The perils of property tax: many legislatures cut or capped property taxes during the boom years of the 1990s, promising to make up local losses through sales and income taxes. But then the economy went bad, and they didn't do it.

• Author: Kelly, Janet M.

State-local fiscal relations deserve another look in the wake of the economic recession that produced the deepest state deficits in 50 years.

When coffers were brimming during the 1990s, states created new programs and services (and new benefit constituencies for them) in health and social services, education and the arts.

Overall, state spending increased by 28 percent, adjusted for inflation and population growth, according to Donald Boyd of the Rockefeller Institute of Government.

Many states also were able to cut their own taxes during this period. They took steps to reduce local property taxes, supplanting the revenue lost to localities with state revenue from sales or income taxes.

Supplanting local property taxes with state revenues is problematic for a number of reasons, however.

First, from an intergovernmental perspective, the line between state taxes and local taxes becomes blurred when states pay localities for forgiven taxes. From a financial perspective, a stable source of revenue at the local level (property tax) has been replaced with state revenues (income and sales taxes) that may or may not be stable.

When the bottom dropped out in the third quarter of 2001, states did not respond by raising taxes. They cut discretionary spending and used one-time or short-term money, like the tobacco settlement, to fund ongoing programs. Predictably, the targets of state cuts were the fastest growing budget items (Medicaid and to a lesser extent K-12 education) and the two "balance wheels" of state budgeting, higher education and state aid to local governments.

State reimbursement for local property tax relief granted to homeowners falls squarely into the category of state aid to local governments, and is a favorite target for budget cutters when state revenues are stretched thin. That is the danger of fiscal centralization, or the tendency toward states assuming a larger share in the provision and financing of government services. When states need revenue, history demonstrates that revenue shared with localities is an attractive target.

Steven D. Gold and Sarah Ritchey wrote about this when they were studying state actions affecting cities and counties in the early '90s. They demonstrated a propensity for states to target shared revenue and higher education first as a source of budget cuts during fiscal downturns.

The Wisconsin experience is instructive. The Shared Revenue Fund was created in 1911 (when the state income tax was enacted) to reimburse cities and counties for lost property tax revenue on personal and intangible property. At its outset, 70 percent of the income tax revenue went to municipalities, 20 percent to counties and 10 percent to the state for administrative costs.

The Shared Revenue Fund was expanded over the 30-year period prior to the recession of 2001 as the state offered localities property tax relief and some fiscal equalization, especially for schools. Despite historically harmonious state-local relations, Wisconsin Governor Scott McCallum recommended...