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SPENDING INCENTIVES IN NEW YORK'S SCHOOL
TAX RELIEF PROGRAM
(1)
Local property taxes in New York state are among the highest in the
nation. This heavy reliance on the property tax combined with a wide
range in wealth per pupil across districts is a major source of existing
disparities in educational funding. It is not surprising, therefore,
that many policy makers in New York have focused on property tax relief,
not only as a way to gain political favor for cutting taxes but also as
a way to add balance to the state's revenue system and to reform
educational finance in the state. Indeed, the most significant change in
educational finance in the state in recent years, the School Tax Relief
program, STAR, is a property tax relief program passed in 1997 and fully
effective in 2001
A lively debate is now taking place concerning the long-run effects of
STAR on educational spending in the state. Governor George Pataki, the
main supporter of STAR, argues that it is simply tax relief and has
nothing to do with educational spending. Moreover, he adds, STAR
contains several provisions designed to make certain that spending will
not rise. In contrast, several scholars have argued that STAR
fundamentally alters local voter's incentives to spend money for
education and will, in fact, result in a dramatic increase in
educational spending -- and in property tax rates -- in all districts
except the big cities where the need for more revenue is greatest.
This debate is important because, if they occur, local spending
increases could magnify existing educational disparities in the state,
have a negative impact on the State's economic development efforts, and
greatly increase the cost of the STAR program.
Description of STAR
In five large cities in
New York, (Buffalo, New York, Rochester, Syracuse, and Yonkers), the school
district is a department of the city government and school property taxes
are part of the city tax levy. Everywhere else in the state, school
property taxes are levied by independent school districts.
A homeowner's local school property
tax payment equals the tax rate selected by her school district multiplied
by the assessed value of her home, which is required to be set as near as
possible to its market value. The main feature of STAR is a property tax
exemption that will be subtracted from assessed value, so that the tax
payment becomes the rate multiplied by the excess of assessed value above
the exemption. In symbols, the property tax payment, T, now equals the tax rate,
t, multiplied by the assessed value, V, or T
= tV. Once the STAR exemption, X, is in place, this
equation becomes T = t (V - X).
When fully implemented in 2001, the STAR exemption will equal a base
amount of $30,000 for the owners of owner-occupied one- to three-family
houses, mobile homes, condominiums, and cooperative apartments or
$50,000 if the owner is aged 65 or older with an income below $60,000.
School districts must provide this exemption and the State will
reimburse them for its cost. To give a simple example, consider a house
worth $100,000 in a school district with a 1.5 percent property tax
rate. Without STAR, the owner of this house pays a property tax of
(.015)×($100,000) = $1,500, but with STAR, this owner's tax drops to
(.015)×($100,000 - $30,000) = $1,050, a tax reduction of $450, or 30
percent.
One of the key features of the STAR exemptions is that the base amount
is multiplied by a "Sales Price Differential Factor," which is the ratio
of the three-year average sales price of residential property in a
district's county relative to the three-year average in the state as a
whole. This factor cannot fall below 1.0. Thus, this provision greatly
increases the amount of the exemption in counties with high property
values. The STAR exemptions also are multiplied by an "Equalization
Factor," which accounts for the fact that not all assessing districts
assess property at 100 percent of market value.
How STAR Affects
Voters' Tax-Prices and School District Spending
STAR raises many issues of concern to voters and public officials. For
example, a property tax exemption promotes equity across taxpayers by
lowering the burden of the property tax the most on taxpayers with the
smallest property values, and therefore with the least ability to pay.
However, STAR's "Sales Price Differential Factor," offsets this equity
improvement by giving a larger tax break to taxpayers in higher-wealth
counties. The basic exemption in the richest county, Westchester County,
will be about $72,000, for example, compared to $30,000 in most of the
state.
For the purposes of this discussion, however, another feature of STAR
must be emphasized, namely the fact that it alters the "tax price" faced
by voters. The tax price is the voters' share of any increase in
property taxes to pay for schools. This tax price varies widely across
school districts, largely because some districts have far more
commercial and industrial property than others. The tax price is lower
in a district with a great deal of commercial and industrial property
because much of the burden of any school tax increase falls on
commercial and industrial taxpayers, not on homeowners and other voters.
In effect, the tax price operates like any other price; the higher the
price, the more consumers substitute away from a product toward other
products. Just as consumers buy less coffee if the price of coffee is
higher, they will vote for less spending on schools if the tax price is
higher.
This tax-price effect is not just hypothetical. Dozens, if not hundreds,
of academic studies have shown that spending (for schools and for other
local public services) is higher if the tax price is lower. These
results are usually expressed as an elasticity, which indicates the
percentage change in spending for a one percent change in tax price.
Most studies estimate that the price elasticity of demand for public
services is in the -0.1 to -0.5 range. For example, a recent study of
school spending in New York by two professors at the Maxwell School of
Syracuse University, found that the price elasticity of demand for
school spending is -0.45. In other words, a one percent increase in the
tax price results in a 0.45 percent decline in school spending.
Several studies also have found that this tax-price effect can work
through state aid programs. In particular, a so-called matching program
is designed so that the state pays a certain share of every dollar spent
on education. If the matching rate is 33 percent, for example, then
state's share of every dollar of spending approved by local voters is
$0.33 and the voters themselves have to pay only $0.67. In effect,
therefore, the local tax share equals one minus the matching rate.
According to these studies, the higher the matching rate, and hence the
lower the local tax price, the higher local spending on education.
The easiest way to derive an expression for a tax price is to combine a
single voter's budget constraint with the budget constraint for a school
district. A simple version of this process begins by defining
non-housing commodities, Z, which sell for a price of PZ
per unit and housing, H, which sells for a price of PH
per square foot.(2)
A voter sets her income, Y, equal to her spending on
non-housing commodities, PZ Z, plus her
spending on housing, PH H, plus her
property tax payment, tV [or t (V - X)
once STAR is in place]. A district's tax base is the sum of property
values across households and can be summarized by property value per
pupil, V*. A district must set spending per pupil, E,
equal to total property tax revenue per pupil, tV*, plus state
aid per pupil, A. With STAR in place, the district must provide
exemptions equal to tX*, where X* is the total value
of exemptions in the district per pupil, but the state compensates the
district for these payments. In equation form:
|
|
Without STAR |
With STAR |
|
Individual Budget Constraint |
Y = PZ
Z + PH H + tV |
Y = PZ
Z + PH H + t (V - X) |
|
District Budget
Constraint |
E = tV* + A |
E = t(V* - X*) +
A + tX*
= tV* + A |
Now a little simple algebra leads to the tax price. With or without
STAR, solving the district budget constraint for t yields t
= (E - A)/V*. Substituting this expression for t into the
individual budget constraint yields the following combined budget
constraint:
|
|
Without STAR |
With STAR |
|
Combined Budget Constraint |
Y = PZ
Z + PH
H
+[V/V*](E-A) |
Y = PZ
Z + PH
H
+[(V-X)/V*](E-A) |
In these combined budget constraints, income is spend on three things,
non-housing, Z, housing, H, and school spending per
pupil above state aid, (E-A). In each case the amount consumed
is multiplied by a "price." Without STAR, the amount a voter must pay
for each dollar of school spending per pupil above state aid is the
value of the voter's house divided by property value per pupil in the
district, [V/V *]; in other words, [V/V *] is the
voter's tax price. Once STAR is added, the tax price drops to [(V-X)/V*].
For example, consider a district in which every house has an assessed
value of $100,000 and is the home to a single student. Then without
STAR, the tax price is 100,000/100,000 = 1 for every voter; when all
houses are alike, each voter must pay $1 to raise spending by $1 per
pupil. Adding STAR, with its $30,000 exemption, cuts the tax price in
this district to (100,000-30,000)/100,000 = 0.7, which is equivalent to
a 30 percent price cut.
In a less homogeneous district, voters who have a relatively expensive
house will have a relatively high tax price. If the average house in a
district is worth $100,000 then the owner of a house worth $200,000
faces a tax price of 200,000/100,000 = 2.0 (again assuming, for the
purposes of illustration only, one pupil per household). Intuitively,
any increase in the tax rate to increase spending per pupil will have
twice the impact on the owner of a $200,000 house than on the owner of a
$100,000 house. Moreover, STAR will have a bigger effect on the tax
price of a voter with a lower-valued house (ignoring the "Sales Price
Differential Factor"). When STAR is implemented, the owner of the
$200,000 house will see her tax price drop from 2.0 to (200,000 -
30,000)/100,000 = 1.7, which is a 15 percent drop.
Because not all voters have the same tax price (or the same change in
tax price from STAR), one cannot predict the amount of spending selected
by a school district (or the change in its spending in response to STAR)
without selecting a "decisive voter," defined as the voter whose demand
for spending coincides with the spending level selected by the majority
of voters. The most common approach, which works well in many
circumstances, is to say that the decisive voter is the one with the
median house value in the community, VM. With this
approach, a district's tax price is VM / V*
without STAR and (VM - X ) / V* with STAR,
and the difference between these two tax prices can be used to predict
how much the district's educational spending will increase when STAR is
implemented. The percentage change in tax price will, of course, also be
influenced by the amount of commercial and industrial property in the
district and the number of pupils per household, both of which affect
V*.
The Case for a Large
Spending Impact from STAR
Perhaps the most basic theorem in economics is that people substitute
toward goods and services when their price goes down. Because STAR
causes such large declines in tax prices, some scholars have predicted
that it will result in a large increase in educational spending. In the
average school district in New York, STAR will lower the tax price by 37
percent. A price cut of this magnitude could induce voters to want to
spend considerably more on education. In fact, according to the price
elasticity for New York cited earlier, namely -0.45, a 37 percent price
cut will result in a (.37)(.45) = 16.65 percent increase in spending per
pupil in the average district. To fund these spending increases, the
local property tax rate would have to increase by over one-third in the
average district.
This analysis does not apply to a school district in which a majority of
the voters are renters. Renters demand for education is not well
understood, but it is clear that the incentives facing renters are quite
different than those facing owners. The most important difference is
that renters may not gain from an increase in educational spending
because such an increase will cause their rents to rise. Moreover, STAR
applies only to homeowners. Even if the tax price for renters were well
defined, therefore, it would not be affected by STAR. As a result, STAR
may have no impact on spending in districts with a majority of renters,
which includes all the large cities in the state.
If these predictions are correct, they have three important implications
for state policy. First, they imply that the disparity in spending
between suburban and city school districts will go up. New York State
already faces two major law suits that claim it has not lived up to its
responsibility for delivering adequate education in its large city
school districts. An increase in spending disparities would not
strengthen the State's position in these suits.
Second, they imply that STAR will result in a large increase in local
property taxes on commercial and industrial property. New York State is
already perceived as a high-tax state, and many business leaders and
public official argue that the high property taxes in the state are a
serious deterrent to attracting new business. According to this widely
held view, a 33 percent increase in property tax rates in the average
school district would be devastating for the State's economic
development prospects.
Third, these predictions imply that the official estimates of the cost
of STAR, which assume no local spending increases, are far too low. STAR
obligates the State to pay each district an amount per pupil equal to
tX*, where, as defined earlier, t is the districts
property tax rate and X* is the total value of its STAR
exemptions per pupil. If t goes up, so does the cost to the
state. If the local property tax rate increases by one-third in the
average district, then the overall cost of STAR to the State will also
increase by one-third.
The Case Against a Large Spending Increase
from STAR
For two main reasons, many commentators and public
officials have rejected the argument that STAR will increase local
spending on education.
First, some people argue that estimated price elasticities are simply
irrelevant for STAR, which is, they say, nothing more than tax relief.
Voters may spend more on education, they concede, when there is a lot of
commercial and industrial property in a district to share the tax
burden, but they will never make the connection between their exemptions
and the "price" of education.
Second, even if voters are tempted to increase spending due to lower tax
prices, STAR contains two provisions designed to prevent such spending
increases. Under the first provision, STAR sets aside $25 million for a
new form of state aid, called tax-freeze aid. Although the details of
this new form of aid are complicated, it is designed to reward a
district that increases its tax levy by less than about 3 percent per
year, with the highest aid to districts that do not increase their levy
at all.
Strange as it may seem, this "tax-freeze" provision does not recognize
the difference between a tax rate increase and a tax base increase, so a
district that succeeds in attracting a new manufacturing plant will be
penalized for increasing in its tax levy, as will a district that raises
its property tax rate. (This same error was made, and then corrected, in
a famous property tax limitation measure, Proposition 2 ½, that was
passed in Massachusetts in 1980.)
Tax-freeze aid will provide a bonus to districts that do not want to
raise their tax rate. One study of STAR estimates that about one-third
of districts, containing about one-quarter of the state's students, will
receive tax-freeze aid. Because there are about 2.8 million pupils in
the state and the budget for tax-freeze aid is $25 million, these
districts can expect to receive tax-freeze aid of about 25/[(.25)(2.8)]
= $35 per pupil, on average. In other words, a district might be able to
receive aid of about $35 per pupil if it holds the percentage increase
in its tax levy below 3 percent. If all districts in the state were to
receive tax-freeze aid, the aid per pupil would drop to 25/2.8 = $9 per
pupil.
However, an increase in a district's tax levy also results in more aid
through the basic STAR exemptions. Before possible spending increases
are considered, the STAR exemptions are expected to cost $2.24 billion
or $800 per pupil, on average. As shown earlier, a district's STAR
reimbursement equals tX*, which is the local property tax rate
multiplied by the district's total exemptions per pupil. Thus, a 1
percent increase in a district's tax rate, t, results in a 1
percent increase in a districts STAR reimbursements, tX*. In a
district where the tax base stays constant, a 3 percent increase in the
tax rate (and hence in the tax levy) results in a (.03)(800) = $24
increase in reimbursements per pupil, and a 5 percent increase in the
tax rate results in a (.05)(800) = $40 increase in reimbursements per
pupil. In many, if not most districts, therefore, the state aid increase
associated with an increase in the local tax rate may exceed the state
aid increase that results if local tax rates are frozen.
The second provision involves the rules governing a school district's
"contingency" budget, which is the amount it can spend if voters reject
its spending request. (Under New York State law, a school district must
seek voter approval for its budget each year.) STAR limits the growth in
the contingency budget to 4 percent per year or 1.2 times the growth in
the Consumer Price Index, which ever is smaller. STAR places no limits
on the budgets submitted by school districts for voter approval.
The Debate
Leaders of the New York State Senate and Assembly
have recognized the importance of this debate and have convened a
conference to discuss it. You have been asked to make a presentation at
this meeting. In particular, you have been asked to indicate whether you
think STAR will have a significant impact on local educational spending
and to explain in detail the reasoning behind your conclusion. Explain
why you think local educational spending will be affected, if at all;
how large the effect will be; and why the change in spending is relevant
for state policy makers. If you think that local spending increases
will occur, the conveners of this conference would also like you to
suggest revisions to STAR that might minimize these increases without
penalizing needy school districts or that would solve any other problems
that this increases might cause. You have been asked not to evaluate
STAR in general, but instead to focus on those aspects of STAR that are
related to potential changes in local educational spending.
1. This
case was written by Professor John Yinger solely for the purposes of
class discussion.
2. This
version of the problem leaves out some items that are not essential for
the derivation of a tax price, such as household borrowing or school
district revenues other than property taxes, and state matching aid.