First Thoughts about Property Taxes and the 2007 Indiana General Assembly

May 10, 2007 (revised May 31)

Contents
Introduction
Homeowner Tax Bill Increase Estimated at 24 Percent
Is This Homeowner Tax Bill Increase Really Happening?
Property Tax Relief through Homestead Credits
What Happens in 2008 and 2009?
What Happens to Business and Agricultural Taxpayers?
Local Income Taxes
Income Taxes and Property Taxes
The 2% Circuit Breaker
Tax Simplification
A Shift to the Locals?

Introduction
Estimates prepared in March 2006 showed that 2007 property tax bills for Indiana homeowners would increase a lot.  Revised estimates in April 2007, late in the legislative session, showed that homeowner taxes would increase a lot more.   The General Assembly responded to this problem with a short term “band-aid,” but also with more substantive changes in local finance which could have far-reaching effects. 

Homeowner Tax Bill Increase Estimated at 24 Percent 
In March 2006 the Legislative Services Agency (LSA) used its property tax model to estimate that the average statewide homeowner tax bill would increase 14.6% in pay 2007.  This estimate was made using 2005 levy and assessment data.  Assumptions were made about changes in assessments and levies for 2006 and 2007 in order to project tax bill changes more than a year in advance.  The result showed that homeowner tax bills would increase substantially more than usual in 2007, as a result of policy changes that were already scheduled to take place. 

Five policy changes had the largest effects on homeowner tax bills.  These changes included the elimination of property taxes on inventories, the state property tax relief cap, the drop in the homestead credit, and, offsetting this last change, the increase in the homestead standard deduction. 

The fifth policy change was trending, the between-reassessment adjustment of real property assessed values taking place for the first time for 2007 taxes.  The adjustment would incorporate market value changes from 1999 to 2005 into assessed values. No trending data were available by March 2006, for the original 2007 tax bill estimate. Trending estimates were based on statewide and national price indexes for real property.

By the third week of April 2007 trending data had been collected from 33 counties, comprising 38% of Indiana assessed value.  The data showed that trending increased residential assessments at a rate similar to that estimated by the price indexes.  However, non-residential assessments had not increased as much as the price indexes had indicated.  As a result, more of the statewide property tax burden was shifting to residential property, away from non-residential property. 

Legislative Services issued a revised estimate of homeowner tax bill changes for pay 2007, showing the average statewide increase at 23.8%.  The newly available trending data accounted for the largest part of the change in the estimated tax bill increase. 

These revised results are shown in the above table, in the “average homestead” column.  The tax bill increases for the whole residential homestead category were even higher, because these include new construction and remodeling, which also increase tax bills.  The average homestead’s land and building is assumed to be unchanged from one year to the next.

The table shows sizable increases in taxes on all property in 2007 and 2008.  This does not mean that local governments are receiving a tax windfall.  A relatively small part of this increase represents increases in revenue for local governments.  More of it represents shifts in tax payments from the state to local taxpayers.  The homestead credit had been scheduled for a reduction in 2007.  This would have increased homeowner tax bills, while decreasing state credit payments dollar for dollar.  Local revenues would not have been affected.  The state has capped its tax relief payments to local governments.  Again, this increases property tax payments but decreases state credit payments.  Local revenues are not affected.

Is This Homeowner Tax Bill Increase Really Happening? 
The projection that homeowner property tax bills would increase an average of almost 24% came from LSA’s complex property tax model.  The model requires many assumptions about tax levy and assessment changes.  As a check on these results, estimates were made independently of this model, using assessment and tax rate data already available for 2007. 

By mid-April the Department of Local Government Finance (DLGF) had certified and published tax rates, property tax replacement credit (PTRC) rates and homestead credit rates for 23 counties.  In addition, LSA had acquired assessment data for 33 counties.  Combined, there were 16 counties and 270 sub-county taxing districts for which both tax rates and assessment data were available. 

Assessment data for 2006 were used to calculate the average homestead assessed value in each of these 270 districts.  These assessments were then increased by the average trending percentage increases, to estimate the average homestead value for 2007.  For each year, the $3,000 mortgage deduction was subtracted from assessed value.  In 2006 the $35,000 homestead standard deduction was subtracted, and in 2007 the $45,000 standard deduction was subtracted.  Both deductions were limited to 50% of the homestead’s assessed value. 

The remaining net assessed value was multiplied by the tax rates for each year, as published by the DLGF.  Then the PTRC and homestead credits were subtracted using the DLGF rates.  The result was the tax bill paid by this average or typical homestead in each taxing district. 

The average increase in homeowner tax bills was 21.4%, slightly less than the 23.8% projection from the property tax model.  This was explained by the fact that the 16 counties used in this exercise had smaller than average trending increases in homeowner assessed values.  In these 16 counties homestead assessments rose 14%; in all 33 counties for which trending data are available the increase was 19%.  Also, only 7 of the 16 counties (44%) eliminated their inventory taxes in 2007.  Statewide, 51 of 92 counties (55%) eliminated inventory taxes.  

The results of this exercise supported the results from the property tax model. Homeowner tax bills do appear to be rising substantially this year, near the 24% increase estimated by the model.

Property Tax Relief through Homestead Credits 
The General Assembly responded to these tax increases by pledging $300 million in new tax relief for homeowners in 2007, and $250 million in new relief in 2008.  In 2007 homeowners will receive special rebate checks at the end of the calendar year.  In 2008 the homestead credit percentages will be increased, reducing the size of homeowner tax bills.  This new property tax relief is estimated to reduce the 2007 average homeowner tax bill increase from 23.8% to about 7.7%.  The average rebate check is expected to be about $235.

Indiana has never delivered property tax relief through rebate checks before, and this procedure was criticized by some members of the General Assembly.  At least one legislator admitted publicly that the move was political, designed to make sure that taxpayers gave the legislature credit for delivering tax relief. 

Some legislators have complained that in past years substantial tax relief has been provided—state property tax relief spending has doubled since 2002—but because it reduced very big tax hikes to merely big tax hikes, many taxpayers did not realize that tax relief had been increased.  Unfortunately, the rebates may create the appearance that local officials caused the large tax bill increases for the legislature to remedy.  In fact, the larger part of the tax bill increases were caused by legislative changes in assessment and credit provisions.

There are at least two non-political reasons for the rebate procedure.  First, new higher homestead credits require the recalculation of tax bills.  The counties that have already mailed their 2007 tax bills would need to recall them and issue new bills.  This would create confusion.  The rebates allow tax billing to go forward as usual.  However, some counties anticipated legislative changes and delayed their tax billing.  In many other counties billing has been delayed by trending, so fewer counties than usual would have been affected if tax bills were changed this late in the billing process.

Second, the state won’t have the money for the rebates until late in the year.  Tax relief will be financed by the sale of slot machine licenses to the two race tracks, turning them into “racinos.”  These two $250 million payments are expected in the summer or fall.  An additional $300 million tax relief payment before the racino money arrives would strain already low state balances.   

What Happens in 2008 and 2009? 
The same property tax model that estimated a 23.8% increase in homeowner taxes in 2007 projected a further 11.3% increase in 2008.  Much of this increase was due to the cut in the homestead standard deduction from $45,000 to $35,000.  The 2006 legislature had increased it to $45,000 for one year as a temporary tax relief measure. 

This year’s General Assembly decided to keep the homestead standard deduction at $45,000 for 2008, and then reduce it by $1,000 a year until it reaches $40,000.  Along with the added $250 million in higher homestead credits, this deduction change is expected to cut the 2008 increase in homeowner tax bills from 11.3% to 7.8%.  This seems a small effect from so much new tax relief, but recall that the $250 million in credits will be required just to continue the level of tax relief of 2007—it provides no added relief compared to 2007 tax bills.

What about 2009?  Here’s a guess.  The $250 million added homestead credit isn’t funded for 2009.  If it disappears, homeowner tax bills are likely to rise 10% or so, in addition to the increases that will occur because of levy increases, the drop in the homestead standard deduction and trending.  A 15% increase is plausible.  In other words, by mid-2008 we’ll be right where we were in mid-2006, looking ahead to a big homeowner property tax increase.

What Happens to Business and Agricultural Taxpayers? 
In 2007 commercial, industrial and utility businesses are expected to see tax bill reductions.  Trending appears to be increasing residential property assessments substantially more than business property assessments.  Trending does not affect personal property, which is almost entirely business equipment.  And property taxes on business inventories are being eliminated in 51 counties.  All three of these factors decrease the share of business property in the tax base, and this explains the expected reductions in business tax bills.  The homestead credit rebate adopted for 2007 does not affect business, because only homeowners are eligible for this relief.

Business tax bills in 2008 were expected to change very little from 2007.  The usual increases in local property tax levies would have been offset by the drop in the homestead deduction from $45,000 to $35,000.  More homestead property would be taxable, so taxes would shift away from business property.  The General Assembly decided not to reduce this deduction in 2008, however, and this will result in small increases in business tax bills.

Agricultural property owners are likely to see substantial tax bill increases in both 2007 and 2008.  The same factors that increase tax bills for residential homesteads also increase tax bills for agricultural homesteads.  Further, agriculture does not benefit from inventory tax elimination as much as other businesses.  Agricultural homesteads will receive some benefits from the homestead credit rebate in 2007.

In 2008 trending will increase the base rate assessment of a farm land acre from $880 to $1,140, a 30% increase.  Increases in commodity prices, particularly corn, are raising farm income in the capitalization formula used to calculate the base rate.  This increase in farm land assessments explains the large expected tax bill increase for agriculture in 2008.  Policy changes add to this increase.  Maintaining the homestead deduction at $45,000 reduces tax bills on agricultural homesteads, but shifts taxes to farm land and buildings.

Local Income Taxes*   
The tax relief passed for 2007 and 2008 might be called a band-aid, in that it merely postpones the problem for another two years.  But the General Assembly also made more substantial changes in local finance.  Local governments were offered three new local income tax options. 

First, local governments can decide to fund the annual increase in civil government property tax operating levies (that is, non-school, non-debt-service levies) with local income tax increases instead.  This decision would be made by the county council in counties with the county adjusted gross income tax, and the COIT council in counties with the county option income tax.  In counties with neither tax, either body can make the decision. The COIT council is made up of the fiscal bodies of counties, cities and towns, with votes based on population.  The county represents people outside cities or towns.  In the few counties with neither tax, either body could decide.  The Department of Local Government Finance (DLGF) would determine the income tax rate required to fund the levy increase. 

Second, the county council or COIT council may adopt an income tax to reduce property taxes.  The maximum rate is one percent, and the money may be distributed in three ways.  It can be used to increase the property tax replacement credit, which means it will reduce the property taxes of all property owners.  It can be used to increase the homestead credit, which means it will reduce the property taxes of homeowners only.  Or, it can be used to increase a third credit, which applies to homesteads and residential rental property, whether it’s classed as residential (small rental units) or commercial (large apartments).  The county council may select any combination of these three tax relief formulas.

Third, the county council or COIT council can adopt an added income tax to raise new revenue for public safety.  Public safety is broadly defined, as police and fire, emergency medical services, corrections and juvenile services, and includes current operating costs, debt service and pension obligations.  The maximum rate is 0.25%, and counties must adopt the two property tax relief income taxes to be allowed to adopt the public safety rate. 

The deadline for adopting local income taxes used to be April 1 each year.  Now it’s August 1.  The legislature wants counties to be able to consider these options this year, for taxes in 2008.

[* This section has been revised to clarify the role of the COIT council in income tax decisions.]

Income Taxes and Property Taxes  
The property tax relief delivered by local income taxes could be substantial.  They are not reflected in the above tax bill table.  Statewide, a one percent income tax raises about $1.3 billion.  The total net property tax levy is about $6.3 billion.  Statewide, each added one percent income tax would reduce property taxes by about 20%. 

How much taxpayers benefit depends on what they own, what they earn, where they live, and how their county decides to distribute tax relief. The most important factor is the comparison of the taxable income and property assessed value of a taxpayer.  Taxpayers with more assessed value and less taxable income tend to benefit when income tax rates rise and property tax rates fall.  People who pay less generally include farmers, retired homeowners and property owners who live outside the county.  This latter group includes most corporate businesses.  People with more income and less property tend to pay more when income taxes reduce property taxes.  People who pay more include renters (at least at first), and, generally, employed homeowners. 

The method chosen to distribute the property tax relief will matter.  The above applies if tax relief is distributed broadly, to all property owners.  If the relief is devoted to homeowners alone, most homeowners are likely to pay less, and other property owners who earn taxable income in the county will pay more.

It’s possible for renters to benefit from property tax relief, even though they don’t own property.  Lower property taxes paid by landlords make rental property more profitable.  In pursuit of these profits, more rental property may be made available.  This added supply of rentals could reduce rents, or at least slow their increase, as landlords bid to attract renters.  Low income renters, who pay little in added income taxes, could benefit if lower property taxes create a boom in rental property.

Likewise, lower property taxes on businesses could make operating a business in a county more profitable.  If business expands, more employment opportunities become available, and wages and benefits rise.  Part of the tax cut to business could be passed on to working people. 

Where taxpayers live also matters.  There are different property tax rates in different parts of a county, but the added income tax rate would be the same for the whole county. Suppose the local governments in a county decide to pay for their levy increase with an income tax instead of property taxes.  Suppose also that more of the county’s high income residents live in one town, and fewer in a second town.  If both towns increase their levies by the same amount, income taxpayers in the first town will pay some of the added levy of the second town.  The link between taxes and location is weaker with income taxes than with the property tax.

Which counties are likely to adopt new local income taxes?  When the county adjusted gross income tax (CAGIT) first became available in 1974, all of its revenue was devoted to broad property tax relief.  About one-third of Indiana counties adopted CAGIT in the first year it was available.  Almost all of those counties were rural, suggesting that agriculture had the political influence in those counties to reduce taxes on land and raise taxes on income. 

Urban counties with lots of industrial property did not adopt CAGIT.  CAGIT provided a tax break to the owners of such property, most of whom did not live in the county, at the expense of income earners who did.  Urban counties also have large numbers of renters, who do not benefit directly from property tax relief, but who may pay income taxes. 

It’s possible, then, that we’ll see more rural CAGIT counties adopt the two income tax options that reduce property taxes.  Urban counties may be less likely to adopt.  This is confounded by two other features of the tax package, however.  To get the added public safety revenue—something urban counties may want—counties must adopt income taxes for property tax relief.  And Lake County, an urban county which has never adopted an income tax of any kind, will likely be forced to adopt one this year.  The General Assembly decided that in Lake only, civil operating levies will not be allowed to increase at all in 2008 unless an income tax is adopted.

In Lake County, and everywhere else in Indiana, the decisions about local income tax adoption are upon us right now.  Local governments have until August 1 to decide what to do for 2008. 

The 2% Circuit Breaker 
A looming problem for local governments is the effect of the 2% circuit breaker on local property tax collections.  As originally passed in 2006, residential property owners would see their tax bills limited to 2% of their gross assessed values (before deductions) in 2008 and 2009.  In 2010, all property taxpayers would benefit from this limit.  Unlike other Indiana tax credits, the state would not fund the 2% circuit breaker.  Local government would lose this revenue.  Estimates made in January 2007 showed that the circuit breakers would cost local governments $122 million in 2008 and $426 million in 2010. 

The General Assembly made two substantial changes in the circuit breaker credit.  First, it excluded school general funds from the credit.  Taxpayers will pay the full school general fund rate regardless of the tax ceiling.  Second, it increased the circuit breaker rate to 3% for non-residential property in 2010.  Many fewer taxpayers will be eligible for the credit.  These changes helped reduce the revenue loss estimate to $4 million in 2008, $9 million in 2009, and $101 million in 2010.  In each year about three-quarters of the revenue loss is in Lake County.

The local income tax options offer a further solution to the revenue problems created by the circuit breaker.  Most of the income tax revenue must be used to reduce property taxes.  Lower property tax rates will mean that fewer taxpayers will be eligible for the circuit breaker, which means less revenue will be lost by local governments.      

Tax Simplification
Once again, Indiana’s system of local finance has become more complex.  In 2007 there will be a tax rebate for homeowners, calculated with a formula that only experts can understand.  The reasons for the size of the “Christmas bonus” will be a mystery to most taxpayers.

The size of the homestead standard deduction will change every year for five years, starting in 2009.

The 2% circuit breaker credit for homeowners now excludes the school general fund, which means that homeowners cannot calculate their maximum possible tax payment without data on the composition of their tax rate.

In addition to the three existing local income taxes, and the extra income tax rate for inventory tax replacement, we now have three more income tax options, one of which can be distributed using three different formulas at the same time.  These three distributions could add three more tax credit boxes to the typical property tax bill. 

Before 2007 the property tax system was so complex that most taxpayers could not understand the calculations on their tax bills.  Now the system is even more complex.

A Shift to the Locals?  
The General Assembly applied a short-term band-aid to Indiana property tax problems, but made changes in local finance which could be significant for the long haul.  It used up-front payments from the new racinos to pledge $300 million in property tax relief to homeowners in 2007, and $250 million in 2008.  The 2007 tax relief will come as a “Christmas bonus” rebate check at the end of the year. 

In 2009 this relief will run out, and homeowners will again face substantial property tax bill increases.  The 2009 General Assembly again may find money in the state budget to extend homeowner tax relief for additional years.

Or perhaps the 2007 General Assembly has handed the property tax problem to local governments.  The new income tax options allow counties to deliver substantial property tax relief to homeowners or to taxpayers more broadly.  The options also allow local governments to freeze non-school operating levies at current levels, funding levy increases with income taxes instead.  Counties have until August 1 to adopt these local income tax options for 2008.

When the next homeowner property tax problem hits in 2009, the General Assembly may act.  Or, state legislators may say to local officials:  it’s your problem now.