Indiana's 2008 Property Tax Reforms Part 1
Larry DeBoer, Professor
Homeowner tax bills increased substantially in many Indiana counties in 2007. Taxpayers and voters registered their unhappiness in protests and at the polls. During the 2008 short session the Governor and General Assembly responded with the most sweeping reform of property taxes and local government finance in at least 35 years.
Homeowner property taxes will fall substantially. Ceilings were placed on all property tax bills, and the legislature began the process to amend these limits into the state Constitution. The sales tax has already increased.
Homeowner tax relief.
In 1973 the Bowen administration and the General Assembly enacted across-the-board property tax relief, called property tax replacement credits (PTRC). All property owners received a 20% property tax reduction, and revenue from an increase in the sales tax was used to replace the revenue losses of local governments. With many modifications, this system has lasted until now.
In 2008, however, Governor Daniels and the General Assembly have taken a different approach. Instead of across-the-board relief, entire local government functions that are supported by local property tax levies will be funded by state revenues instead. The state will take over the school general fund, the various county child welfare funds, and several smaller functions, including payments for juvenile incarceration in state facilities, some police and fire pension payments, and payments for indigent hospital care. The state will also eliminate the very small state property tax levies, used mainly for the State Fair and a forestry fund. These functions make up about 30% of all property taxes, and by 2010 are expected to amount to $2.8 billion.
Funding for this new state spending will come from two main sources. The sales tax increased from 6% to 7% on April 1, 2008. By 2010 this will provide about $1 billion in added state revenue. Most of the remaining revenue will come from the existing property tax replacement credits and homestead credits. The PTRC and homestead credits will no longer be subtracted from property tax bills. The revenue that had been paid to local governments to replace these reduced property taxes will instead be used to fund the state levy takeovers. Existing property tax relief will be used a different way, so it is not a net gain in property tax relief. Added relief will come from the new sales tax revenue.
The elimination of property taxes for school general fund and county welfare levies will reduce property tax rates, but not all taxpayers will share in the tax relief. The tax relief will be directed to homeowners with a new homestead deduction. The deduction equals 35% of a homestead's assessed value, after the existing $45,000 homestead deduction is subtracted, up to a value of $600,000. Beyond that the deduction is 25%. This is a large additional deduction that will reduce statewide taxable assessed value by about 15%.
Tax rates are set by dividing a local jurisdiction's levy—the revenue collected from the property tax—by a jurisdiction's assessed value. The state takeovers will reduce county and school levies, but the lower assessed value means that tax rates will not drop as much. Across the state, tax rates will fall, but not quite enough to offset the elimination of the property tax replacement and homestead credits. Many taxpayers whose assessments don't change will see small increases in their tax bills. Homeowners pay less, because the new homestead deduction reduces their assessments. Homeowner taxes are expected to drop about a third, statewide, from what they would have been.
The state levy takeovers and new homestead deduction begin in 2009. In 2008 homeowners will receive significant property tax relief through an extra homestead credit, which is a percentage reduction in tax bills. This will be funded with the added sales tax collections from April through December, 2008. The temporary credits phase out in 2009 and 2010. They have the effect of advancing the one-third reduction in homeowner taxes from 2009 to 2008.
This means that the way tax relief is provided will change between 2008 and 2009. Some counties fare better with one method; some fare better with the other. In counties where PTRC and homestead credits are relatively high, but the school and welfare share of the tax levy is relatively low, homeowner taxes will increase between 2008 and 2009. Homeowner taxes will still be lower than they were in 2007, or than they would have been under the current system, but the tax break in 2008 will be greater than the break in 2009.
Renters and low income households.
Renters pay the added sales tax, but do not own taxable property and so receive no direct property tax relief. To lessen the impact on renters, HEA1001 increases the renters state income tax deduction from $2,500 to $3,000. At the 3.4% state rate plus a 1% local rate, this reduction in taxable income would save a renter $22.
Lower income households receive an added state income tax benefit through an increase in the Indiana earned income credit. The Federal government provides an earned income credit to households with earned incomes less than about $40,000. It takes the form of an income tax refund, which is paid whether or not the household owes income taxes. Indiana has provided its own credit, calculated at 6% of the Federal credit. HEA1001 raises the Indiana earned income credit to 9% of the Federal credit.
HEA1001 also offers an added tax break to lower income homeowners aged 65 and over. Those who own a home assessed at less than $160,000, with an adjusted gross income of $30,000 (single return) or $40,000 (joint return) can receive a tax credit to hold their property tax increases to 2% per year.
The 35% homestead deduction provides most of the new property tax relief for homeowners. Much of the focus during the legislative session, however, was on the new "circuit breakers," which will phase in by 2010. The circuit breakers limit property tax bills to a maximum percentage of the gross assessed value of a taxpayer's property. Gross assessed value is the assessed value before any deductions.
A circuit breaker for homeowners was already scheduled to take effect for tax bills in 2008. The maximum limit is 2% of gross assessed value. The new legislation reduces this maximum to 1.5% in 2009, and 1% in 2010 and after. Circuit breaker limits for rental housing, farm land and long-term care facilities will be 2.5% in 2009 and 2% in 2010 and after. Circuit breaker limits for all other property will be 3.5% in 2009 and 3% in 2010 and after. This property is mostly commercial, industrial and utility land, buildings and equipment, and agricultural buildings and equipment. It includes vacation homes.
The General Assembly also passed a joint resolution to amend the circuit breaker limits into the state Constitution. This starts the amendment process. The resolution must pass the next legislature, in either 2009 or 2010, and then be approved by a voter referendum, for the Constitution to be amended.
How the circuit breakers work.
Consider a home with a market value of $120,000, in a taxing district with a property tax rate of $2 per $100 assessed value (2%). This is Homestead One in Table 1. Suppose the county assessor gets it right, so that the gross assessed value of the home is $120,000. Suppose the home is occupied by its owner, and is the owner's primary residence, so it is eligible for the homestead deductions. The existing deduction is $45,000, which leaves a remainder of $75,000. The new supplemental homestead deduction subtracts another 35% of this remainder, or $26,250, leaving $48,750. Most homeowners also receive the existing $3,000 mortgage deduction. Its taxable value is $45,750. Assume a $2 tax rate, multiply by net assessed value, and the tax bill is $915. If the year is after 2010, there are no additional calculations. State property tax replacement credits and homestead credits have been eliminated, though there could be local credits.
The homeowner's circuit breaker credit limit is 1% of gross assessed value, $1,200. Since the $915 tax bill is less than this limit, the homeowner would not receive a circuit breaker credit.
Suppose instead that the tax rate had been $3 per $100 assessed value (Table 1, Homestead Two, click to view). These calculations would result in a tax bill of $1,373, which is higher than the circuit breaker limit. The taxpayer would receive a credit of $173, which would bring the tax bill down to the $1,200 maximum. Local governments would not collect the amount of the credit.
Suppose the tax rate is back at $2, but the home is worth $400,000 (Table 1, Homestead Three,click to view). After deductions, the taxable value is $227,750. At the $2 tax rate, the tax bill is $4,555, greater than the 1% circuit breaker maximum of $4,000. This homeowner would receive a $555 circuit breaker credit, and local governments would not collect this amount.
These examples show which homeowner property will be eligible for the circuit breaker credit: moderately valued homes in areas with high tax rates, and expensive homes in areas with moderate tax rates. Places with higher tax rates will see more homeowners eligible for the circuit breaker credit. In a jurisdiction with a more typical $2 tax rate, though, more expensive homes are more likely to receive a credit, while less expensive homes likely will not. This is because of the fixed $45,000 standard deduction. It is a large part of the lower valued home's assessment (about 38%), but a small part of the expensive home's assessment (just 11%). As a result, before the circuit breaker more expensive homes are taxed at a higher percentage of gross assessed value. After the circuit breaker, this percentage is limited to 1%.
Circuit breaker calculations for other property can be much simpler. An acre of farm land assessed at $1,200 has a 2% circuit breaker limit, which is $24 (Table 1, Farm Land, click to view). The tax bill on this acre cannot exceed this amount. Farm ground rarely receives deductions, and without the property tax replacement credits, there will be no credits (other than local credits in some places). The tax bill is the assessed value times the tax rate. If the tax rate is higher than $2 per $100 assessed value, the land owner would receive a circuit breaker credit.
Circuit breaker tax cuts.
Homeowners in higher tax counties and owners of expensive homes in average tax counties will see tax reductions due to the circuit breaker. However, almost all of the tax relief received by homeowners will come from the increased homestead deduction, not the 1% circuit breaker.
This is shown in Table 2 (click here to view Table 2), which divides tax relief into two parts. The top line shows the effects of the state levy takeovers and the new homestead deduction. The average homeowner statewide would see taxes almost 32% lower than under our existing tax system (Indiana Legislative Services Agency 2008a). Other property owners see tax increases. The effect of the circuit breakers is shown in the second line. Homeowners receive a small amount of added tax relief as a result of the circuit breakers. Owners of rental housing are the taxpayers who benefit most from the circuit breaker credits. "Non-homestead residential" property is mostly small rental housing units.
To see why landlords benefit most from the circuit breakers, consider three properties, a home, a small apartment, and a small business property, each assessed at $120,000. These are shown in Table 1(click to view) as Homestead One, Rental Apartment and Business Property. The circuit breakers limit the homeowner's tax to $1,200, the landlord's tax to $2,400, and the business owner's tax to $3,600. The home receives homestead deductions which reduce its taxable assessed value to $45,750. Suppose the apartment and the business building receives no deductions.
At a $2 tax rate, none of these properties is eligible for the circuit breaker. The home has a circuit breaker limit of 1%, but it is applied to the gross assessed value of the home. The tax rate applies to the net assessed value, after deductions, and homeowners get a lot of deductions. The homeowner's tax bill is $975, less than the $1,200 limit. The landlord's and business owner's tax bills are both $2,400. This is equal to the landlord's 2% circuit breaker limit, but less than the business owner's 3% circuit breaker limit.
Now, suppose the tax rate is $2.50. The homeowner's tax bill would be $1,144, still below the 1% limit. The homeowner receives no circuit breaker credit. The landlord and business owners' tax bills are $3,000. The business owner receives no circuit breaker credit, because the 3% limit applies. The landlord receives a $600 credit, because the tax bill is greater than the 2% limit of $2,400.
Owners of rental property will receive the biggest circuit breaker credits, because they don't receive deductions like homeowners do, and their circuit breaker limit is less than those applied to other business property. Farm land is in the same circuit breaker category as rental housing. Rental housing is mostly in cities, however, so its owners pay higher tax rates and will be eligible for more circuit breaker credits. Farm land is mostly in unincorporated areas—outside of cities and towns. Its owners pay lower tax rates and few will be eligible for the credits.
Revenue losses by local governments.
The circuit breaker credits are the first property tax credits Indiana has ever offered that are not funded by the state budget. The earlier property tax replacement credit and the homestead credit reduced property tax bills, but the revenue lost by local governments was replaced by state funds. The circuit breaker revenue losses will not be replaced.
Consider Homestead Two in Table 1(click to view), the $120,000 home in a jurisdiction with a $3 tax rate. The taxpayer received a $173 circuit breaker credit. The example in Table 3 supposes that the $3 tax rate is the sum of a $0.75 county rate, a $1.00 city rate, a $0.75 school corporation rate, and $0.50 in rates for other units (townships, library districts, other special districts). Each unit would share in the lost $173 from this homeowner, based on the share of each in the total tax rate. The city's $1.00 rate is one-third of the total rate, so it would lose one-third of the homeowner's circuit breaker credit, about $58. The county and school corporation would each lose $43, and the other units would lose the rest.
By 2010 local governments as a whole are projected to lose (and taxpayers to keep) $524 million, about 8% of total property tax revenue, and 5% of total local budgets (Indiana Legislative Services Agency 2008c). About $300 million of these losses are in three counties, Lake, Marion and St. Joseph. The losses for Lake and St. Joseph would have been larger, but the legislature provided that property taxes for debt service—the repayment of bond borrowing—will be exempt for the circuit breaker limits in those two counties. About $159 million will be lost by school corporations in 2010 and the legislature made additional appropriations to partially offset these losses in the corporations that are most affected.
Cities and towns are projected to lose the most, $188 million in 2010. Cities add an extra layer to each taxpayer's tax rate, making more property eligible for the circuit breakers. And, city tax rates will increase as a result of the tax reform. No city levies will be taken over by the state, but the new homestead deduction will reduce total assessed value. Rates will have to be higher to maintain city tax levies.
New budgeting challenges.
The circuit breakers create a new wrinkle in the local budget process. In places with significant circuit breaker credits, local budgets will be interdependent. For example,
if the school corporation in Table 3 (click to view) were to raise its $0.75 tax rate to $1.00, the total tax rate would be $3.25. At this rate the homeowner's tax bill would be $1,487, but the $1,200 circuit breaker maximum would be unchanged. The homeowner's circuit breaker tax credit would rise to $287, so he or she would continue to pay $1,200. The school corporation's revenue would increase. Its revenue from this taxpayer would be its rate times the net assessed value, less its share of the circuit breaker credit. It would receive $69 more of the taxpayer's $1,200. The other units would give up that $69 dollars. Their tax rates are unchanged, but their circuit breaker losses are greater. A tax rate hike by one local government can create revenue losses for other local governments.
This could be a new challenge for the budgeting process. In places with lots of circuit breaker credits, each jurisdiction cannot know how much property tax revenue it will receive in the coming year until it knows the rates that will be charged by the overlapping jurisdictions. No one can budget until everyone budgets. Local officials may need to consult with one another before setting their budgets, something that has not been necessary in the past. HEA1001 recognizes this difficulty. It provides that jurisdictions must submit their budget and tax proposals to the county council before they are final. The council is required to make non-binding recommendations about these proposals. In addition, though, the council could serve as a clearinghouse for the tax information that all the jurisdictions need in order to set their own budgets.
There's more. The circuit breaker credits create additional issues for local policy. HEA1001 requires referenda for bigger capital projects, and shifts most assessing duties to the counties. And, with homeowner property taxes falling, and the sales tax rising, do households pay more or less in total? More analysis needs doing. Part 2 of this article will address some of these issues.
Indiana Legislative Services Agency. 2008a. "Estimated Impact on Net Property Tax, HB1001 CC08 Update" (March 13).
Indiana Legislative Services Agency. 2008b. "Fiscal Impact Statement, HB1001." (March 20).
Indiana Legislative Services Agency. 2008c. "Potential Circuit Breaker Tax Credits, HEA 1001 (2008)." (March 17).
For more information, see the Indiana Local Government Information website, www.agecon.purdue.edu/crd/Localgov .
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