Larry DeBoer
Professor of
Agricultural Economics
Purdue University

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The Big Drop in Local Income Tax Revenue

The announcement from the Indiana Budget Agency came in mid-March, and the news was bad. Local governments would see another reduction in their income tax revenues in 2004, just like in 2003. For some counties, the estimated reductions would be big. Adams County would see its local income tax revenue fall 11.7 percent. Wayne County would see revenues fall 14.3 percent. Hamilton County was the unfortunate champion--a 20 percent drop, from $84 million in 2003 to $67 million in 2004. You can read the announcement on the Indiana Budget Agency's Web site,

Our economy is struggling, but is it so bad that incomes in Indiana's richest county have fallen by one-fifth?

No, things aren't that bad. Mostly, it's a problem with the administration of the tax. No one did anything illegal or even particularly wrong. It's just that a system that worked well in good times didn't work so well when times turned bad.

Indiana's first local income tax was invented back in 1973 as part of Gov. Otis Bowen's property tax relief effort. Counties could adopt a local income tax and use the revenue to reduce property taxes. The tax was (and is) collected by the state, paid on the same Indiana adjusted gross income as the state income tax.

This created a problem for local budgets. The property tax rate is set each year based on how much revenue each local government needs in the coming year, after all other revenues are accounted for. The income tax would be one of these other revenues. But how would local governments know how much income tax revenue would be collected? That would require a guess about what the local economy would do in the coming year, and most local governments didn't have that kind of expertise.

So, the state decided to guarantee local governments the revenue in advance. In July before the budget year, the budget agency would tell each county its "certified distribution," the amount of local income tax revenue each county's government would get. That way, locals could set their property tax rates with confidence, and the job of forecasting the economy would be left to a state agency with the expertise for the job.

Unfortunately, it takes a long time to compile information about local income tax collections. This year, for example, the 2004 certified distributions will be fixed in July 2003, based on the most recently available county income tax numbers. Those numbers are from 2001. The budget agency must forecast 2004 using data from three years before.

That works fine when the economy is growing. It even works OK when there's a mild recession that doesn't affect taxable income very much. In 2000, though, the stock market crashed, and it turned out that a big part of Indiana's taxable income was capital gains from stock. State income tax revenue grew 7 percent or more each year from 1995 to 1999, but grew only 1.5 percent in 2000, 0.7 percent in 2001 and fell 6.3 percent in 2002.

That slower growth caused the problem. In 2000, when income tax collections started to slow, the fixed distributions were based on data from 1997, with its rapid growth. In many counties, the state distributed more income tax revenue than county residents paid. Only in 2002 did the numbers for 2000 become available, and they showed a big slowdown in tax collections.

That meant that distributions in 2003 had to reflect much slower growth. Worse, the budget agency had to make up for three years of overpayment by cutting distributions even more. That's what is making distributions fall by more than the drop in taxable income. In 2003, local income tax distributions fell 20 percent. They'll fall again by about 7 percent in 2004.

The Indiana General Assembly passed a bill to address this problem. Senate Enrolled Act 166 says that the budget agency must set distributions based only on what has been collected, not on an estimate of what will be collected. That will solve the problem in future recessions. In 2004, though, local governments--and all of us who use government services--will have to live with less.




Writer: Larry DeBoer
Editor: Olivia Maddox