Why Uncle Sam Needs Your Property Taxes

By: RAY A. SMITH: The Wall Street Journal Online
A new analysis shows that cash-strapped state and local governments have increasingly come to depend on property taxes to fill revenue shortfalls as other sources of income soured.

Though not an unexpected trend during economic downturns, the reliance on property taxes has lasted well beyond the end of the recession of 2001. Economists say it is has been of greater depth, and likely will have more lasting consequences, than it did during prior downturns.

In good part, that's because the soaring housing market has lifted the median price of single-family homes by 15%, making property taxes attractive to state and municipal governments facing spending increases. Meanwhile, states have grown more reluctant to lift income or sales taxes in recent years for fear of political retribution, economists say. In some cases, they are even prevented from doing so by laws passed during the 1990s boom.

"The local property tax is one tax the local [authorities] can use to offset declines in state money," says William Fischel, a professor of economics at Dartmouth College. "To some extent, if the state is sending municipalities or even school districts less money because they're in fiscally difficult times, the one tax the local [authorities] have some discretion over raising is the property tax."

Though municipalities can offset rising property values by changing their millage rates, or the rates at which taxes are levied on properties, many strapped municipalities chose not to do so in recent years. "Ultimately, what determines whether property taxes go up is the overall budget for the taxing district," says Matt Gardner, state tax policy director with the Institute on Taxation and Economic Policy in Washington, D.C.

The new analysis, prepared for The Wall Street Journal, shows that property taxes have risen rapidly since 2001 as a share of state and local tax revenue, while income taxes fell and sales taxes rose only slightly. Property taxes represented a 28.2% share of state and local revenue in the first quarter of 2004, up from 25.5% in the first quarter of 2001.

During that span, income taxes fell to 19.4% of state and local revenue collections from 22.4%, while sales taxes as a proportion rose to 32.2% from 31.4%.

The analysis was done by Robert Tannenwald, assistant vice president and economist at the Federal Reserve Bank of Boston, using data from the federal Bureau of Economic Analysis.

Overall, between 2001 and 2003, property taxes, which are used to fund everything from police and fire departments to schools and recreational services, rose an average of more than 10% nationwide, estimates Deloitte & Touche LLP's Property Tax Services Group.

The increased state and local reliance on property taxes over the past few years marked a reversal from the trend of the mid to late 1990s. "Over time, there had been a trend for property taxes to play a smaller role in overall tax collections than income or sales taxes," says Judy Zelio, principal at the National Conference of State Legislatures' fiscal affairs program. But in recessions, property taxes tend to creep back up as a percentage, as happened during the recession of the early 1990s.

The recent rise in property taxes has spurred a political backlash in some areas. In Maine and parts of New Jersey, Ohio and Texas, residents and sometimes city officials have succeeded in getting property-tax reduction initiatives on the Nov. 2 ballot. But economists warn that such limits could potentially squeeze state and local governments even more in a future downturn -- especially if rising interest rates cause the scorching housing market to cool off, forcing housing prices lower.

"If you get ballot measures that put caps on rates and they pass, that could have a significant impact on state and local governments," says Robert Lynch, a research associate with the Economic Policy Institute in Washington and economics professor at Washington College in Chestertown, Md. Governments forced to restrict property taxes could face major revenue problems during a future downturn, and thus may face service cuts, he warns.

Many factors contributed to the increase in property tax revenues that began during the recent recession, economists say. The suddenness of the recession, and the stock-market collapse in 2000, rapidly decimated income and sales tax revenues. Confronted with severe budget problems, states were forced to make drastic budget cuts and, to a lesser extent, increase fees and drain their reserves.

Meanwhile, after years of steady growth as a result of the economic boom of the mid- to late-1990s, state income and sales tax collections were hit hard during the downturn. That also hurt local governments. State tax revenue declined 8% in fiscal year 2002, the first time such revenue had declined in 10 years -- during the recession of the early 1990s, according to the Nelson A. Rockefeller Institute of Government, the public policy research arm of the State University of New York. It fell a further 3.4% in fiscal 2003.

Some of the decline in tax revenue was due directly to the weak economy, specifically job losses and reduced spending. The stock market downturn also hurt. "The drop of 2001 had an especially large impact, because capital gains had become as much as 15% of the overall income tax base over the course of the boom of the 1990s, and then almost dried up," says Harley Duncan, executive director for the Federation of Tax Administrators, a Washington D.C.-based organization that provides services to state tax authorities and administrators.

In that environment, the strong housing market proved to be the real potential gold mine to state and local governments. The median price of an existing single-family home rose 15% between 2001 and 2003 to $170,000. Declining commercial bases, rising health-care and pension costs, and expanding tax breaks for business and elderly and low-income homeowners all played a role in pushing up property tax bills for those without such exemptions.

So did soaring expenses. According to the National League of Cities in Washington, D.C., 62% of cities said they had increased public-safety spending, much of it due to homeland security, in the past year; 38% said they had increased capital spending on infrastructure; and 10% said they had increased spending on education. Four out of five cities and towns reported being less able to meet their financial needs in 2003 than in the previous year and expected to be less able to meet those needs in 2004, citing declines in sales, income and tourist tax revenues and cuts in federal and state aid, among other things.

Economists note that property-tax increases are not irreversible. Mr. Duncan points out that they are set each year by votes of local governing boards, which makes them easier to change than the acts of state or federal legislatures.

At the moment, states seem to be recovering from their fiscal problems. State tax revenue, for example, increased 6.7% during the second quarter, the end of the 2004 fiscal year for 46 states, according to preliminary data by the Rockefeller Institute. But that may not quickly result in increased aid to cities or reduced property taxes. "State tax revenue is definitely growing, but it has a long ways to go to reclaim the levels that it reached before the 2001 recession," says Nicholas W. Jenny, a senior policy analyst in the Institute's fiscal studies program.