Georgia Department of Audits and Accounts Performance Audit Division Greg S. Griffin, State Auditor Leslie McGuire, Director

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1 Special Examination Report No January 2013 Georgia Department of Audits and Accounts Performance Audit Division Greg S. Griffin, State Auditor Leslie McGuire, Director Why we did this review This review was conducted at the request of the Senate Appropriations Committee. Specifically, the Committee is interested in arrangements that alter the tax digest; the impact of changes in the tax digest on education funding; and instances in which counties can receive funds through special arrangements as well as receive increased education earnings for a lower tax digest. About Tax Digests and Education Funding K-12 education funding in Georgia is comprised of federal, state, and local funds. State funds are largely provided through the Quality Basic Education Funding formula. Two components of education funding are impacted by a local tax digest: the local fair share obligation and equalization grants. The local fair share is the amount each school system must contribute to local education from its own tax revenues. The Department of Education calculates the local five mill share for each school system, largely based on the system s tax digest. Equalization grants provide additional funding to school systems that have lower tax revenues relative to the number and type of students they serve. Property Tax Digests Impact on Education Funding What we found Local economic development arrangements provide incentives by reducing or abating taxes for companies that agree to expand or locate in an area. These arrangements may remove taxable property from a school system s tax digest, thereby reducing local tax revenues for education. A reduction in tax digest size, for any reason, changes two aspects of K-12 funding formulas: it lowers the school district's share of overall education costs, and may increase the amount the school system receives from the state in equalization grants, if eligible. However, because of austerity cuts to the total education budget, the impact of tax digest reductions on state funding is currently negligible. Instead, increases in education funds to one system require reductions in funds to other systems. Whether an increase in funding is enough to offset a system's lost tax revenues depends on a number of factors, and would be hard to predict at the local level. Payments in lieu of taxes (PILOT), special arrangements used to mitigate a school system s revenue losses, can influence these gains in equalization funds. If PILOT funds are treated as tax revenue, equalization grants generally increase, to the system's advantage. Current revenue reporting practices do not ensure consistent reporting of PILOT funds. However, our survey of county chief appraisers and tax commissioners indicated that PILOT arrangements are not prevalent statewide. Tax digest values are used to calculate a small portion of the total education funding: local fair share and equalization grants. In fiscal year 2013, the state spent $6.3 billion in education funds for the Quality Basic Education formula. By comparison, the state awarded a total of $436 million in equalization grants and the local districts local share was $1.7 billion. 270 Washington Street, SW, Suite Atlanta, Georgia Phone: (404)

2 Billions Education Funding Components SFY (Billions) $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $ State Funds before Equalization Local Fair Share Equalization Grants Unfunded Source: Department of Education QBE State Allotment Sheets As noted, because of austerity cuts, changes to the tax digest have a negligible impact on the state education budget. However, under normal budget conditions, a decrease in tax digest size would reduce a school system s local fair share obligation, improve its chances for equalization grant eligibility, and increase the size of that grant, if eligible. As a result, state education costs would increase. Fluctuating property values, economic development deals and other property exemptions are not the only cause of changes to the size of tax digests. Intentional or accidental misclassification of property can cause increases or decreases in the size of a digest. Successful appeals of property valuation can also reduce a digest. In addition, recent legislative changes have affected the ability of tax officials to reflect the actual value of properties within a digest. For example, from tax year 2009 until 2011, the state declared a moratorium on increases to the assessed value of property, unless improvements had been made. What we recommend During the course of this special examination, areas were identified that may warrant additional review and analysis. For instance, before changes are considered for the specific reporting of PILOT funds, we recommend overall consideration be given to the reporting of tax revenues by school systems. Whether or not PILOT funds to school systems should be included as revenue in equalization grant calculations is a policy decision beyond the scope of this report. However, currently, DOE can neither include nor exclude PILOT funds from the calculations unless these payments are reported separately from other revenue sources. Making their existence more transparent would require extensive changes across multiple entities. For both school system and county officials, revenues are reported only in fairly generic categories, and detailed source information is not required. Therefore, PILOT funds, in the rare instances they are received, are not identifiable under current revenue reporting practices. This report is intended to provide answers to questions posed by the Senate Appropriations Committee. We hope that this report provides pertinent information to inform policy decisions.

3 Property Tax Digests: Impact on Education Funding i Table of Contents Purpose of the Special Examination 1 Background 1 Property Tax Digests 1 Impact of Tax Digests on Education Funding 5 Requested Information 8 Determine what arrangements alter tax digests. 8 Development authorities, working with county and municipal governments, enter into bond agreements that reduce a company s property tax obligations in order to encourage economic development. These property tax reduction arrangements are common across the state but vary considerably in their substance. Errors, appeals, and legislative changes can also alter tax digests. Determine the impact of changes to a tax digest on education funding calculations. 14 In the current budget environment, the impact of local digest changes on state education appropriations may be minimal, but the influence of one system s digest change on all other systems funding formulas has increased. Any change to its tax digest will create a similar change in the size of a school system s local fair share obligation. A reduction in an eligible school system s tax digest will increase its equalization grant funds. A reduction to a school system s digest could raise one school system s final equalization grant while lowering another s. Identify the circumstances under which counties receive funds under special arrangements and increased formula earnings from lower tax digest values. 21 Reductions to a local tax digest may produce greater losses in estimated property tax revenue at the local level than is gained from beneficial adjustments to the local fair share requirement and equalization grant. In the majority of cases in our study, estimated property tax revenue losses outpaced local fair share and equalization gains. Whether or not a county reports PILOT payments as local tax revenues has direct influence on the outcome of equalization grant calculations. The reporting of revenues paid in lieu of taxes is not standardized; this gap is part of a greater lack of transparency in tracking school system revenues.

4 Property Tax Digests: Impact on Education Funding ii Appendices: Appendix A: Objectives, Scope, and Methodology 27 Appendix B: Georgia Property Tax Classifications 30 Appendix C: Timeline for Education Funding 31 Appendix D: Survey Information 32 Appendix E: Local Arrangement Examples 36 Appendix F: Equalization Grant Calculations 38

5 Property Tax Digests: Impact on Education Funding 1 Purpose of the Special Examination We conducted this review of local property tax digests and their impact on K-12 education funding at the request of the Senate Appropriations Committee. To address their questions, we developed the following objectives: 1. Determine what arrangements (for example, payment in lieu of taxes for economic development projects) alter a tax digest. 2. Determine the impact of changes to a tax digest on education funding calculations. 3. Identify the instances in which counties can receive funds from special arrangements and increased formula earnings from lower tax digest values. A description of the objectives, scope, and methodology used in this review is included in Appendix A. Because they provided assistance and information during the course of this review, a draft of the report was provided to the Department of Revenue, the Department of Education and the Governor s Office of Planning and Budget for review. Comments from all agencies were addressed, as necessary, in the body of the report; responses to specific issues were also incorporated. Background Property Tax Digests A property tax digest is the listing of all taxable and exempt property held within a tax district s boundaries. 1 Both real property, such as land, and personal property, such as manufacturing equipment, are subject to ad valorem taxes. Creating an accurate and complete tax digest is fundamental to a district s ability to tax residents and businesses for the value of their property, and thus generate the revenue required for governmental operations, including education. The process by which local property is valued and assessed for taxes, and then validated at the state level, involves a number of local and state entities. The process is ongoing over the tax year, and includes the following key steps: Assess value of all potentially taxable property (county); Classify property to determine if taxable and if so, at what rate (county); Equalize values to ensure consistent valuations within and among counties (state) ; Authorize digests for collection of taxes (state); and Bill and Collect taxes based on digest (county). 1 According to DOR, A tax district is a geographical grouping of property within which an authority, such as a county board of commissioners, a school board or a city council have authority to levy taxes. For example, a school board may have the authority to levy taxes on all property in the county, whereas a city would have authority to levy taxes only on the property within the city limits. Any given property may be in multiple tax districts, and therefore multiple digests. For example, a property will generally be on a county tax digest, and a school system digest (either the county school system or an independent school system.) Both districts collect taxes through a single tax bill.

6 Property Tax Digests: Impact on Education Funding 2 The digests segregate properties into classes, which can include exemptions or specially assessed property types. (Appendix B contains a listing of all property classifications currently authorized for use in Georgia.) Extensive state and local laws and regulations govern the processes by which local property taxes are assessed and education funding is allocated. Georgia s Constitution establishes the right of taxation and places limits on the process. Title 48 Revenue and Taxation of the O.C.G.A. governs the taxation process, including the State Auditor s responsibilities for equalizing each tax digest, and the Department of Revenue s authority to review and approve the digest. Title 20 Education outlines the education funding processes, which relies on digest information. Title 36 Local Government governs activities of Local Development Authorities (LDA), which can impact tax revenue as described later in this report. Finally, two Georgia Supreme Court findings are mentioned frequently in LDA bond agreements: DeKalb County Board of Tax Assessors v. W.C. Harris & Company (1981) and Macon-Bibb County Board of Tax Assessors et al. v. Atlantic Southeast Airlines, Inc. (1992). Creation of Local Tax Digests Within a county, three entities are involved in the compilation of local tax digests. (See Exhibit 1.) The Chief Appraiser determines the value of all property in the county, and reports to the Board of Assessors, which reviews these appraisals and property assessments to certify that they reflect appropriate values. The Tax Commissioner submits the digest package to the Department of Revenue (DOR) and, once it is approved for collection, calculates, bills, and collects taxes on all taxable property in the county. Equalization of Tax Digests The Sales Ratio Division (SRD) of the Department of Audits and Accounts, applying international standards, tests the accuracy and uniformity of county property tax digests. SRD provides counties, the Department of Revenue, and the Board of Education with an equalized adjusted property tax digest for each county and independent school system. The intent is to provide corrected total property valuations within counties and among counties in order to compare taxable values despite different levels of appraisal accuracy. SRD tests accuracy and uniformity by comparing a county s real estate sale prices 2 to the appraisal values established by county officials. In addition, SRD staff performs appraisals on a sample of unsold properties of various classes and compares to county valuations. The results of these comparisons are analyzed statistically to measure accuracy and detect potential bias among assessments of specific property types (e.g., analyzing whether lower-valued properties are assessed closer to market value than are higher-valued properties). 2 Sales data comes directly from the Georgia Superior Court Clerks Cooperative Authority. The Authority receives this data from county courts.

7 Property Tax Digests: Impact on Education Funding 3 Exhibit 1 Timeline for Property Tax Digests Timeline Local Tax Officials Department of Revenue DOAA Sales Ratio Division January Chief Appraiser February Determine Fair Market Value (FMV) of Property March Board of Tax Assessors April Classify Exempt Properties May Compute Assessed Value (FMV x 40%) June July Tax Commissioner August September Compiles Tax Digest Submission Package for DOR review/ certification Review Digest Submission Packages for each County October Order Authorizing Collection of Taxes November December Tax Commissioner Sends Tax Bills per Digest Compile Tax Consolidation Summary Sheets January February Conduct Sales Ratio Study March Digest Development Responsibilities by Agency April May June July August Tests 1. Assessment Ratio 2. Coefficient of Dispersion 3. Assessment Bias Begin Extended Third Year Review of Tax Digests Computation Sheets 100% Equalized Adjusted Tax Digest and Assessment Ratio Source: Agency interviews and program documents

8 Property Tax Digests: Impact on Education Funding 4 Exhibit 2 contains an excerpt from the 2011 State-wide Equalized 100% Adjusted Property Tax Digest Report, published November By law, only 40% of the value of a property is taxable. 3 Each county appraises potentially taxable property and then calculates the assessed value, which is generally 40% of the appraised amount. The equalized digest contains two numbers for each county and independent school system: a ratio that indicates how close the county s assessments are to the 40% target as computed by SRD, and a 100% adjusted digest dollar amount. The adjusted digest reflects the total value of the system s taxable property, once equalized to remove the impact of appraisal variations. For example, the exhibit illustrates that properties were generally undervalued in Appling County (33.87) and overvalued in Banks County (41.78) for the period under study, so the overall value of each district s property was adjusted accordingly to create the 100% Digest. Exhibit 2 Equalized Digest Excerpt: 2011 Data Source: 2011 Sales Ratio Study State-wide Equalized 100% Adjusted Property Tax Digest Reportrevised November 7, 2012 Tax Digest Review and Approval The digest packages submitted by counties to DOR include a listing of all real and personal property in each tax district and its assessed value. Once DOR has established that a county meets its review standards, the digests are authorized for the collection of local taxes. Using statistical analysis provided by the State Auditor to determine the average assessment ratio for each property class, DOR reviews all digests to ensure goals for uniformity are met. Final approval of a tax digest occurs a year later, after the State Auditor s and DOR s review. Annually, revenue staff provides a rotating in-depth 3-year review in one third of the state s counties. 3 The law allows for harvested timber to be assessed at 100% of fair market value and preferential assessment property to be assessed at 30% of fair market value. In addition, certain independent school systems in municipalities are authorized to assess property in excess of 40% of fair market value.

9 Property Tax Digests: Impact on Education Funding 5 Local Development Authority (LDA): Arrangements Affecting Property Tax Digests Property may be classified as exempt from taxation or eligible for reduced taxation for a number of reasons. For example, land owned by governments or qualifying nonprofit organizations is by law exempt from ad valorem taxes. Additionally, homeowners in Georgia may claim a partial homestead exemption on their primary residences. The state also offers exemptions or preferential tax rates to encourage certain activities such as land conservation or urban redevelopment. Similarly, although the Georgia constitution does not allow for tax abatements, local development authorities can enter into arrangements that allow tax incentives to be created for economic development purposes. As a government entity, the authority s property is exempt from property taxes. To provide tax incentives, title to property is transferred to the authority, generally using revenue from bonds issued by the authority. Issuance of bonds is at the discretion of the authority, and the duration and amount of lease agreements is negotiated between the development authority, the company and county officials. Depending on the valuation and classification of the property prior to these arrangements, tax districts may lose revenue because of resulting changes to their tax digests. To reduce the impact on tax revenues, authorities can use payment in lieu of taxes (PILOT) agreements, which require the company to make payments to offset at least a portion of the taxes that would have been paid if the company had title to the property. These payments may or may not be designated for specific purposes, such as education, and the recipient varies depending on the agreement. Other arrangements increase the company s tax liability as the bond payments are made. Either of these types of arrangements can have requirements for the company to provide a specified number or jobs or amount of investment for the agreements to continue. Cities and counties can adopt policies defining the terms and conditions under which these arrangements can be made. A local government entity created for specific economic development purposes. LDAs may issue industrial revenue bonds, purchase land, and enter into economic development arrangements with private entities to provide incentives such as low-interest financing or property tax avoidance. LDAs are required to register with and report to the Department of Community Affairs. Impact of Tax Digests on Education Funding Each public school system in Georgia is provided state funding through a series of calculations called the Quality Basic Education (QBE) Funding Formula. The QBE funding formula is used as both a planning tool during the budgeting process and as the state s official allotment calculation to determine each school system s QBE earnings. A timeline of the funding process is included in Appendix C. The primary QBE formula is comprised of a set of base earnings values that are created using a weighting system for educational program types, and the number of full-time equivalent (FTE) students. Total QBE earnings include the base calculation plus an adjustment for teacher training and experience unique to each school system. For example, to calculate the earnings for a primary grades program within one school system, the QBE formula would incorporate these components:

10 Billions Property Tax Digests: Impact on Education Funding 6 Base Earnings $2, x x $1,109,440 = $3,517,900 Base Cost Program Weight Grades 1-3 Full Time Students (Projection) Teacher Training and Experience Total Earnings, Grades 1-3 The QBE earnings themselves do not reflect the total amount of funds transferred to the local systems, but instead represent a beginning point for the sharing of education costs between state and local governments. In addition, the state provides education related grants. These grants, combined with QBE earnings, comprise education funding state-wide (Exhibit 4). Exhibit 4 Education Funding Components SFY (Billions) $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $ State Funds before Equalization Equalization Grants Local Fair Share Unfunded Source: Department of Education QBE state allotment sheets Local tax digests affect two aspects of education funding calculations: the school system s share of QBE earnings and the state s efforts to provide additional grants to systems with low relative wealth per student served. As shown in Exhibit 4, these two aspects represent a small portion of overall education funding. They are discussed briefly below, and in greater detail later in the report: Local Fair Share (or Local Five Mill Share ), discussed in more detail on page 15, represents the amount each school system is required to contribute to local education from its own tax revenues to remain eligible for state QBE funds. The Department of Education compiles the local fair share for each school system based largely on the 100% equalized tax

11 Property Tax Digests: Impact on Education Funding 7 digest provided by SRD, minus certain exemptions. The local fair share is then deducted from the state QBE calculation. Equalization Grants, discussed in more detail on page 17, are designed to provide additional aid to school systems whose local tax revenues are low relative to the number and type of students needing education. DOE adds grant funds after QBE earnings are calculated and then reduced by the school systems local fair share. To qualify, school systems taxable wealth per student must fall below a state average and the school board must levy a minimum effective millage rate for local education funding purposes. 4 The process for calculating eligibility for and the size of equalization grants changed for the 2013 budget year, as the result of recent legislation. Since the school year, budgetary constraints have resulted in austerity reductions that limit the amount of state funds available for QBE. As shown in Exhibit 4, QBE base earnings have not been fully funded recently. In fiscal year 2013, total state QBE and equalization spending served 1.66 million full time students (FTEs) for $6.7 billion. Exhibit 5 provides detailed spending information and related activity data. Exhibit 5 Education Funding Components SFY (Millions of Dollars) FTE Total 2 1,630,671 1,641,396 1,650,981 1,650,904 1,656, % State-wide Equalized Adjusted Tax $873,776 $962,389 $1,029,613 $1,005,719 $935,559 Digest 3 Education Funding Local Fair Share $1,690 $1,698 $1,698 $1,698 $1,698 State QBE Share $6,094 $5,663 $6,162 $6,176 $6,279 Unfunded $496 $1,355 $1,090 $1,148 $1,144 QBE Earnings Total $8,279 $8,715 $8,949 $9,021 $9,120 Equalization Grants $557 $436 $436 $436 $436 Note: QBE charter system adjustments and other educational grant funds are not included in this table. (Approximately $180 million in 2013) 1 For all years except FY2013, the mid-term adjustment state QBE allotment sheet was used. 2 When used to calculate QBE funding and equalization grants, FTE counts are weighted by program. Our reported FTE values are unweighted aggregate state-wide counts. 3 The values represent the equalized tax digest used to calculate the funding for the associated fiscal year. The tax year used is three years prior to the fiscal year budget (e.g., Tax Year 2010 is used to calculate Fiscal Year 2013). Source: Department of Education QBE State Allotment Sheets; Department of Audits and Accounts Sales Ratio Study 4 Effective millage rate is the amount of local tax revenue collected for education, compared to (divided by) the assessed value of a school system s tax digest.

12 Assessed Value Property Tax Digests: Impact on Education Funding 8 Requested Information Determine what arrangements alter tax digests. Development authorities, working with county and municipal governments, enter into bond agreements that reduce a company s property tax obligations in order to encourage economic development. In general, these bond arrangements reclassify property from privately-owned (taxable) to government-owned (tax-exempt) status for a particular period. Because tax digests are used to compute and collect ad valorem taxes, moving property from taxable to exempt classifications reduces the total value of a tax district s digest. The short-term loss in tax revenue is expected to be offset by escalated employment, increased sales taxes, or improved infrastructure leading to future increased tax revenues. Exhibit 6 Sample arrangement for property tax abatement Millions $50 $45 $40 $35 $30 $25 Exempt Property (Not on Digest) $20 Taxable Property (on Digest) $15 $10 $5 $0 Year of Arrangement Taxable property removed from digest, gradually increases in value as improvements are made Digest increases annually at an agreed-upon rate : Generalized from results of county tax official survey The impact of these arrangements on a particular district s tax digest varies based a number of factors, including the monetary size of the deal in proportion to the overall digest, the previous taxable value of the property exempted and the number

13 Assessed Value Property Tax Digests: Impact on Education Funding 9 of such deals in the district at one time. 5 Exhibit 6 provides a common example of arrangements that exist in Georgia. In this example, an existing manufacturer is encouraged to expand local operations through a bond transaction that finances improvements to the property and facilitates the creation of additional jobs. The development authority takes title to the property and the manufacturer pays back the bond over ten years. The manufacturer pays taxes on its increasing leasehold interest in the property (10% per year of the assessed value.) The school and county tax digests increase each year by the taxable value of the leasehold interest. For example, in year one, the entire property is exempt from taxation. In year two, the assessed value of the property has increased to $25 million because of improvements made. The manufacturer pays tax only on the value of its leasehold interest, which is equivalent to 10% of the total value of the bond. Because this accrued leasehold interest is classified as taxable industrial property, the digest increases by that amount. Exhibit 7 Sample PILOT arrangement payments in lieu of taxes Millions $50 $45 $40 Assessed Value increases, is basis for payments in lieu of taxes (School District Only) Taxable Property (on Digest) $35 $30 Exempt Property (Not on Digest) $25 $20 $15 $10 $5 $0 Year of Arrangement Taxable property removed from digest, gradually increases in value as improvements are made Year of arrangement Improved property reverts to digest at end of arrangement Source: Generalized from results of county tax official survey Exhibit 7 illustrates an arrangement of equivalent value and duration in which no leasehold interest accrues. The assessed value of the property increases as 5 Multiple tax districts, and therefore multiple digests, can be affected by a single arrangement of this sort. In general, a property will be listed on the county digest and that of one school system. It may also be listed on a municipal digest.

14 Property Tax Digests: Impact on Education Funding 10 improvements are made, but the property is not on the tax digest for the ten years of the agreement. No property taxes are paid for the duration of the arrangement. However, the manufacturer makes PILOT payments, equivalent to the school taxes that would have been levied, based on the assessed value of the property. In this example, in year one and all other years, the manufacturer pays no county taxes, but makes non-tax payments equivalent to what it would owe for school taxes if it owned the property. The payments escalate with the increase in property value. The digest (as relates to this property) is unchanged for the duration of the arrangement. Based on our survey responses, this type of arrangement is much less common than that shown in Exhibit 6. These property tax reduction arrangements are common across the state but vary considerably in their substance. We were unable to quantify the number of such arrangements in the state, or measure the degree of their impact, because no comprehensive database exists to track them; reporting requirements are minimal. However, bond data reported to the state Department of Community Affairs provide some idea of the number and size of deals that exist. This listing is not exhaustive, but its 735 current deals total approximately $24 billion. The top 10% (73) of deals represent over half of the bond value in the list. We acquired a significant amount of information on the arrangements in place across the state by using a survey that drew on the knowledge of each county s chief appraiser and tax commissioner. Officials from 134 of 159 counties (84%) responded to our request. Respondents reported that approximately 60% of their jurisdictions (75 of 134) have at least one such arrangement currently in effect. Many respondents supplied, as requested, additional documentation describing the details of the agreements. 6 We were able to draw a number of conclusions from the information they provided, as discussed below. At least a dozen local entities have created specific policies for the establishment of these arrangements, and therefore we saw contracts that were consistent within the same jurisdiction. 7 Among the survey responses we found: Boards of Assessors establishing rules for property valuation and tax calculation for such arrangements, local ordinances dictating a common structure for these deals, and development authorities using standard formats for all tax abatement agreements. We also talked to county officials who had requested examples from neighboring counties to help guide their process when creating an arrangement for the first time. In reviewing the text of agreements, we noted that a number of counties/development authorities use the same law firm(s) for representation; their agreements use a common template making language largely consistent from one deal to another. 6 We received information on more than 500 arrangements. The level of detail provided ranged from a single statement to complete contracts hundreds of pages long. 7 Our survey did not specifically ask about the existence of such standards so we cannot estimate the frequency of their use. Based on a review of hundreds of contracts within and across individual jurisdictions, however, standardized processes appear to be the exception and not the rule.

15 Property Tax Digests: Impact on Education Funding 11 Overall, however, we found marked variation in the details of these arrangements across the state: Dollar values ranging from hundreds of thousands to hundreds of millions for a single agreement. (In our survey, we saw bond agreements ranging from $300,000 to $1,130,000,000.) Property types including real (land) and personal property (equipment), and both industrial and commercial classifications. Durations extending 5 years to 30 years. Enterprises involving entities as diverse as car dealerships, resorts, manufacturing plants, prisons, and data centers. Performance standards and reporting requirements ranging from nonexistent to explicit requirements for number of jobs created, minimum salaries and minimum investments, with stringent clawbacks of tax breaks for failure to meet them. Payment requirements mitigating some of the dollar value of tax exemptions, including PILOT agreements to ensure school revenues are protected, to fees and payments covering county or development authority costs. Participants limited to the development authority, county commission and the company, or broadly including acknowledgement of the arrangement by Board of Assessors, Tax Commissioner, and School Board. 8 Aggregate information from the survey responses is included in Appendix D. We also provide a few case studies describing details of specific arrangements as examples in Appendix E. Errors, appeals, and legislative changes can also alter tax digests. Economy-related fluctuations in property values, economic development deals and other property tax exemptions are not the only causes of changes to the size of tax digests. Intentional or accidental misclassification of property can cause increases or decreases in the size of a digest. Successful appeals of property valuation can also reduce a digest. In addition, recent legislative changes have affected the ability of tax officials to reflect the actual value of properties within their digests. Errors/Misclassifications: Each county is responsible for ensuring the accuracy of property classification within its districts. Classifying a taxable property as exempt will reduce the size of a digest by the assessed value of that property. Similarly, classifying an exempt property as taxable erroneously increases the size of a digest. Appeals: After local tax officials send assessed value notifications to property owners, the owners may then appeal these valuations. Typically a 8 According to the National Education Association, it is a good practice to have tax officials and school boards sign their acknowledgement to these deals, in order to ensure that agreed-upon taxes are properly collected and the impact on school funding has been evaluated.

16 Property Tax Digests: Impact on Education Funding 12 local board convenes to hear the appeals and the rulings of these boards may significantly adjust the appraised and/or assessed value of a property. In tax year 2012, two of the counties with the largest tax digests had approximately $1.2 billion and $1.5 billion of assessed property value in dispute. Legislative Changes: From tax year 2009 until 2011, the state declared a moratorium on increases to the assessed value of property, unless improvements had been made. (The moratorium has since been lifted.) In addition, the statutory definition of an arm s length, bona fide sale, which is used to determine the fair market value of property, was changed to include distressed, short, bank and public auction sales. Prior to this change, these types of sales were not considered to reflect the fair market value of the property involved. The inclusion of these properties inherently lowers the overall value of a tax digest, because their reduced values become part of appraisal calculations based on comparable sales. The consequences of these changes are outside the scope of this special examination. Therefore, we did not attempt to measure their impact. However, the ramifications of relative changes to digest size on education funding discussed in the rest of this report would also apply to the influences discussed above.

17 Property Tax Digests: Impact on Education Funding 13 Our Education Funding Impact Model To determine the effect of changes to a tax digest (for example, by reclassifying property from taxable to exempt) on local fair share requirements and equalization grants, we obtained the Department of Education s (DOE) calculation tool used to determine each school system s funding for fiscal year We used this tool as the basis for a spreadsheet model to test the impact of one system s digest reduction on local fair share obligations and equalization grants for all 180 school systems in the state. The model simulated a 5% reduction (one system at a time) for every school system in the state. Results were used to determine the impact to the adjusted school system and compare the impacts among school systems. The model also estimates changes in tax revenues resulting from a reduction in a tax digest. This feature estimates the ad valorem property tax revenue associated with the value of property removed from the digest during test iterations. The revenue estimation considers value of property, actual school system millage rates, and assessment ratios as determined by the Department of Audits and Accounts. This adjustment assumes that the taxing authority did not adjust school millage rates or otherwise collect additional revenues to accommodate for the loss of taxable property value. During the 2012 legislative session, HB824 amended the way the state calculates equalization grants. The Department of Education implemented the new formula as the standard calculation structure starting in fiscal year The impacts discussed in this report reflect the HB824 equalization grant formula. Because equalization grants are calculated based on an adjustable average benchmark, it would be challenging for any school system to anticipate its relative digest wealth compared to all other systems in the state. While the model assesses the impact of an isolated digest reduction to one school system holding all other factors constant, in reality, tax digests throughout the state change each year and those changes do not occur in isolation. In addition, other components such as tax revenues and student counts also fluctuate each year within one school system and among school systems. Therefore the model can only provide generalized guidance on the operation of the local fair share and equalization grant formulas in the context of the current budget environment. Our use of a theoretical 5% reduction was a fairly arbitrary choice, and in most cases would exaggerate the impact of one reclassification action. Average taxable industrial classifications we deemed to be most likely to be exempted in an economic development deal (I1 Industrial Real Property-Improvements and IF Industrial Personal Property-Furniture/Fixtures/Machinery/Equipment) represent approximately 2% each of the total value of property statewide, as reported for the 2011 school system digests. Median values are 1.5% and 1.8% of individual digest value, respectively. Four school tax districts reported industrial real property of >10% of digest (max 16%), a dozen districts reported industrial personal property >10% of digest (max 30%).

18 Property Tax Digests: Impact on Education Funding 14 Determine the impact of changes to a tax digest on education funding calculations. In the current budget environment, the impact of local digest changes on state education appropriations may be minimal, but the influence of one system s digest change on all other systems funding formulas has increased. Under normal budget conditions, a decrease in tax digest size would reduce a school system s local fair share obligation, improve its chances for equalization grant eligibility, and increase the size of that grant, if eligible. The general effects of a digest change are shown in Exhibit 8. Exhibit 8 General Effects of a Change to a Local School System s Tax Digest (from local perspective) School System 100% Equalized Tax Digest Local Revenues Local Fair Share Obligation As Designed Local Funding Equalization Grant State Funding to School System Overall State Education Funding School System 100% Equalized Tax Digest Local Revenues Under Austerity Budgets Local Fair Share Obligation Local Funding Equalization Grant State Funding to School System Overall State Education Funding Source: Auditor analysis of funding model Austerity reductions (the unfunded portions shown in Exhibit 4, page 6) have kept overall state education funding flat over the budget years. State appropriations have been held constant for the local fair share obligation and equalization grants for this period. For example, in 2011 and 2012, equalization grants totaled $436 million and overall state spending decreased from $6.89 billion to $6.79 billion. During the same period, the unfunded portion of QBE earnings increased from $1.09 billion to $1.15 billion. As a result, as shown in Exhibit 8, reductions to a school system tax digest will currently not affect overall state spending. 9 However, holding state appropriations for local fair share and equalization grants constant means that each system s calculated earnings are reduced by prorating down to the specified limit. Therefore, reductions in one system s tax digest will not only affect that system s education funding formula, but potentially change all other 9 In rare cases, errors in digest submissions discovered after the equalization formula calculation has been finalized can result in additional state funding through a supplemental budget appropriation.

19 Property Tax Digests: Impact on Education Funding 15 school systems local fair share obligation and equalization grant eligibility and size. Exhibit 9 demonstrates these effects. Exhibit 9 Interactive Effects among School Systems in Current Budget Environment Local Fair Share Any change to its tax digest will create a similar change in the size of a school system s local fair share obligation. Each year, DOE parses total QBE earnings for each school system between the amount the state will contribute and the local fair share to be contributed by school systems. To determine the share of QBE earnings required locally, DOE calculates five mills of the assessed value of taxable property using each school system s 100% Equalized Tax Digest, less some exemptions. As shown, a simplified version of the

20 Property Tax Digests: Impact on Education Funding 16 calculation for one hypothetical school system conveys the process. In this example, the $483,750 local fair share obligation would be further prorated as would every other school system s calculated obligation to meet statewide funding limits. 100% Equalized Digest Determine the Assessed Digest Value Subtract Exemptions Calculate Local Fair Share (Five Mills) $250 million x 40% = $100 million - $3.25 million = $96.75 million x = $483,750 Before proration, the relationship between digest values and local fair share obligations statewide is linear, so for any school system in the state, a 5% reduction of its equalized tax digest reflects a 5.2% reduction, on average, to its local fair share obligation. Following a hypothetical 5% reduction, school systems with relatively small digests exhibited a slightly greater reduction to local fair share than those with larger digests. However, because of interactions among the digest and other factors within the formula, this is a less than standard relationship. Exhibit 10 shows changes, before proration, to local fair share following a 5% reduction to the tax digest of five sample school systems with varying digest wealth. As shown below, a 5% reduction in System A s equalized digest results in a 5.1% reduction in its local fair share obligation. The same reduction in a system with a smaller equalized digest, for example, System E, results in a larger percentage reduction of 5.5%. Exhibit 10 5% Equalized Digest Reductions: Impact on Local Fair Share (Before Proration) School System 100% Equalized Digest 5% Digest Reduction Change in Local Fair Share Percent Reduction A $79,077,080,255 ($3,953,854,013) $7,907, % B $4,046,114,033 ($202,305,702) $404, % C $1,802,997,505 ($90,149,875) $180, % D $768,302,204 ($38,415,110) $76, % E $128,289,279 ($6,414,464) $12, % Source: Auditor analysis of funding model Since fiscal year 2010, the state has held the total local fair share obligation constant and prorated each school system s obligation. Therefore, a reduction in one system s digest increases the prorated obligations for all other school systems. For example, if a system with digest wealth of $4 billion (such as System B in Exhibit 10) underwent a 5% digest reduction ($200 million) and a corresponding local fair share reduction of $404,611, after proration, all other school systems requirements would increase by 0.022%. In real dollars, the increase would impact every school system differently (from $48 to $32,500), but as a percentage of overall local fair share, each system would see a similar effect.

21 Property Tax Digests: Impact on Education Funding 17 A 5% reduction to the system with the largest tax digest (System A, approximately $79 billion) would have the greatest ripple effect throughout the state after proration (0.437% increase for all other school systems). By the same logic, a 5% reduction in the system with the smallest tax digest (System E, about $128 million) would have the least impact (0.001% increase for other systems). Equalization Grants A reduction in an eligible school system s tax digest will increase its equalization grant funds. Equalization grants are designed to offer a measure of education funding equity for those school systems with a low relative taxable wealth per student served. 10 As shown, the calculation of these grants relies on three factors: wealth per student gap, effective millage rate and recent student count. The basic formula calculates and then multiplies these three factors together to provide additional funding to school systems with wealth per student below the calculated statewide average. Wealth per Student Gap Statewide Benchmark - Local Wealth per Student x Effective Millage Rate Tax Revenues Assessed Digest Value x Most Recent Student Count = Equalization Grant As shown in Appendix F, which contains a detailed explanation of the equalization grant formula, the process ranks each system based on its calculated wealth per student. The highest-ranked 5% and the lowest-ranked 5% of schools are excluded and the average is calculated for the remaining systems to obtain a benchmark. School systems with a wealth per student below this benchmark qualify for an equalization grant, provided they meet other stipulations. 11 School systems above the benchmark do not qualify for equalization grants. In our tests of 5% tax digest reductions, 50 (28%) school systems would not receive an equalization grant before or after the simulated change, because their reduced wealth per student would still be above the benchmark wealth per student. Five other systems, however, would become eligible for equalization grants following a 5% digest reduction. The remaining 125 school systems would see an increase in equalization funds resulting from a decreased digest value. Including the five newly-eligible systems, grant fund increases for a school system ranged from $25,000 to $17 million with an average increase of $741,000. Grant increases ranged from $14 per student to $111 per student, with an average increase of $60 per student. Exhibit 11 illustrates the changes that would be experienced by four different school systems as a 5% drop in 10 Wealth per student is a simplified term we are using to describe the calculation of the assessed value of the equalized tax digest (wealth) divided by the weighted FTE count. References to student in this discussion are equivalent to weighted FTE as calculated in the QBE formula. 11 Qualification stipulations are discussed on page 18 and currently include a minimum effective millage rate greater than five mills. Per HB824 (2012), the minimum effective millage rate will increase in coming years.

22 Property Tax Digests: Impact on Education Funding 18 digest value reduced each system s wealth per student, its distance below the benchmark, and the resulting increase in that system s equalization grant. Exhibit 11 Impact of 5% Digest Reduction on Equalization Grant Funding: Sample of Four Systems Ranked by Wealth per Student Average (Benchmark) R A N K Wealth/ Student Source: Auditor analysis of funding model School System Rank Change Gap from Benchmark (Thousands) Effective Millage Grant $/ Student 10 $ 300, , , , ,000 #51 n/a 9.56 $ - A ,000 #58 $ $ ,000 #75 $ $ 182 B ,000 #86 $ $ , ,000 #101 $ $ 318 C ,000 #110 $ $ , , , ,000 #151 $ $ 602 D ,000 #158 $ $ , ,000 The magnitude of any grant increase is influenced by the factors within the formula: Changes to a school system s wealth per student relative to the benchmark. Digest reductions decrease wealth per student value and rank. When a school system s wealth per student falls further below the statewide benchmark, the formula increases equalization funds that the system will receive. Changes to a school system s effective millage rate. The calculated effective millage rate (tax revenues divided by assessed digest value) is used as a multiplier in the equalization formula, in order to encourage adequate local taxation rates. A higher effective millage rate means a higher equalization grant to a qualifying school system. According to our model calculations, school system revenues fall at a different rate than a reduction