayers may differ from the short run effect, to the benefit of taxpayers who do not own inventories.

Adoption Dates

Inventory deduction: A county ordinance adopted in 2003 will be effective for assessments in 2004 and 2005, and for taxes payable in 2005 and 2006.  The statewide inventory deduction becomes effective in 2006-pay-2007.

Homestead Credit and EDIT:  The county can adopt the added homestead credit and added EDIT rate between January 1 and March 31 of the calendar year in which the deduction is first effective.  Adoption in 2004 will offset higher homestead credits for taxes in 2005.  The higher homestead credit and EDIT rate can continue in 2007 and after, to offset the effects of the statewide inventory deduction.

The county council can adopt the inventory deduction.  The homestead credit and EDIT rate are adopted by the county income tax council in counties with COIT, the county council in counties with CAGIT, and either body in counties with EDIT only or with no local income tax.

Constitutional Amendment 

The 112^th and 113^th General Assemblies agreed to a resolution to amend the Indiana Constitution.  It will be put to a statewide vote in November, 2004.  If passed, this change could alter the timing of the exemption of inventories from the property tax, and could change the method used to exempt them. 

Article 10, Section 1 of the Indiana Constitution lists the kinds of property that the General Assembly can and cannot exempt from taxation.  It says that the General Assembly can exempt "Tangible personal property other than property being held for sale in the ordinary course of a trade or business, property being held, used or consumed in connection with the production of income or property being held as an investment."   The amendment eliminates the words in italics, so the clause will read "Tangible personal property other than property being held as an investment.  In other words, the General Assembly can exempt property being held for sale and property being held, used or consumed in connection with production.  Those are inventories.

The amendment would allow inventories to be exempt from assessment.  If passed by the voters in November 2004 the General Assembly could act quickly and eliminate inventories from assessed values in 2005, for taxes payable in 2006.  In addition, if inventories are not assessed (rather than assessed and then allowed a 100% deduction), it will be more difficult to measure how much tax rates have increased, how much the added homestead credit must be, and how much the EDIT rate must increase.