The tax we love to hate

In 2008, 95 percent of local government tax revenue and 30 percent of total state and local government tax revenue will come from property taxes. Given our dependence on the property tax for government services and public infrastructure, a consideration of the merits and demerits of the property tax and its proper role in the public finance system is in order.

The property tax is clearly one of the most controversial of taxes. (“Controversial” as used here is a euphemism for “hated.”) There are good reasons for its unpopularity.

First, the incidence of the property tax is only poorly related to taxpayers’ ability to pay. The property tax is a regressive tax, meaning that it takes it a larger bite from the pocket books of those with the least ability to pay. So-seniors on a fixed income and struggling young families are paying a higher percentage of their income in property taxes than wealthier households. Income-sensitive refund programs reduce-but do not eliminate-property tax regressivity.

Property tax critics argue that it is a relic of the middle ages, when the ownership of property was the measure of wealth. In the 21st century, income is a far better measure of wealth and the ability to pay than is the ownership of property. With this development, the property tax has become somewhat of an anachronism.

The second problem is related to the first. Property taxes frequently increase even if a taxpayer’s ability to pay remains constant or declines. If your property value increases more rapidly (or decreases less rapidly) than other properties in your city, county, or school district, the share of the local tax levy that you pay will increase.

A typical homeowner pays property taxes from his or her income. If your income is flat or declining at the same time your property taxes are going up due to appreciating property values (a common situation in Minnesota prior to the mortgage foreclosure crisis), you are apt to resent the growing bite that property taxes are taking out of your budgets.

The third reason is that property taxes can increase even if the value of your property is not changing relative to properties in the taxing district. For example, from 2002 to 2008 homestead property taxes in Minnesota have increased well above the rate of inflation even though the homestead share of statewide estimated market value declined.

Rising homestead property taxes might be more palatable if homeowners were receiving improved public services-more police protection, better local roads, or smaller class sizes. However, since 2002 city, county, and school revenues have fallen below the rate of inflation at the same time that homeowner property taxes have risen at a rate well above the rate of inflation.

In defense of the property tax, it should be noted that this problem is not the result of an inherent flaw. The growth in homestead property taxes since 2002 is the result of state leaders’ decision to cut the aid to local governments combined with other structural changes that shifted a greater share of the tax burden to homeowners. In the absence of state aid cuts and the other changes, the statewide growth in homestead property taxes would not have exceeded the rate of inflation, all other things being equal.

The property tax system is not without merits, although some virtues have been overstated. Some claim that the property tax is an ideal way to pay for local services-such as local roads, police, and fire protection-as the more of these public services you consume, the more property taxes you pay.

However, the link between property taxes paid and the benefit from local services is questionable. For example:

* I live in a household consisting of two adults, as do my neighbors. So far as I can tell, my neighbors are using local roads no more frequently than are the members of my household. However, because my neighbors own a more valuable house, they are paying more for local roads and all other local services than I am. In truth, the degree of usage of public roads has little to do with the value of the property at which you reside and the level of property taxes you pay.

* It could be argued that my neighbors benefit more from police protection, since they own a more valuable home. However, no thief is going to steal a home or the land on which a home is located-the two items upon which we pay property taxes. Police protection may protect the goods within our houses from the conniving thief; however, we pay no property tax upon the personal property within our homes. Thus, we pay no property tax on the property that is actually protected by the police.

* My neighbors will potentially benefit more from fire protection, since they have more to lose if a fire destroys their home. However, they pay property taxes not only on the value of the home, but also on the value of the land on which the home is located. A fire will not destroy the land itself, but only the home. Yet we pay property taxes on both the home and the land, even though only the home is protected by the local fire department.

In short, the relationship between property tax paid and the benefit derived from the local services funded with those tax dollars is-at best-imperfect. The claim that the property tax is a good way to pay for local government services should not be accepted uncritically.

However, two benefits of the property tax are undeniable: stability and predictability. While sales and income taxes can take fairly abrupt swings due to changes in underlying economy, the same is not true (or true to a far lesser extent) for the property tax. For this reason, the level of property tax collections is far more stable and predictable than the level of sales and income tax collections.

The benefits of predictability and stability should not be understated. During a recession, sales and income tax collections frequently dip along with the level of economic activity. For this reason, it is important that the government have at least one stable source of revenue to pay for public services, many of which are in greater demand during a recession.

Given the need for predictability and stability in government revenues, the property tax is unlikely to disappear any time soon. However, that is not to say that significant reform within the property tax system should not be explored. There are at least two ways in which the property tax could be improved.

First, our growing dependence on property taxes should be halted, if not reversed. In 2002, the state reduced dependence on the property tax by replacing the general education property tax with state aid dollars. However, since then real state aid for schools and other levels of local governments has fallen precipitously, causing increased dependence on property taxes. Based on the most recent Price of Government report from the Minnesota Department of Finance, property taxes as a percentage of total state and local government tax revenue will be higher in 2008 than at any point since the turn of the century.

Secondly, more should be done to reduce the regressivity of the property tax. The income-tested property tax refund program-also known as the “circuit breaker”-helps to reduce property tax regressivity by targeting property tax relief to taxpayers with the least ability to pay. Attempts by the Minnesota House of Representatives in 2008 to dramatically enhance the property tax refund program were only partially successful. The House’s “homestead credit state refund” program should be given renewed consideration as a way of making the property tax less regressive.

Property tax reform will likely be a hot topic during the 2009 legislative session. The goal of this reform should be to find the appropriate niche for the property tax within the state and local revenue system given the merits and demerits of the tax. Such reforms should include reducing the dependence on and regressivity of the property tax.