The property tax predicament.

Property taxes, like the weather, always rouse complaints. But can states agree on alternatives to this stable source of school revenue?

When Michigan voters approved a March ballot measure to transfer more than $2 billion in school funding from the property tax to sales and other taxes, pundits predicted that the idea would spread across the country. After all, here was an opportunity to eliminate the hated school property tax and replace it with relatively benign sales and excise taxes.

It appeared that other states might quickly follow suit. Similar proposals emerged and passed at least one house in Colorado, Idaho, Vermont and Wisconsin.

But lawmakers quickly found out that replacing a major revenue source like the property tax raises some difficult questions and requires some difficult choices. As the 1994 sessions came to a close, none of these states had approved a major school finance restructuring like Michigan's although Wisconsin had boosted school funding substantially.

The issue is not dead. The coalition of conservatives who want to cut property taxes and liberals concerned about disparities between rich and poor school districts, instrumental in Michigan's reform, could emerge in other states to drive school finance and tax reform to the top of the 1995 legislative agenda.

However, intervening elections and the between session "cooling off" period will probably spark a more careful and critical review of the implications of shifting more school funding from local sources to states. Two key questions will frame the debate: 1) Can state government afford to commit more general revenue to schools and continue to provide the other services it currently provides, or will state spending cuts be necessary? 2) Will more state money mean less local control?

The School Finance Dilemma

The issues of local control and state funding are not new to the school finance debate. Back in the 1970s, there was widespread agreement that schools needed to be less dependent upon the property tax. States began a major push to boost state aid for elementary and secondary schools.

Even the federal government tried to get involved. In 1972, President Richard Nixon asked federal agencies to study "whether a federal value added tax is the best substitute for residential school property taxes" and "the best means of ensuring, under a system of school finance in which states have primary responsibility, that local school districts will be able to retain control of basic education decisions..." While the federal financing role never did expand significantly, the state share of K-12 funding grew from 40 percent in 1970 to 47 percent in 1979.

A new round of state funds was targeted for schools in the 1980s, both in response to school funding equity lawsuits and in support of the "school improvement" initiatives that came in the wake of the report, A Nation at Risk. But in many states these additional funds came with strings attached. And, rather than reducing property taxes, they sometimes required local schools to increase their own spending to meet new state requirements for such things as smaller class sizes and higher teachers' salaries.

New money has failed to stem the tide of equity lawsuits. Cases are still pending in 11 states. States like New Jersey and Texas that have changed their school finance systems in response to earlier court decisions are facing new legal challenges. Yet the political environment makes it extremely difficult to resolve the equity issue.

Finance formulas that successfully equalize school district spending are very difficult to pass because all three practical courses of action are politically unpalatable:

* Raise taxes substantially to bring poor schools up to the level of wealthy ones.

* Reduce or eliminate state aid to wealthy districts and redistribute it to poorer ones.

* Tell wealthy districts that they cannot spend their own money on their own schools.

The first option, raising taxes, is difficult when all state citizens pay higher taxes, but the benefits only accrue to some schools. The second option, eliminating aid to wealthy districts, is difficult given gains that relatively wealthy suburban areas have made in legislatures in both 1980 and 1990 following redistricting. The third option, telling wealthy districts that they cannot spend their own money, flies in the face of common sense and national efforts to improve education.

In addition to the difficulties in equalizing school funding, there is also the problem of state revenue adequacy.

Property taxes are the most stable of all revenue sources because they are not subject to fluctuations in economic cycles. Property assessments change slowly; increases and decreases in property values take a long time to work their way through the complicated assessment and mill levy system. Property tax liability does not change if a taxpayer is laid off. This may be hard on taxpayers, but it eases school district planning.

State tax sources--sales, income, and excise--are notoriously volatile. When times are good, like the mid-1980s, states have plenty of money to share with schools. But when recessions hit, state funds for schools can dry up fast. State school aid increases fell from 8.9 percent in FY 1992 to 2.1 percent in FY 1994. Such fluctuations complicate planning.

Although the stability of property taxes makes them an ideal school revenue source, taxpayers do not like them. They are perceived as unfair, arbitrary and burdensome. Some home-owners, particularly the elderly, bristle at the notion of paying property taxes for schools from which they get no direct benefit. As the population ages, a smaller and smaller proportion of property taxpayers will have a direct connection to the schools. The peril of having to ask voters to fund schools through the property tax is obvious.

The Michigan Plan

It is against this backdrop that the Michigan plan first emerged as a political dare in the summer of 1993. Republican Governor John Engler dared the Legislature to cut school property taxes, and Democratic Senator Debbie Stabenow took him up on it. The Republican controlled Senate quickly passed the bill, eliminating all $6 billion in school property taxes for the 1994-95 school year. The House quickly followed suit.

The sales tax rate is set in Michigan's Constitution, so it was imperative that any school finance fix involving a sales tax increase be approved by the end of 1993 to allow time for a statewide election. The Legislature passed the school finance bill on Christmas Eve 1993, and the governor signed it on New Year's Eve. Under the complicated measure, a package of sales taxes, cigarette taxes, a statewide property tax and the reauthorization of some local property taxes on nonresidential parcels would go before the voters on March 15. If the proposal failed, a backup plan to raise the income tax, cigarette taxes and the single business tax and to levy a larger statewide property tax was to automatically take effect. Thus the election became a contest between the sales tax and the personal income tax.

Proponents argued that income taxes were more progressive and that federal deductibility would reduce the actual amount of the increase borne by state taxpayers. Sales tax proponents argued that income tax burdens were already too high and that the state's low sales tax rate of 4 percent could accommodate the increase. In the end, the sales tax won hands down by a 70-30 margin, reflecting national polls that show sales taxes as less unpopular than income taxes.

Will replacing the local property tax with state tax sources require cutbacks in other state spending? Senator Joanne Emmons, chair of the Senate Finance Committee and supporter of the school funding reform, does not think so. "In good times, the funding mechanism will provide money for schools and other programs. In bad times, schools will get cut along with everything else. Under the old system, the state budget was balanced by shifting school costs onto the property tax. Now, schools will no longer be singled out for cuts to sustain spending in other areas of the state budget."

After voters approved it in March, the Michigan plan immediately became the focus of national interest. To states facing lawsuits over their method of funding schools, the Michigan solution held promise. It also looked good to lawmakers in some states with high property taxes. However, Michigan's situation has some unique elements that may not fit so well in other states.

First, Michigan's property taxes were among the highest in the country. Many other states had already taken action in the 1970s and 1980s to boost the state share of K-12 funding and relieve pressure on the property tax. In Michigan, the state paid about 32 percent of K-12 costs as opposed to 48 percent nationally. (Under the new system, the state share is about 80 percent.) Another factor was Michigan's relatively low sales tax rate. Even after the increase from 4 percent to 6 percent, it is near the national average.

Action in Other States

One state that appeared likely to follow Michigan's lead was South Carolina. Voters in some regions of the state were in rebellion because a newly completed property tax re-assessment had boosted their property taxes substantially. Early in the session, legislative leaders and the governor endorsed a bill to eliminate school taxes on primary residences, with the state reimbursing local governments for lost revenue by expanding the state's homestead exemption program. Sponsored by House Ways and Means Committee Chairman Billy Boan, the measure passed his committee and was taken up by the House in March.

An amendment by Representative Larry Koon that would have eliminated all local property taxes--not just school taxes--was narrowly defeated on the House floor. The Koon amendment was vigorously opposed by local governments because it would have required a popular vote for any increase in local taxes or fees.

However, after business interests successfully pressed for additional property tax exemptions and limitations on local government spending, the leadership pulled the bill from the calendar. "The bill veered too far from its original intent. We'll work over the interim to develop a bill that everyone--business, local governments, and schools--can support. I'm optimistic that we will succeed next year in addressing the core issue--school property taxes," said Representative Boan.

Wisconsin's circumstances are perhaps more similar to Michigan's than any other state. Both are large, industrial, upper Midwestern states with high property taxes. Sensing a growing voter frustration over rising property taxes, Speaker Walter Kunicki quickly moved a school property tax repeal bill through the House in February. Like the original Michigan bill, the Wisconsin speaker's bill would have repealed taxes and left the Legislature to find replacement revenue later. The Senate would not go along, however, and the compromise bill ended up providing enough additional state aid to freeze or reduce property taxes for most school districts for the 1994-95 school year. An eight-member commission was also established to recommend a plan to boost the state share of school funding from the current 47 percent to 67 percent for the 1996-97 school year.

Idaho lawmakers faced an additional complication when considering legislation to take schools off the property tax--the threat of an initiative petition to roll back property taxes. A bipartisan group of legislators on the Joint Ways and Means Committee proposed repealing the authorization for schools to levy property taxes--a $127 million reduction. The proposal would have raised $126 million by extending the sales tax to numerous services and exempt goods including construction labor, telecommunications and lottery tickets.

When it became clear that the Ways and Means proposal lacked the votes to pass, House Speaker Michael Simpson introduced his own bill to repeal school property taxes without expanding the sales tax base to replace lost revenues. With the state enjoying very strong revenue growth, the speaker argued that the state could make selective spending cuts and replace school funds with the existing tax system.

Speaker Simpson's bill passed the House and the Senate easily. But the plan was vetoed by the governor in April after the Legislature adjourned, thus preventing a veto override attempt. In his veto message, Governor Cecil Andrus claimed that the bill "imperils the future of education in Idaho [and] plunges the state into the quicksand of deficit spending." Andrus is not running for re-election.

Anti-tax groups have promised to respond to the veto with a vigorous citizen initiative campaign to limit property taxes. A measure to limit property taxes to 1 percent of market value could be on the ballot in November, even though a similar initiative was soundly defeated by voters in 1992.

Vermont was one of the states that pumped significant new money into education in the mid-1980s. In fact, between 1988 and 1992, state aid increased by 70 percent. New mandates from the state, however, forced up local spending requirements. Since the recession hit in the early 1990s, state aid has essentially been frozen, yet the local spending requirements adopted in the 1980s remain. As a result, school property taxes have increased substantially in the last four years. Voters, who must approve school budgets on town meeting day, have rebelled, rejecting school budgets and forcing school boards back to the drawing board to cut expenditures.

Vermont House Speaker Ralph Wright, trying to forestall a property tax revolt, proposed a bill to shift school funding from residential property taxes to a local option income tax. His bill also created a statewide tax on non-residential property that would be shared throughout the state as part of the finance formula. His bill passed the House in February.

The Vermont Senate passed a bill in May that did not include a statewide property tax or a local income tax. It would have added new money to the existing school finance formula and required regional property tax sharing. It also contained provisions for charter schools and other governance reforms aimed at improving educational outcomes.

Both bills died in the final hours of the session, as the House and Senate could not agree on a middle ground between the very different proposals. "I'm disappointed that we could not reach agreement," said Senate Education Committee Chairman Jeb Spaulding, "but I remain hopeful that all of the public debate on this issue will lay the groundwork for next year. The issue is not going to go away. School budgets are still being rejected by voters because of property taxes."

An Issue for 1995?

Property taxes and school finance are likely to be on the top of the agenda again in Idaho, South Carolina, Vermont, Wisconsin and perhaps some other states as legislators digest the policy and political impact of Michigan's reform.

More than anything, legislators want to devise a solution that will put complaints about school finance equity and property taxes behind them. Such a goal may be unrealistic, however. As long as schools must compete with other programs for limited state funds, lawmakers will always have to make hard choices. As veteran Vermont statehouse reporter Jack Hoffman concluded during the recent session, "There is no perfect fix, no permanent solution...[P]eople are always going to complain about property taxes--or whatever taxes are used--just as they will always complain about the weather."

Scott Mackey specializes in tax and budget policy for NCSL.