There ’s a feeling lately that the worst of the economic crisis may be passing like the leading edge of an especially large and violent thunderstorm. It isn’t sunny out yet, but the rain may be easing a little, the sky lightening. For local governments, though, more stormy weather lies ahead. Here’s how worrisome the local outlook is. In April, Moody’s Investor Services took the unusual step of assigning a negative outlook to the creditworthiness of all local governments in the U .S., the first time it has ever issued such a blanket report on state or local governments as a whole. The sources of the problem are diverse. Many governments were caught with the same toxic investments as the portfolios of many Americans. Some local governments, such as those in New York and surrounding states, are losing revenue because of their reliance on the banking and financial services sectors for their tax bases. Moody’s said any municipality that relies heavily on tourism, gambling or manufacturing will face continued problems.

The sources of the trouble are diverse but at their heart is the property tax, which accounts for more than 70 percent of local government general revenues nationwide. Most state and local revenues aren’t performing too well right now, but the property tax is going to pose ongoing problems for local government. The tax looks backwards in the sense that this year’s tax levy is based on last year’s property assessments. In fact, the reality is that property tax collections lag the real estate market by more than a year because local assessments take time to catch up with market changes. Current property tax collections typically reflect property values from 18 months to two years ago.

Eighteen months to two years ago, conditions weren’t nearly so bad. The Federal Housing Finance Agency (FHFA) index of median home prices shows that home prices peaked in April 2007. Nonresidential construction was also doing well in most states back then. Since then, the housing market slump has slammed residential values nationwide. FHFA recently reported that U .S. home prices nationwide fell more than 8 percent last year. Housing starts were down 48.4 percent over the same period. Those are national totals. Some areas have fared far worse.

Complicating this bad news further is the fact that many Americans have exhausted their options for keeping up their home payments and are starting to walk away—or at least to think about it.

Nationwide, nearly 804,000 homes received at least one foreclosure-related notice from January through March, up from about 650,000 in the same time period a year earlier, according to RealtyTrac Inc., a foreclosure listing firm.

Some of the worst hit areas are the nation’s largest metropolitan areas. Standard & Poor’s Case-Shiller National Home Price Index track changes in the value of the residential real estate in 20 metropolitan areas. Over the past year, the index has decreased by 18.23 percent, the largest annual decline on record. The index shows that aggregate house prices in the major metropolitan areas have fallen continuously since January 2007. The index now stands at about the same level as in the fall of 2003. It’s as though the first economic upswing of the 21st Century never happened, perhaps appropriately, since it seems mainly to have happened on paper and in the fantasies of Wall Street con men anyway.

Insofar as the property tax is concerned, residential property values make up only about half or less of most local tax bases. While residential construction values have been in decline for some time now, nonresidential construction values have not experienced as significant a drop off to date, but this sector is not without its problems. There’s a growing concern among economists that commercial construction will drop sharply in coming months due to restricted financing. That will affect the property tax base further into the future.

Some of these effects are already visible. According to Census Bureau data, the value of nonresidential construction put in place through February of this year is down pretty much across the board from last year. Commercial construction is down 23 percent, and office construction is down 12 percent. The only sectors showing healthy growth are manufacturing and the public sector, and even that growth gives one pause because government spending on key infrastructure projects like transportation and power development is down while government office space construction is up. With state and local governments laying off employees all over the country, that’s a hard one to understand.

Property tax problems were already becoming evident last year. Back in September, the National League of Cities did a survey of its members that showed the effects of declining property values on their tax revenues. “The effects of the well-publicized downturn in the real estate market over the past year are becoming increasingly evident in city property tax revenues,” the analysts noted. “Collections for 2007 revealed strong revenue growth as assessments caught up with the previous growth in the real estate market. Property tax revenues increased in 2007 by 10.7 percent compared to 2006 levels, or in constant dollars, an increase of 6.3 percent. Projected property tax collections for 2008, however, point to the impact of the downturn in real estate values. Property tax revenues for 2008 are projected to grow in current dollars by 1.8 percent, which amounts to an actual decline of 3.6 percent in constant-dollar terms.”¹

Here in my home state, we’ve only recently begun to see the effects of this problem. Up to the end of last year, the state had avoided the recession. There were high-fives and congratulations all around. Not any more. The Texas economy very likely fell into recession last December, according to the Dallas Federal Reserve Bank. Property values are starting to weaken, particularly in the state’s major urban areas, though not precipitously at this point. The Harris County Appraisal District — which covers Houston and its suburbs — recently reported that the total value of the 860,000 homes assessed so far this year has fallen by about 2.5 percent from last year. It’s the first time property values have declined or stagnated since the oil price bust of the 1980s.

Recognizing the lag between changes in property values and their effects on tax collections, you can get an idea of what the near-term prospects for property taxes are nationally by looking at what happened to the purchase prices of homes in the various states last year. Based on Federal Housing Finance Agency data, the states can be divided into three buckets. 2 The first bucket includes the handful of states — Texas, Wyoming, North and South Dakota and Alaska — where home prices continued to rise. The growth, though, has been fairly minimal even in those states — the “strongest” growth rate was 1.9 percent in North Dakota. You will doubtlessly note that most of these states are energy producers, and energy prices were up last year, pulling the state economies along in their wake. That trend has since reversed itself, and the figures I cited earlier for Houston illustrate the resulting slowdown.

The second bucket includes the states it’s tempting to label “basket cases.” These are states which have had ongoing problems because of the subprime mortgage meltdown or more fundamental long-term economic problems that clearly haven’t abated yet. Home value declines were vertigo-inducing last year in these states, with values declining between 10 and 30 percent. The basket case states include California, Arizona, Nevada, Florida, Georgia, Michigan, Virginia, Maryland and the District of Columbia, with California, Nevada and Florida being in the worst pickles.

The 37 remaining states fall into the final bucket where home prices are down, but not dramatically so on average. Prices in those states were down 10 percent or less last year, not a good trend for homeowners or local governments, but not too bad either when compared to what happened in the states where property values have declined at double-digit rates.

As with most things involving taxes, the issue isn’t uniformly black and white nationwide. No local government should expect a bed of roses in the next couple of years, but a number of factors will influence what happens to the finances of individual government over the next 24 months or so. One of those factors, as already noted, is the condition of local economies, which vary widely, but other factors will figure in as well. Jane Malme, who is a Fellow with the Lincoln Institute of Land Policy in Cambridge, Massachusetts, helped me identify several of those factors. The question is a matter of some interest to the Lincoln Institute since its mission is to address a wide range of issues dealing with the use, regulation and taxation of land, both here in the U.S. and in other countries.

According to Malme, there are some interesting anomalies in how local property taxes work that will affect how they perform in the coming year. Different places with similar market conditions could have different experiences with their taxes. “Each state’s situation depends on it policies,” she said.

For one thing, there’s the reassessment cycle. “If a government never reassesses property — and there are still some out there that don’t — then what happens in the market doesn’t matter. There won’t be much change in their tax base. If, on the other hand, the requirement is for full cash value appraisal and that’s being met on a regular cycle, the amount of property tax that a city or county can raise without increasing rates may decline.”

There will also be variability within states, including those with the most problems. Massachusetts, where Malme lives, provides an example. Based on FHFA data, purchase prices in the state on average declined by 5.5 percent last year. That wasn’t the case in the town where she lives. “I happen to live in a historic town with many historic buildings, and there’s been very little change in our values. They aren’t going up. They’ve stabilized.” Of course, even stability can cause problems. “Our problem now is that we’ve built a new school, and we can’t afford to open it without a tax increase requiring voter approval,” she said.

Even in states where conditions are the direst, some localities will fare worse than the average, however bleak, and many of the local governments facing the worst outlooks are among the nation’s largest metropolitan areas. For example, Phoenix, San Francisco and Las Vegas each has experienced more than a 30 percent drop in house prices over the last year, according to the Shiller-Case index. Phoenix leads the ranks of the unfortunate among the largest metro areas with a 34.96 percent decline over the last year.

The areas experiencing the largest drops in house prices are usually the same areas that saw dramatic increases, over 40 or even 50 percent a year, during the boom. “The common theme is that values are falling, but it’s hardly uniform. Detroit’s values are down, but it didn’t have nearly as much to lose relative to Las Vegas,” Malme noted.

She also said that tax growth limitations may work to prop up tax collections in the short run, despite value drops. Some states, including Massachusetts, have full market assessment requirements in their property tax laws but impose levy limits. “Massachusetts is a little unique, and I always thought it was a good model,” she said. The state followed California during the heyday of Proposition 13-style property tax limitations, but it maintained full-market appraisal in the process. “We have limits on the total amount that can be raised from the property tax, but we don’t tinker with appraisals. It has proven to be a stable process.”

In 1980, Massachusetts voters approved Proposition 2.5, which mandates that the property tax levy ceiling — the amount of revenue raised — can never exceed 2.5 percent of the full cash value of all taxable property in a city or town. In addition, the property tax levy cannot increase from year to year by more than 2.5 percent, with certain exceptions for new growth or as a result of overrides or exclusions adopted by local voters. Because of the limit on levy increases, the system in effect produces excess capacity in the tax base during years of strong value growth. T axes will keep rising for a time during a downturn in property values as the excess capacity created in better times is absorbed. “I’m not sure how many states have this excess capacity,” she said.

I couldn’t find a precise answer to that question either, but it’s probable that several other states will have at least some reserve capacity on which to draw because of levy limitations. A 2008 Lincoln Institute study identified 20 states with some type of limitation on the annual increase in property tax assessments, most often directed at residential homesteads but with some applying to all property. The limits typically range from a two to ten percent increase in taxable assessments regardless of how much actual market values rise.3

Of course, no good deed goes unpunished. The same Lincoln Institute report also pointed out a clear downside to the limitations in tough economic times — taxpayer unhappiness with rising property taxes even when the value of their property is declining.

According to the report: “Ironically, even assessment limits adopted in times of rising house values can contribute to taxpayer discontent as residential prices fall. By breaking the link between market values and assessments, these limits may result in assessed values that rise by a given percentage amount annually, even as owners observe a precipitous drop in their housing wealth as a whole.”

To a degree, the boom preceding the current downturn set up a perfect storm in this regard. The late, lamented boom drove up residential property values in many states much more rapidly than values in the commercial or industrial sectors. “Over time, there was a shift toward residential property taxpayers in terms of the amount of taxes paid,” Malme said. “As residential values have gone down and commercial has continued to rise, there is has been a shift away from residential again. It’s a correction.” It’s a correction, though, from which residential property taxpayers may not immediately benefit, much to their chagrin.

And what about business taxpayers? They, too, are likely to be unhappy. Studies show that effective property tax rates on business property typically are higher than the rates on residential property, mainly because businesses don’t usually benefit from various limitation measures and may, in fact, be subject to higher tax rates under classified property tax systems. As residential values drop sharply, any temptation local governments may have to make up the difference through higher taxes on the business property is likely to meet with resistance and ultimately may have to be tempered by economic development concerns if nothing else.

For some policy analysts, the effects of property tax limitations are more far reaching and can prove particularly problematic for local governments in times of economic distress. The Center on Budget and Policy Priorities (CBPP), for example, analyzed the use of tax caps in, conveniently enough, Massachusetts.⁴ According to the CBPP researchers, limitations on local property taxes imposed by Proposition 2.5 have resulted in a disconnection between the tax and the rising cost of services, forcing bud get cuts and a heavier reliance on state aid.

Economic stress will exacerbate difficulties for local governments subject to such limitations. “Proposition 2.5 took effect during a period of extraordinary economic growth—the ‘Massachusetts Miracle.’ State revenues were rising, which allowed the state to boost aid to compensate for constrained property taxes, and construction was expanding, which allowed communities to raise their property tax revenue by more than 2.5 percent per year. If a state were to adopt a property tax cap during an economic slowdown or a period of weak state revenue growth, a major sustained infusion of state aid would not be possible and property tax revenue growth would be more constrained. As a result, schools and other services dependent on the property tax would have to be cut much more severely than in Massachusetts.”

Malme also underscores the problem with local dependence on state aid in turbulent economic times. “One problem many local governments are likely to face if property assessments and therefore property taxes fall, is that state revenues are also declining so that aid is being cut from state budgets just as local budgets come under pressure.”

Not all local governments are destined to be disappointed by their state lawmakers, however. Texas provides no state aid to local governments so localities don’t have to anything to lose. The worry here is that the state will complicate an already worsening budget situation by imposing further limits on local property tax authority. In the current legislation session, state lawmakers are considering either imposing more stringent assessment caps or imposing revenue caps similar to those in Massachusetts. Legislators have been thinking about expanded property tax limitations since 2004, mainly because of ongoing taxpayer complaints about rising property taxes and the related political considerations. However, the intensity, if anything, was ratcheted up in 2007 because the massive cut in school taxes enacted in 2006 hardly made an impression on taxpayers as rising property values offset much of the effect of the rate cut. Of course, taxes were lower than they would have been, but it’s harder to appreciate a tax increase that didn’t happen than to loath one that did.

I asked Elna Christopher of the Texas Association of Counties about the legislation, which the Association, not surprisingly, strenuously opposes. She said counties are already preparing for rockier budget conditions in the year ahead. “Around the state, I’m seeing counties preparing flat budgets to avoid having to raise tax rates.

It’s happening in counties of all sizes—rural, urban and suburban— growing or not. Some are already facing budget shortfalls this year. Their projections are based on the idea that they’ll see at least a four percent reduction in appraisals.” Expanded revenue limitations would make what is likely to be a tough situation even tougher. “If further property tax caps are imposed right now, it would make the current problems local governments are already facing worse, and it will take longer for them to dig out,” she said.

In the meantime, she said, local government costs are continuing to rise with the main pressures coming from rising health costs, local transportation needs, particularly in urban areas, and the increasing costs of law enforcement. Many of those costs will continue rising regardless of economic conditions, and many local governments have only limited revenue alternatives other than the property tax to fall back on.

A sagging local economy produces its own budget pressures for local governments as well. More people seek various forms of public assistance, and the amount of uncompensated health care rises as people without insurance or money seek medical care at local emergency rooms that are often maintained by local governments.

At times, the problems can assume an almost surreal quality that would be funny if they weren’t so sad. “In one west Texas county,” Christopher said, “the sheriff had to go to the commissioners’ court recently to get more money because his budget for dealing with stray animals had already run out for the year—months early.” The cause, she said, is that people are abandoning animals they can no longer afford to feed. Some of those abandoned critters are large animals like horses and cattle, but this development has to give you pause.

For a state whose musical heritage is rich in songs about guys who lose their jobs, their wives and their kids but hang onto their dogs, it’s a troubling sign of things to come.

Regardless of how their laws affect the property tax, it seems pretty clear that local governments are going to be for stormy weather in the next couple of years. Appraisals should come down so that should eventually reduce some of the pressure on lawmakers to protect their citizens from hidden increases in their property taxes tied to rising home values. The challenge in the months to come is much more likely to be convincing citizens, as in Malme’s town, to go along with rate increases. Whatever is the case, that’s a local matter that local officials should sort out with the citizens that elected them. State legislatures should resist the temptation to impose further limits on the scope of local action. The weather’s going to be bad enough for the local governments with state lawmakers snatching their umbrellas.

This article was previously published in State Tax Notes, which can be found online at www.tax.org.

About the author
Billy Hamilton is a national recognized expert in tax policy, having made his name over the past three decades during several stints in the Texas State Comptroller’s Office as chief revenue estimator and as deputy comptroller. He has advised officials in Oklahoma, North Carolina, Louisiana and California on government performance reviews, which are used to find taxpayer savings. He has also worked as a consultant to the World Bank on issues related to public debt management, tax policy and performance management in Poland, Hungary, Romania and Bosnia/Herzegovina. The Comptroller’s office originally hired Hamilton away from the Texas Department of Community Affairs in 1977 to write an accounting manual for county governments.

¹ National League of Cities, “City Fiscal Conditions in 2008,” Research Brief on America’s Cities, Issue 2008- 2 (September 2008). Available at: http://www.nlc.org/ASSETS/A49C86122F0D4DBD812B91DD5777F04D/CityFiscal_Brief_08-FINAL.pdf

² Federal Housing Finance Agency, “Record Home Price Declines in Fourth Quarter; Isolated Pockets of Strength,” February 24, 2009. Comparisons based on changes in purchase prices of homes from the fourth quarter of 2007 to the four quarter of 2008. Available at: http://www.fhfa.gov/webfiles/1282/4q08hpi.pdf

³ Mark Haveman and Terri A. Sexton, Property Tax Assessment Limits: Lessons from Thirty Years of Experience, Lincoln Institute of Land Policy, Policy Focus Report, 2008. Available at: https://www.lincolninst.edu/pubs/dl/1412_733_PFR%20Property%20Tax%20Limits.pdf

⁴ Iris J. Lav and Cliff Oliff, “Hidden Consequences: Lessons From Massachusetts for States Considering a Property Tax Cap” Center on Budget and Policy Priorities, May 21, 2008. Available at: http://www.cbpp.org/files/5-21-08sfp.pdf