In a nutshell:
- The recent revenue estimating conference suggests that state revenues may not fall as much as initially expected, but the state and its local governments still face tough revenue and spending decisions in the coming months and years.
- Cities in Michigan can levy local income taxes and this provides some diversification in their revenue sources beyond property taxes and state revenue sharing. Income tax revenue tends to fall faster in a recession, and some of these cities may be struggling to replace lost revenues in the short-term.
- Even though income taxes are more volatile during economic downturns, increased revenue diversification would help local governments address this and future economic storms by allowing for a mix of stable and high-growth revenue sources.
The COVID-19 pandemic has changed life as we know it for just about everyone – local and state government officials, private business owners, workers attempting to do their jobs under new and different circumstances, and parents and students adjusting to a new normal in school, whether remote or in-person. The effects of the pandemic don’t stop there; the state shutdown and subsequent recession caused revenues at both the state and local levels to drop quickly and unexpectedly beginning in March. While some earlier state and local revenue estimates may have been too dour, governments still face tough decisions ahead. Those with a broad mix of taxes and other revenues will likely fare better in the long run.
The May 2020 Consensus Revenue Estimating Conference projected revenue declines of $3 billion in both Fiscal Year (FY)2020 and FY2021. Updated numbers from the August conference are a bit cheerier with a revenue decline of only $0.9 billion in FY2020 and $2.5 billion in FY2021 from January revenue estimates. And the good news continues, as the House Fiscal Agency recently reported that August 2020 revenues came in higher than projected. These reflect state, not local revenues, but they impact local revenues as local governments rely on state revenue sharing to support their budgets.
Local government revenues
Like state revenues, the pandemic recession has caused reductions for many local governments’ tax revenues, as well as user fees and charges. The Research Council has been telling all who would listen that the local government finance system is broken and local governments need more revenue options. The state levies multiple types of taxes, giving it diversity in its revenue structure and allowing it to benefit from some revenues that are more stable and others that have greater growth potential in a growing economy. This helps it to better weather unexpected financial storms.
Local governments are largely restricted in their revenue options with most dependent on property taxes and state revenue sharing. We have done a lot of research showing why the strict property tax limitations and pared back version of state revenue sharing provide insufficient revenue for local governments. Furthermore, Michigan is an outlier compared to other states, many of which allow their locals to levy more types of taxes.
Revenue diversification through a local income tax
The city income tax is one option that is currently being levied by 24 cities across Michigan, but is available to all 276 cities in the state with city council and voter approval. Levying a city income tax diversifies a city’s revenue sources, and it has provided a boon to at least one city in Michigan during this pandemic.
East Lansing recently passed a city income tax and began collecting the tax in 2019. In this first year of income tax collections, revenue exceeded expectations by 33 percent. Of course, this reflects revenue collected before the pandemic, but even with a drop due to the recession, this revenue will still boost and diversify city coffers.
While a city income tax does provide revenue diversification, it also can make a local government more susceptible to declining revenues during a recession. City income tax revenues will generally fall as unemployment rises sometimes creating stark revenue losses and budget implications for cities. The cities that levy income taxes tend to rely heavily on them (one-third of general fund revenue on average), and this can make for hard times during periods of recession and declining employment. East Lansing may be unique in being a city that is not negatively impacted by its income tax during this recession.
Diversified revenues in Detroit
The city with the most diversified revenue structure is also the city that has suffered the most during this pandemic. Detroit’s consensus revenue estimating conference held this month shows a projected 12.9 percent decline in city income tax revenues in FY2020 and then an additional 20.7 percent decline in FY2021. This is due to increased unemployment as well as the recent increase in remote work (non-residents only pay city income tax if they are actually working in the city; if they work from home, the city loses that income).
Detroit is also expecting severe declines in its casino wagering tax revenues as casinos have only recently reopened at very limited capacity (15 percent). Estimated revenues for FY2021 are projected at half of the total revenues for FY2019. Property taxes, on the other hand, are projected to remain fairly stable with a slight (0.6 percent) increase in FY2020 and a 3.2 percent decline in FY2021.
Property taxes are generally stable
Our previous research into property tax revenues has shown that with the exception of the Great Recession from 2007 to 2009, which was precipitated by the housing market crash, property values and corresponding tax revenues tend to remain fairly stable during recessionary periods. This is a benefit of local governments in Michigan relying so heavily on property tax revenue and is evidenced in the large projected revenue declines in Detroit for income and wagering, but not property, taxes.
The dependability of local property taxes during most economic recessions cannot be overlooked and may provide local governments with one reliable revenue source during this pandemic-induced recession. So far, state revenue sharing remains stable as well, which provides additional constancy for local units right now. Income, as well as other types of local taxes, are much more volatile during recessionary periods and local governments need to understand that as they form budgets around expected revenues.
Diversification still the best policy
Ignoring the unexpected boost in tax revenue for East Lansing, most cities in Michigan that rely on an income tax are struggling right now. However, while the short-term outlook may be bleak, income-tax cities will benefit from having more diversified revenue sources as the economy improves. Furthermore, some cities that rely primarily on property taxes are still struggling from the decline in those revenues caused by the Great Recession. While it is not often that property tax revenues fall, when they do fall, they grow slowly once the economy begins improving. Property tax limitations passed over the years coupled with the stable nature of property taxes leads to slow revenue growth even in an improving economy.
Diversification of local government revenues will allow local units throughout the state to levy different kinds of taxes to meet their spending needs. Diversification does not mean more local taxes, but more local control (including local voter control, no local taxes can be levied without voter approval) allowing for local tax options that can grow with the economy and meet each community’s unique needs. Local governments with stronger local economies and tax structures that are connected to these economies will be better able to weather this and future recessions.