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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO MAY 1994 NUMBER 81 Chicago Fed Letter School reform and tax reform: a successful marriage? Over the past year, the state of Michi gan has profoundly changed the way in which the state’s elementary and secondary schools are funded and, at the same time, fundamentally re formed the state’s revenue system. With the passage of Senate Bill 1 dur ing the summer of 1993, the Michigan legislature effectively abolished the use of local property taxes as a prima ry funding mechanism for elementary and secondary education. In doing so, the state eliminated over $6 billion in locally imposed property taxes that would have provided more than 60% of the cost of the state’s public ele mentary and secondary education. In its place, Michigan recently put to gether a blend of other tax sources, including a statewide property tax and an increase in the sales tax. This new state tax structure is intended to en hance the state’s competitiveness and environment for growth and invest ment. At the same time, the state has established an entirely new system for distributing revenues for education that will reduce disparities between communities in per pupil spending. Michigan’s new tax plan has been more dramatic than most, but it re flects a combination of forces that has put both education and tax reform near the top of many states’ agendas since the 1980s. For this reason, oth er states are examining the Michigan reform package as one way of achiev ing both school reform and tax re form. In this Chicago Fed Letter, we look at the Michigan education fi nance reform plan and the ways in which it changes the state’s tax struc ture while attempting to improve the delivery of educational services. Michigan’s new plan A ballot measure passed by Michigan voters on March 15 makes wholesale changes to the state’s tax structure in order to replace property tax reve nues for education and boost overall spending on education. The measure raises the state sales tax from 4% to 6% effective May 1, 1994, increases the tax on cigarettes from $.25 to $.75, and levies a new real estate transfer tax and a new 6% tax on outof-state phone calls. The proposal also trims the state’s personal income tax rate from 4.6% to 4.4%. Michigan’s new plan does not elimi nate property taxes to fund education. In place of a locally determ ined com mon rate on all types of property, however, the state now has statewide tax rates for different classes of prop erty. The plan significantly reduces the school operating property tax rate for homeowners and makes modest average reductions for business prop erty. The new state property tax rates will be 6 mills on primary homes (an 82% reduction from the previous statewide average property tax rate for homeowners) and 24 mills on second ary homes and businesses (a 30% reduction). Rather than being dedicated to local school operation, tax revenues raised from local real property will now be pooled and distributed to local school districts through the state’s school aid allocation program. In the process, some of the traditional disparity in per pupil expenditure across districts will be eliminated. Minimum per pupil expenditures will be raised from the current $3,000 to $4,200 in the first year. Districts that have been spending less than $4,200 per pupil— primarily rural and some urban dis tricts—will be the major beneficia ries.1 Elsewhere, districts’ historic decisions on school spending will help determ ine prospective funding. Districts that currently spend between $4,200 and $6,500 per pupil (mostly large urban and suburban districts) may gain some additional revenues because of increases in state aid for districts with high concentrations of at-risk pupils. At the same time that low-spending school districts experience enhanced funding, the Michigan plan discourag es high-spending districts. Districts that currently spend more than $6,500 per pupil have two possible avenues to maintain existing spend ing. However, both of these avenues may discourage them from doing so because they involve either obtaining approval through a local referendum or narrowing the local property tax base from all property down to local homesteads only. Additionally, em ployer contributions to teacher retire m ent funds and Social Security will now become the responsibility of individual school districts rather than being funded by the state. Wealthy districts tend to have higher salaries and lower pupil-teacher ratios. These districts will now have to pay their own way for relatively costly pension programs. O ther features intended to equalize spending are more binding than dis couraging. Beginning in 1995-96, districts that currently spend $6,500 or more per pupil will be allowed to increase their spending only within prescribed limits. Tax reform to spur economic development Over the last two decades, Michigan has changed from a national leader to a laggard in terms of economic growth and living standards. Much of this change is due to massive realign ments in the automotive sector that have reduced the num ber of highpaying jobs in m anufacturing even while new jobs have been generated in lower-wage occupations. By 1992, Michigan’s per capita personal income had fallen to slightly below the U.S. average.2 Part of this economic de cline has been ascribed to the high cost of doing business in the state, with the state’s sharp reliance on the prop erty tax portrayed as a contributing factor.3 In 1990, for instance, on a per capita basis, Michigan’s average prop erty tax was nearly 31% higher than the U.S. average (see figure 1). Michigan’s tax reform will do little to lower the overall tax burden in the state, especially since overall educa tional funding will be enhanced rather than diminished.4 Yet the reforms are expected to bring a much-needed elem ent of balance into the state’s revenue system. The principle of bal ance among revenue sources suggests that overreliance on any one source tends to retard economic performance by distorting the prices that people and businesses face when making economic choices. It is still debated just what the optimal balance of reve nue sources is. In practice, states tend not to want their own state revenue systems to fall too much out of line with the nation or neighboring states. While Michigan’s revenue system dif fered from the average, the case against the state’s reliance on local property taxes was not open and shut. Average statewide property taxes were high, but businesses enjoyed ample choices among localities in Michigan, with many communities having low or average property tax rates. Moreover, in Michigan and elsewhere, some types of business activity may be acutely noxious to a local community in terms of creating a dangerous or unpleasant environment, or in dem anding costly levels of public services. If so, rather than simply deterring business loca tion and investment, high property taxes may be seen as a bargain struck between community and business concerning the use of land for indus trial purposes. 1. Property tax, 1990 Per capita U .S . I llin o is In d ia n a Io w a M ic h ig a n W is c o n s in R ange $626 754 472 660 820 738 Rank Percent of U.S. average _ _ 14 33 19 10 15 120.4 75.4 105.4 131.0 117.9 $163-1246 Percent of personal income 3.6 3.9 2.9 4.1 4.7 4.4 Rank __ 20 32 17 9 12 1.2-6.1 Source: A d viso ry C om m ission on Interg o ve rn m e n ta l Relations, Significant Features o f Fiscal Federalism, Volume 2:1992, W ashington, DC: ACIR, Septem ber 1992, table R-2, p. 275. In Michigan and other states, howev er, it appears that this mechanism whereby property taxes act as a “fair price” for the costs of development has been overshadowed by a more detrimental behavioral pattern of business location. In the process of searching out the lowest property tax rates, businesses have tended to lo cate within certain school districts in such great concentrations that they more than compensate local residents for the price of public services they require or any noxious effects they may generate. “Tax havens” have come about where community tax rates are very low while business prop erty concentration is very high, there by enabling extraordinary levels of school funding.5 Not all tax havens have heavy concentrations of business and industry. Some wealthy commu nities have very low property tax rates because of the generally high average value of the residential property. At the same time, however, in communi ties such as Detroit, the heavy proper ty tax burden is sharply deterring investment in the city (see figure 2). Michigan’s revised tax structure may help on two fronts. First, it will help level the playing field for investments inside the state. No longer will high property tax rates for education deter investment. Second, even with a 6% sales tax, Michigan’s tax structure will not be out of line with those of neigh boring states when the state competes for economic development, since the state sales tax throughout the Mid west is between 5% and 6%. With greater balance in the state’s tax struc ture and lower property tax rates, the state may improve its business climate and enhance its development pros pects. W hether this new mix of taxes will improve the business climate of Michigan will ultimately depend on how the modified tax structure plays itself out for existing businesses as well as for businesses Michigan hopes to attract. Each business will find some types of taxes more burdensome than others, depending on its mix of pro duction inputs and the market for its product. Further research and obser vation will be needed to determ ine the ultimate impacts. Education reform to reduce inequities between school districts Because Michigan relies so heavily on local property taxes to fund education, per pupil spending largely reflects the combination of the relative property wealth of the school’s community, and that community’s willingness to fund education. While the state’s average per pupil expenditure is higher than the U.S. average, the pattern of local spending displays a high variation, ranging from $3,000 to $11,000 per pupil. Property-poor towns have been unable to levy sufficient revenues to provide adequate local education. In support of greater equalization, it is argued that education is a fundam en tal interest to both society and the individual. For society, an educated populace is essential to the economic and social well-being of the country as 2. Homeowner’s tax rate, 1990 D e tro it, M l 4.4 0% M ilw a u k e e , W l 3.7 8 N e w a rk , NJ 2.9 6 P h ila d e lp h ia , PA 2.6 4 B a ltim o r e , M D 2.4 6 H o u s to n , T X 2.19 J a c k s o n v ille , FL 2.1 8 A tla n ta , G A 2.0 8 C le v e la n d , OH 2.0 0 M e m p h is , T N 1.77 In d ia n a p o lis , IN 1.62 C h ic a g o , IL 1.59 U .S . a v e ra g e 3 1.67% Note: Tax rates are expressed as percent o f fu ll value. aU nw eighted average effective pro p e rty tax rate fo r the largest city in each state. Source: O ffice of Econom ic and Tax Policy, "Tax rates and tax burdens in the D istrict o f C olum bia: A n a tio nw id e co m parison, 1990," W ashington, June 1991. igan will allow local interests to estab lish “charter schools” outside the regular network of local school dis tricts. These will be specialty schools emphasizing the development of par ticular skills such as math and science. Over the long term, other features of Michigan’s plan may facilitate addi tional school choice programs. In an effort to boost school productivity and match students with schools, other Midwestern states such as Iowa and Minnesota now allow students to choose to attend any public school in their respective states. This option is intended to prom ote customization of local school services to their clients and to improve school performance and accountability through competi tion. When students choose to attend schools outside their home districts, they carry state an d /o r local funding with them to their chosen schools. More equalized resources per pupil would ensure that migrating students carry along funds that are on par with spending levels at the new schools. Similarly, establishing a statewide uniform core curriculum, as the Mich igan plan promises to do, will help ensure that fundam ental education is being provided in those schools that otherwise choose to specialize in spe cial subject areas or innovative modes of operation. well as a necessary ingredient to the proper functioning of a democracy. For the individual, education is a re quirem ent for successful participation in the economy. This reasoning holds that at a minimum, the state’s respon sibility is to insure or provide a foun dation level of educational services. Investing in the education of lowerincome children may be particularly im portant to the state’s economic development efforts, since globally competitive industries require a pro Conclusion ductive labor force. The Michigan plan is a dramatic at While the movement to boost and tempt to combine tax reform with equalize education funding may be education reform. O ther states will laudable from the perspectives of closely evaluate this combination as a both equity and social investment, way of achieving tax reform and re there is nonetheless some concern ducing disparities in school funding, that shifting more of the responsibility while increasing the effectiveness of for education funding onto the state education spending. will diminish local control and the —Paul D. Ballew, ability to customize school programs Richard H. Mattoon, and to fit local conditions. At times, cen William A. Testa tralization of educational funding in the U.S. has been accompanied by centralized or bureaucratic control of According to the Michigan Fiscal Agen how the money is spent. This hap cy, the distribution of school district per pened to some extent in the 1970s expenditures prior to the passage and early 1980s throughout the nation pupil of the new law was as follows: 119 dis as states took on more of the financial tricts (including 13 K-6 districts) serving responsibility for education. To ad approximately 181,000 students spent dress such concerns, the state of Mich less than $4,200 per pupil. 397 districts with 1,245,000 students spent between $4,200 and $6,500 per pupil. 41 districts with 166,400 students spent in excess of $6,500 per pupil. 2$20,114 for the U.S. versus $19,680 for Michigan. (U.S. Department of Com merce, Bureau of Economic Analysis, “Survey of current business,” September 1993, Vol. 75, No. 9, p. 74.) 3National “business climate” surveys such as the GrantThornton Manufacturing Climates Study have ranked Michigan at or near the bottom in a number of costof-doing-business categories including hourly wages (50), unemployment com pensation benefits (49), worker compen sation cost per case (49), and overall state tax effort (47). For more details, see GrantThornton Accountants and Management Consultants, Manufacturing Climates Study, No. 11, Chicago: Grant Thornton, August 1990. 4Funding in fiscal year 1994-95 will be 4% higher than in 1993-94. This ex cludes possible revenue enhancements that local school districts may decide to fund. 5There will be clear winners and losers and certain inequities in any changes that do away with the current system of tax havens. For example, some inequi ties will result to those who have recently purchased property in tax havens. These property owners presumably will now have to pay for the previous fiscal surplus attendant to the community in which they purchased property; i.e., the lower tax rate was reflected in a higher pur chase price. Karl A. Scheld, Senior Vice President and Director of Research; David R. Allardice, Vice President and Assistant Director of Research; Janice Weiss, Editor. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies of the reprints. Chicago Fed Letter 'll available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Midwest m anufacturing output continued to climb in January and February after surging in the fourth quarter. The early 1994 gains were also impressive for having overcome the direct and indirect effects of unusually harsh winter weather. Growth was centered in cyclically sensitive industries im portant to the region, including primary metals, industrial machinery, and m otor vehicles and parts. Production of cars and light trucks slipped in March, but only after surging to the highest level in 15 years in February. Purchasing m anagers’ surveys indi cate that expansion in Midwest m anufacturing activity changed little in March. Sources: The Midwest Manufacturing Index (MMI) is a composite index of 15 industries, based on monthly hours worked and kilowatt hours. IP represents the Federal Reserve Board industrial production index for the U.S. manu facturing sector. Autos and light trucks are measured in annualized physical units, using seasonal adjustments developed by the Board. The purchasing managers’ survey production index for the Midwest is a weighted average of the production components from the Chicago, Detroit, and Milwaukee Purchasing Managers’ Association survey, with assistance from Bishop Associates and Comerica. llie-SSg (2I£) FF80-06909 S1°«HII (oSvoii& j ,)hi,»3 F£8 xog O d uopEuuojuj 3i[C|nj OOVOIH3 3 0 MMVH 3A*I3S3y TVH3CI3i joypq poq chum p)
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