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Restoring Property Tax Relief

March 13, 2013 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

Governor Pawlenty and his “no new tax” allies repeatedly cut funding for property tax relief programs, choosing to shift the state budget balancing burden on to local governments and local property taxpayers rather than increase state taxes. During this period, city Local Government Aid (LGA) experienced some of the deepest and most frequent cuts.

From 2002 to 2013, LGA's nominal funding has been cut from $565 million to $427 million, a reduction of $137 million or 24 percent. This statistic understates the full magnitude of LGA's decline, as it does not adjust for inflation or population growth. In real (i.e., inflation-adjusted) dollars per capita, funding for city LGA has been cut in half since 2002.

From day one of his administration, Governor Dayton has fought to protect property tax relief funding. Thus, it should surprise no one that his proposed FY 2014-15 budget seeks to restore a portion of the LGA cut. Dayton's recommended $80 million LGA increase replaces just 58 percent of the nominal LGA reduction since 2003, and only about one-sixth of the real per capita cut. Even so, given the looming budget deficit and the scarcity of state resources, the Governor’s commitment to restoring LGA funding is noteworthy.

Governor Dayton's proposed LGA funding increase will likely stimulate a renewed debate over the LGA program's merits. The most commonly heard LGA criticism is that it encourages cities to spend more, thereby stimulating city government growth. It's the principal criticism that proponents of an LGA appropriation increase will need to rebut.

At one point in time, LGA was arguably a spending driven program. Throughout much of the 1970s and 1980s, a city’s “revenue need”—a key component in determining how much aid a city would receive—was based on the sum of its levy plus state aid in prior years. Under this system, there was an incentive for cities to increase their levies, thereby increasing their revenue need and, in turn, their LGA payment.

However, this spending driven feature of the city LGA program was eliminated over two decades ago. Beginning in 1989, the measurement of city “revenue need” was changed from prior years’ levy plus state aid to a measurement based on the demographic characteristics of each city.* With this change, cities no longer had an incentive to increase their levies in order to receive additional state aid in subsequent years, because the connection between levies and future aid amounts was severed. At the same time that LGA was reformed, the homestead credit was also modified so as to eliminate the feature of that program that also incentivized local governments to increase spending.†

The structure of the city LGA formula is reflected in city expenditure growth patterns. During the period prior to 1989—when LGA and the homestead credit were “spending driven” programs—city spending increased steadily. From 1972 (the first year of the LGA program) to 1989, real (i.e., inflation-adjusted) per capita city expenditures increased by 17.4 percent. While correlation does not necessarily equal causation, the explanation that the old LGA and homestead credit programs contributed to city spending growth is consistent with this trend.

Since the reforms to LGA and the homestead credit implemented in 1989, real per capita city expenditures have stayed flat or declined. From 1989 to 2001, real per capita city spending remained relatively constant; since 2001, it has declined significantly, likely in response to sharp reductions in LGA. In total, from 1989 to 2011 (the most recent year for which audited city expenditure data is available), real per capita city spending has declined by approximately 20 percent.

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In light of the significant decline in real per capita city spending since 1989, we can safely conclude that the LGA program is not causing excessive city spending growth. After all, the LGA program could not have caused something that did not occur. In fact, per capita city spending in Minnesota is 5.5 percent below the average for cities in other states based on data from the most recent “Census of Governments,” adjusted for differences in the type of services provided by cities in different states.

This is not to say that the $80 million increase in LGA proposed by Governor Dayton will not lead to some increase in city spending. As noted above, real per capita city spending has declined significantly over the last decade, as cities cut services and deferred infrastructure maintenance. In addition to providing property tax relief, the aid increase proposed by Dayton can and should be used to reverse some of these useful public investments.

Governor Dayton’s willingness to restore a portion of past funding cuts to the city LGA is a sign that he has faith in local officials to find the correct balance between property tax relief and the need for investment in city services. The overall track record of city fiscal stewardship over the last twenty years provides indication that this trust is not misplaced. The legislature should agree to Dayton’s proposal to increase LGA funding during the 2013 legislative session.

*Beginning in 1989, the revenue need of cities was based on the number households in each city, with revenue need per household increasing as the number of households increased. While this measure of revenue need was imprecise, it did nonetheless divorce the level of LGA that a city received from marginal city spending decisions. A more rigorous and precise measure of city revenue need based on various city characteristics was adopted in 1993 and revised in 2003. All of the measures of city revenue need used in LGA calculations since 1989 have been divorced from marginal city spending decisions.

†Prior to 1989, the state reduced homestead property taxes by just over 50 percent through the homestead credit, up to a maximum of about $700 per homestead. (The precise amount of this maximum varied over the years.) This feature of the old homestead credit arguably stimulated growth in local levies, since about half of any tax increase borne by homeowners would be effectively paid for from the state (up to the maximum), thereby making it easier for local governments to increase property taxes. In 1989, this spending-driven feature of the homestead credit was eliminated. All of the various forms of the homestead credit implemented since 1989 have all been insulated from the effects of marginal local government spending decisions.

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