TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform is hard. But sometimes local tax reform makes it look easy, particularly when those reforms involve a state-for-local tax swap. Currently, both Texas and Nebraska are considering state-for-local tax swaps, but they’re running into an old problem: frequently, only a net tax cut can ensure that most taxpayers are not worse off, while only a tax increase can hold local governments harmless.
Local revenue systems are often a hodgepodge of taxes, old and new. Mainstays like the property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. or often a local option sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. coexist uneasily with head taxA head tax, also known as a poll tax or capitation, is a flat or uniform tax levied equally on every taxpayer. Unlike an income tax, it is a fixed amount and not based on how much one earns, nor does it change based on any taxpayer circumstance or action. es, inventory taxes, occupation taxes, and license taxes, some of them evolved from peddler’s taxes or other archaic forms of taxation. Tangible personal property taxes, though widely regarded as economically inefficient, hang on in many states, and sometimes so do gross receipts taxA gross receipts tax is a tax applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. es, for all their acknowledged flaws. In some states, a constellation of small, inefficient local revenue sources can be so widely acknowledged as flawed to earn the appellation “nuisance taxes”—in official state publications!
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Policymakers are often interested in eliminating certain taxes, because they’re inefficient, unpopular, volatile, or for any number of other reasons. If, however, the taxing authority cannot afford to forgo the lost revenue from repeal, a replacement revenue is needed—hence the tax swap.
The term “tax swap” often carries negative connotations, but it need not. Most tax reforms involve shifting liability among taxes to some degree, and sometimes one or more taxes outright replace another. Almost all states’ current tax codes are the result of an epochal shift in state taxation beginning about a century ago, when states scrapped their statewide property taxes and began to replace the collections with income and sales taxes. Proposals to modernize sales taxes often involve tax swaps (broadening the sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and using some of the revenue to pay down rate reductions elsewhere), and can promote equity, stability, and economic efficiency. Lesser rebalancing of revenue sources happens with regularity, designed to increase efficiency, equity, simplicity, or some other policy aim.
Each swap must be considered on its own merits: some would improve state tax codes, while others may increase their complexity or undermine a state’s competitiveness. But the concept of the tax swap is itself neutral. When, however, a state revenue source is swapped for a local one, the complexity of the swap increases markedly. This does not mean that no state-for-local swaps are worth doing, but it does require careful deliberations, as the mechanics of a state-for-local tax swap are considerably more intricate than those of replacing one state revenue stream with another.
Four Kinds of Tax Swaps
In theory, four kinds of tax swaps are possible within state and local taxation: state-for-state, state-for-local, local-for-state, and local-for-local. A state increasing its gas taxA gas tax is commonly used to describe the variety of taxes levied on gasoline at both the federal and state levels, to provide funds for highway repair and maintenance, as well as for other government infrastructure projects. These taxes are levied in a few ways, including per-gallon excise taxes, excise taxes imposed on wholesalers, and general sales taxes that apply to the purchase of gasoline. , tied to a reduction in the sales tax rate, is a state-for-state tax swap. A state wiping out a locally-levied gross receipts tax in exchange for aid to localities funded by state income taxes is a state-for-local tax swap. Although rarely done explicitly, a reduction in state tax rates tied to new local spending mandates might be seen as a local-for-state tax swap, particularly if accompanied by new local revenue authority. And a locality paying down the repeal of some of its nuisance taxes with a slight property tax increase would be engaging in a local-for-local tax swap. Notably, local-for-local swaps might be initiated by a given locality or could be mandated by state government.
Distributional impacts must be grappled with where any tax change is concerned; they are not limited to tax swaps. For a tax swap involving a single level of government (state-for-state or local-for-local), the impact of distributional changes takes place at the taxpayer level (that is, changes in individual taxpayers’ overall liability). Where two levels of government are involved, however, they also take place at the governmental level. The same can also be true when states mandate a local-for-local tax swap, depending on the swap’s design.
The Challenge of Tax Distribution
Texas is currently considering an increase in the state sales tax to pay down reductions in local property tax millages, while Nebraska is contemplating using the sales tax to engineer property tax relief in the form of modified assessment ratios and tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s. Other states have gone down this path, and they’ve learned just how complex it can be.
The new revenue stream will, necessarily, have a different economic incidence than the one it replaces. It is likely to have a different geographic footprint as well. However the state chooses to disburse the resulting revenue to localities, there are bound to be difficulties.
For the sake of narrative simplicity, let us use a generic version of the Texas and Nebraska proposals—a state sales for local property tax swap—though the basic analysis would apply to other state-for-local tax swaps as well. Obviously, as a starting point, taxable property and taxable sales are not proportional to each other. Some jurisdictions may have high property values but relatively little retail, hence low sales tax collections. Others may have large retail corridors, but struggle with the rest of the property tax base. How much tax is collected from each geographic region, and from each income class, will change under the swap. Thus far, this is not unique; the same would happen with a tax swap on a single level of government.
Here, however, the second-order effect takes place: not only do collections change, but local distributions do as well. Having collected the revenue, the state must decide now to allocate it to localities.
Policymakers might opt to distribute it proportionally to the revenue being replaced, such that a locality collecting 5 percent of the state’s overall property tax revenue would receive 5 percent of the replacement revenue. This approach rewards the jurisdictions with the highest property tax collections, which could be a combination not only of the properties with the highest assessed values but also those with the highest rates. Jurisdictions which exercised greater frugality might reasonably object to their tax dollars being siphoned off to provide additional aid to jurisdictions which have historically imposed higher taxes.
If, as in Texas and Nebraska, only a partial replacement of the property tax is intended, local policymakers (and the voting public, to the extent that they have to approve rate increases) have an incentive to raise property tax rates and cut other taxes—which runs directly counter to legislative intent—because higher property taxes yield a higher state revenue match. In a scenario where the property tax was repealed outright (which is not part of the proposal in either state), tax collections at a particular point in time could serve as the basis for a redistribution formula indefinitely, with increasingly indefensible results as time passes.
Alternatively, revenue could be distributed based on population, which—in a sales tax for property tax cut swap—would redistribute revenue to higher-density areas, particularly if property tax relief is limited to owner-occupied housing. This could be an explicit policy goal, or it might not, particularly if the intention was property tax relief. Property taxes might be lower, but those who faced the highest overall property tax burdens might—lower property taxes notwithstanding—shoulder an even greater tax burden.
Relief only targeted to owner-occupied housing, meanwhile, can be perversely regressive, since rental properties are generally classed as commercial property. Renters—many of them lower-income—would thus pay the higher sales tax without getting the benefit of any property tax relief.
It might be allocated based on where the additional sales tax is collected (destination sourcing), which makes it functionally like a mandatory local-for-local swap. Or revenues could be distributed by some other formula.
If the goal is to offset educational costs, for instance, it might be allocated according to a school funding formula that reflects educational needs. Such an approach might have merit—but as a school finance measure, not purely or primarily as a tax swap. In both Indiana and Michigan, for instance, state government assumed greater responsibility for education funding, with revenue earmarked from the state sales tax. To avoid (or at least limit) increased levels of overall taxation, mechanisms were put in place to reduce local property taxes in line with the reduced local responsibility for school funding. These policies should be understood, primarily, as school funding equalization measures, not property tax relief. The distributional changes—for individuals and taxing jurisdictions—were the goal, not an unintended consequence of a tax swap.
This is the quandary of a state-for-local tax swap: the only way to ensure that most taxpayers are not worse off is often to design the swap as a substantial net tax cut, while the only way to hold local governments harmless may be to engineer a substantial tax increase.
The Risk of an Overall Tax Increase
Even if, overall, the tax swap does not immediately increase tax burdens within a given jurisdiction, moreover, it might well end up that way. This is one of the biggest objections to state-for-local tax swaps, and while there are mechanisms to mitigate the risk, it is difficult to avoid it altogether.
Typically, proposals for a tax swap impose some sort of rollback or repeal requirement for the targeted local tax. So, for instance, property tax millages might have to decline by 20 percent, or capped below current levels, or be subject to reduction by the amount necessary to ensure a dollar-for-dollar reduction against the new local aid. Each approach has its own implications for local budgets. Equally importantly, however, is that it is difficult to ensure that the rates remain lower because of the tax swap.
Local governments tend to enjoy some autonomy in rate-setting, though they are subject to property tax limitations of varying levels of efficacy. Once rates are rolled back due to a tax swap, state officials can impose limits on the growth of tax collections (often called levy limits) to prevent local tax jurisdictions from reverting to their old rates while pocketing the new state aid, but most limits permit some growth factor and often authorize voter overrides. If property taxes are suddenly lower—even if other taxes have, with little transparency, risen to offset them—localities could easily max out their annual growth, or even secure voter approval to raise rates outside the cap, resulting in net tax increases while failing in the ostensible rationale for the swap: lowering property taxes.
In sum, state-for-local tax swaps are difficult to get right, both as a matter of policy design and practical politics. There are cases in which a state-for-local tax swap is still worth doing, because the targeted tax is so inefficient, or in service of other (non-tax) policy aims. There may, moreover, be options for other kinds of tax swaps, or for granting local governments greater authority to engineer their own local-for-local tax swaps tailored to their aims. At times, it may be appropriate for state government to mandate local participation, repealing authority for a given tax and perhaps replacing it with different tax authority.
Any such proposals require thoughtful deliberation, but some remain well worth doing. The potential moral hazards of a state-for-local tax swap, however, require a particularly cautious approach. Policymakers should want to know the details and contemplate the ramifications, avoiding the temptation to view a swap as an easy solution to goals like property tax relief.
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