In a nutshell:
- The COVID-19 pandemic and ensuing economic recession affected state and local government revenues differently than previous recessions and hit cities that levy a municipal income tax particularly hard.
- For years, the Research Council has advocated for diversification of local government revenues, but this recession is hitting those cities with more diverse revenue streams the hardest. Job loss and the increase in remote work uniquely impact city income tax revenues.
- The property tax provides stability during economic downturns, but local governments with diverse revenue structures benefit from a mix of stable and high growth revenue sources so that they can weather the storms, but also grow when the economy begins expanding.
The 24 Michigan cities that levy an income tax have experienced sharp revenue declines from this source with the economic downturn and job losses across the state. While this certainly presents fiscal challenges in the short-run, it does not mean that local government revenue diversification is bad. When the economy is growing and unemployment is low, a local income tax provides a stronger link between local economic activity and the amount of budgetary resources local governments collect to provide services to constituents. Something that the property tax, the primary local revenue source, does not provide.
While there might be pain today, on balance, revenue diversification is good and leads to greater balance, and potential growth, for local government tax structures.
The unexpected pandemic and subsequent recession
For years, the Citizens Research Council has advocated for revenue diversification for local governments. The state constitution and law limit what taxes local governments can levy. Additionally, a number of constitutional and statutory tax limitations are designed to constrain the growth of local property tax collections. With few other revenue options at their disposal and facing these stringent tax limitations, local governments have developed an over-reliance on property taxes. The problems inherent in reliance on this one tax source became apparent with the massive property value declines brought about by the global financial crises and Great Recession more than a decade ago.
Some cities in Michigan have diversified their revenue streams with a city income tax, thereby broadening the economic base from which they can collect taxes upon. In turn, this has decreased these cities’ reliance on the property tax. But it also means that they are susceptible to other economic shocks, such as the current one.
Cities levying income taxes have been hit particularly hard with revenue declines.
Income tax cities and the COVID-19 recession
Twenty-four Michigan cities levy an income tax with rates ranging from 0.5 to 2.4 percent paid by city residents and non-residents who work in the cities. These cities range from small cities with less than 2,000 residents (Grayling) to Detroit with almost 675,000 residents. Dependence on the income tax varies, but, on average the income tax provides one-third of general fund revenue.
Cities are losing income tax revenue due to job loss of residents and the increase in remote work for non-residents. Job loss has a big impact on city income tax revenues because unemployment insurance benefits are not taxable under a local income tax even though they are for state purposes. A Bridge Magazine article estimates that more than 50,000 Detroiters lost their jobs at some point during this pandemic, at least temporarily.
The increase in remote work affects income tax revenues because non-residents are taxed on income earned in the city. If they are working from home, that income is no longer being earned in the city. If teleworking continues beyond the pandemic, this could have a long-lasting effect on these cities’ revenues. Larger cities like Detroit and Grand Rapids have also been impacted by the cancellation of concerts and events as those entertainers and their entourages are no longer paying city income taxes.
Impact on city budgets
The COVID-19 recession’s impact on state and local revenues is not fully known. Federal stimulus dollars and stronger than expected sales tax revenue have resulted in less state tax revenue reductions than state officials originally predicted. We do not have updated numbers on city income tax revenues, but they are expected to be more dire than the state has experienced.
Detroit’s February 2021 revenue estimating conference projected revenue declines of $124.2 million in the General Fund from Fiscal Year (FY)2019 to FY2020, with an additional decline of $84.4 million in FY2021. Furthermore, the city estimated income tax revenue to fall from $338.0 million in FY2019 to $223.0 million in FY2021 with an estimated $108.4 million lost over the two year period due to remote work alone.
Detroit is further impacted by the revenue losses related to its casino wagering taxes. The casinos were shut down for months and are now operating at limited capacity leading to a projected revenue decline of $80.8 million from FY2019 to FY2021. Property tax revenue, on the other hand, is projected to decline slightly ($5.8 million over a two year period), but largely remain stable.
Michigan’s second largest city is also dependent on the income tax. According to Grand Rapid’s 2020 Comprehensive Annual Financial Report (CAFR), income tax revenues came in about 2.4 percent below budgeted amounts in FY2020 (property taxes came in slightly above budget), but things are expected to get worse. Grand Rapids collects $46 million from non-residents who work in the city and the city’s chief financial officer said the city could lose up to $20 million in income tax revenue.
In recognition of the revenue losses facing income tax cities across the state, Governor Whitmer proposed providing an extra $70 million in state funding for cities that rely on income tax revenue in her FY2022 Executive Budget. It is important to remember that even if this line item makes it through the budget process, payments will not be made until after October 1 and these cities are facing shortfalls in their current FY2021 budgets.
Is diversification bad?
The short answer – no. We stated at the beginning of this pandemic that property taxes have been stable in four of the last five economic contractions and they are likely to remain stable throughout this pandemic recession (we do not know what the impact of the continued economic shutdown will be on commercial property at this point). The reliability of the local property tax during most economic recessions should not be overlooked; property taxes can provide local governments with stable revenue sources during downtimes.
That being said, we have done a lot of research showing why property taxes with their limitations and slow growth and state revenue sharing, which has been cut repeatedly, present challenges to local governments in funding the suite of services that citizens expect. We are seeing firsthand that income taxes and other local-option taxes (e.g., casino wagering) are more volatile during economic downturns, but these taxes have greater growth potential once the economy starts improving again.
Governments at all levels need a mix of stable and high-growth revenues. The stable revenues can help see them through economic downturns while the higher growth revenues help them recover during economic expansions. Governments also need options so that they can pick the best tax mix for their economy and community.