OPINION: The property tax plan

Michael Hicks, Ph.D., director Bureau of Business Research, Ball State University

On Tuesday, Governor Mitch Daniels unveiled a tax proposal designed to remedy a number of widely held concerns over property taxes in the state.  His proposal - in a nutshell - reduces property tax collections by 1/3^rd with additional revenue sources generated by a one percentage point increase in the general sales tax.  The proposal offers a three tiered property tax rate (residential 1%, rental 2% and commercial 3%), and consolidates taxation and perhaps budgetary decision making from the township to the county level.  The proposal also shifts the revenue burden of school expenditures and child welfare from local government to the state government.    

Like any tax plan, this one influences behavior of both businesses and consumers.  I'll be spending lots of late nights over the next few weeks trying to understand these effects.  But before we discuss the magnitude of these effects, it is important to see where we are today.

State tax systems, including Indiana's are regressive.  That means the tax burden, as a percentage of income drops as income rises.  This feature is necessary since states need to balance their budgets and regressive taxes are more stable.  It also helps balance out a very progressive federal tax system (which became much more so with the Bush tax cuts).    

States tax four things: income, wealth, consumption and activities.  The activities tax - primarily licensing fees - is a small part of our state's budget and not part of the current proposal.  Indiana income taxes are a flat 3.4 percent of income.  In a perfect world, income taxes would provide a nice source to offset property taxes.  But, the presence of three different local option income taxes makes adjustment to overall state income taxes problematic.  Hoosiers pay a low income tax at the state level (and half of Indiana households pay no federal income tax).  Overall, Hoosier taxpayers enjoy a tax burden for state and local government that is in the bottom third nationwide.  Sales taxes are in the top third, income in the bottom third and property in the middle, the state enjoys a reputation for a good tax climate.    

Governor Daniels' tax proposal has three immediate economic effects.  First, it reduces the cost of capital for firms and individuals.  Second it increases the cost of purchasing non-food retail items. Third, it reduces the instability in the overall tax system.    

Businesses and residents will respond to these three effects by increasing capital expenditures (on businesses and residential property) and reduce consumption of taxable goods.  The increase in capital expenditures is motivated both by the lower cost of capital and the reduced uncertainty about taxation.  Higher sales tax rates motivate less consumption.  Importantly though, the increase in sales tax is levied against a small proportion of economic activity (retail goods only).  Services, food and most medicines are excluded.  So, effectively, the increase in the sales tax rate is less than 1/10^th a percent of total collections.    

It is too early to fully outline the magnitude of the effects.  Hoosiers will be asking important questions such as: Who bears the burden and relief of the proposed tax changes?  How much shifting of economic activity will occur from retail sales to other industries?  How big will the net effect be on economic activity (it is already obviously positive)?