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October 10, 2013

DEBOER: The paradox of the local option income tax

— Indiana has caps on property taxes. This year, the caps reduced property taxes by about $768 million, or 11 percent.

Indiana has local option income taxes that counties adopt to reduce property taxes some more. All counties now have local income taxes.

Common sense says that when a county adopts a tax-relief income tax on top of tax-reducing caps, taxes will be even lower.

Wrong again, common sense. Sometimes the combination of tax caps and local option income taxes can increase total tax bills and local government revenues. It’s the paradox of local option income taxes.

Here’s what happens. Property taxes are capped at 1 percent of gross assessed value for homeowners; 2 percent for other residential housing (such as rentals or vacation homes) and farmland; and 3 percent for business property. Gross assessed value is the estimated market value of most properties before deductions are subtracted.

Local governments set their tax rates at the end of the budget process. If the rate results in a tax bill higher than a property’s cap, a tax cap credit is applied to reduce the bill to the cap amount.

Here’s the key fact: The tax cap is the taxpayer’s last defense against high tax bills. All deductions and credits are subtracted before the tax cap credit is applied. This includes the credits from local option income taxes.

Indiana’s local option income taxes apply to Indiana taxable income, the same as the state income tax. When a county adopts this tax for property tax relief, the income tax rate increases, and then the property tax bill is reduced by a local option income tax credit. The income tax revenue replaces this lost property tax revenue for local governments.

Counties can distribute tax relief in three ways, or in combinations of the three. On average, across the state, if the local option income tax is adopted at 1 percent and the relief is offered only to homeowners, the homestead credit will be about 51 percent. If the county distributes the relief to all residential property, the credit averages 31 percent. If it goes to all property, the credit averages 17 percent.

Consider a homestead valued at $200,000 and a property tax rate of $3 per $100 assessed value (3 percent). Deductions would usually subtract $102,250, leaving taxable assessed value of $97,750. The tax bill would be $2,933. But taxes are capped at $2,000, which is 1 percent of the gross assessed value. The taxpayer gets a credit of $933 and pays $2,000. That $933 credit is lost revenue for local governments.

Now suppose the county adopts a local option income tax at 1 percent, and distributes the tax relief to all property. The local option income tax credit is 17 percent.

The tax caps come at the end of the tax bill calculation, so the 17 percent credit applies to the tax bill of $2,933. That’s a credit of $499, and the remaining property tax bill is $2,434. The tax cap is still $2,000, but the tax cap credit is now only $434. This homeowner pays the same capped property tax bill, even after the credit.

But the homeowner pays the local income tax, too. Most people who own $200,000 houses also have Indiana taxable income, so they’ll pay more income tax with the added 1 percent local option income tax rate. An income tax designed for property tax relief has increased total property plus income taxes. Paradox explained.

Taxpayers with lower-valued property or with lower property tax rates will see the full tax reduction and may pay less in total taxes. Taxpayers with property at the caps don’t see the full tax reduction, because the local option income tax credit substitutes for the tax cap credit. But all of the income tax revenue is still distributed among the county’s local governments.

Put another way, the income tax credit reduces the property tax revenue lost from the tax cap credits. Local government receives more revenue.

It’s hard to say if this is what the General Assembly intended, since the local option income taxes were invented before the tax caps. One of the reasons for the income taxes, though, was to shift local taxes away from property and toward income.

Local governments know that the income taxes can reduce their tax cap revenue losses. That’s an incentive to adopt. And that shifts taxation toward income, which is what many legislators had in mind.

— Larry DeBoer is professor of agricultural economics at Purdue University.

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