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Property Taxpayers’ Shrinking Fiscal Equity

January 11, 2011 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

A portion of Minnesota’s business lobby—including the Minnesota Chamber of Commerce, the Minnesota Taxpayers Association, and the Minnesota Commercial Real Estate Development Association—have launched an effort to further cut city Local Government Aid (LGA). The arguments for further LGA slashing are flawed and will only lead to more property tax increases for Minnesota homeowners, renters, and businesses and more reductions in funding for public services and infrastructure.

LGA was one of many property tax relief programs enacted in the early 1970s. The state gives local governments general fund dollars—primarily generated from income and sales taxes—to reduce property taxes. In exchange for state dollars, local governments are forbidden from imposing sales taxes, with limited exceptions as defined in state law. The principal mechanism for reducing city property taxes has been LGA.

The first year cities received LGA was 1972; the last major rewrite of the LGA program occurred in 2003 and was based on Pawlenty administration recommendations.

Critics of LGA in the business community have argued that city LGA “creates perverse incentives” for cities to raise city spending because the full cost of marginal spending increases are not borne by local taxpayers.

Back in the 1970s and 1980s, this argument had merit; because city aid was based on average spending over the previous three years, over time city aid would increase as city spending increased.

However, the connection between city spending decisions and the level of aid a city received was broken over two decades ago. Since 1989, the revenue need of a city is not based upon past spending, but upon the demographic characteristics of each city. If city officials decide to increase spending, the cost of that spending is borne entirely by local taxpayers, not by increased state aid.

In this way, the state provides aid to equalize tax levels while maintaining accountability in city taxing and spending decisions. The argument that the current LGA program undermines accountability is unfounded.

The second argument against LGA is that it is so generous that it encourages cities to spend in ways that they otherwise would not. For example, some business lobbyists claim that generous LGA payments enabled some cities to provide generous “other post-employment benefits.”* Whether or not this claim was ever true is debatable; however, after eight years of large LGA cuts, it certainly is not true today.

City LGA has been cut by $138 million from 2002 to 2010, even prior to adjusting for inflation and population growth. The dramatic decline in LGA has caused large property tax increases at the same time that cities were making deep budget cuts. In this environment, the claim that generous aid payments are leading to lavish expenditures is laughable.

The assertion that LGA encourages unnecessary levels of city spending is undermined by the fact that per capita city spending in Minnesota is below the national average, even though Minnesota provides more general purpose city aid than does most states. Since the connection between city spending decisions and aid payments was severed in 1989, real (i.e., inflation-adjusted)† per capita city spending in Minnesota has declined.

The third argument against LGA is that it “goes to the wrong places.” It is true that homeowner property taxes as a percent of income can be less in some cities that receive LGA than in other cities that do not receive LGA. The business critics of LGA site this as a flaw of the LGA program.

However, the LGA formula proposed by the Pawlenty administration in 2003 was designed to equalize property taxes as a percent of the property tax base, not as a percent of income. The current LGA formula performs this function efficiently; the statewide disparity in city property tax rates (i.e., the levy as a percent of the tax base) is dramatically reduced through the LGA program.

Should the LGA formula be redesigned so that it equalizes based on homeowner income? The arguments for this change--pro and con--are too numerous to be examined here. However, LGA critics judge the program based on criteria that it was never intended to satisfy.

The final and most absurd argument against LGA is that “we can’t afford it anymore.” Since 2002, LGA and other aids to local governments have been a piggy bank that the state has repeatedly raided in order to deal with state deficits spawned in large part by “no new tax” policies. A steadily declining state expenditure cannot be blamed as budget buster.

In constant dollars, per capita LGA in 2010 is half of what it was in 2002. Furthermore, real per capita city LGA in 2010 (and certified LGA for 2011 prior to reductions) is less than it was in 1972--the first year of the LGA program.

LGA is not the cause of state budget problems. Rather, deficits resulted from a national economic crisis compounded by eight years of “no new tax” policies.

Proponents of more LGA cuts highlight the need for painful budget decisions. Indeed, after experiencing a 16 percent real per capita revenue reduction over the last eight years, city officials do not need more lectures about “pain.” They also realize that more pain is around the corner.

Property taxpayers--including business property taxpayers--have also experienced the pain resulting from cuts in LGA. Property taxes are regressive, falling disproportionately on those households with the least ability to pay.

There is no reason why the burden of balancing the state budget deficit should fall disproportionately on local governments and local property taxpayers, as they have done for the last eight years. State and local taxes per dollar of income are 20 percent less for the wealthiest five percent of Minnesota households than they are for middle income families.

There is no reason why high income households cannot bear a more equitable share of the tax load to help address the state budget deficit.

Nobel Laureate Joseph Stiglitz noted tax increases on high income households have a less devastating short-term impact on a state’s economy than do cuts in direct government expenditures. For example, city expenditures create jobs and economic stimulus within Minnesota; high income households, on the other hand, either save a large share of their disposable income or spend it on goods and services that are outside of Minnesota’s economy. Thus, tax increases for high income households do less damage to the state’s economy than do more cuts in city spending.

Meaningful suggestions for increased government efficiency are helpful. Reform of state aid programs needs to be considered. More cuts in aid to local governments may be unavoidable. But these measures should not distract us from the compelling need to generate more revenue from Minnesota’s highest income households.

Through large LGA cuts, Minnesota cities have already borne more than their fair share of the pain resulting from past state budget deficits. It is time for the business lobby to step up and acknowledge that high income households also need to bear some of the pain as well.

*In addition, at least one business lobbyist has claimed that “LGA is strongly correlated with higher levels of expenditure on employee health benefits.” However, a critique from the League of Minnesota Cities has underscored serious problems with the methods and data upon which this assertion was based.

† All inflation adjustments in this analysis are based on the implicit price deflator for state and local government purchases, which is the appropriate measure of inflation [] for state and local governments.

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