CHICAGO — Naming property tax reform as its top legislative priority in the coming year, the Indiana General Assembly this week launched the first in a series of hearings to consider Gov. Mitch Daniels sweeping overhaul of the state’s property tax system, which includes proposals that would dramatically alter local government and school debt issuance.

“The whole atmosphere in the state is that something pretty significant is going to happen,” said James Merten, vice chairman of the public finance group at City Securities Corp. “Whether it stops [bond issuance] or slows it down or makes you do it in a different way, we’ll have to wait and see.”

The hearings coincided with the recent introduction of a string of bills that enact the overhaul of the system, including the massive HB 1001, which is largely based on the proposals the governor first began touting in late October.

Daniels’ plan would cut property tax bills for most homeowners by one-third, as well and place a constitutional cap limiting property taxes to 1% of the assessed value for residential properties, 2% for rental, and 3% for commercial properties. The change in the constitution would be subject to voter approval. To replace the lost revenue, the state’s sales tax would go up to 7% from 6%.

The plan would mean dramatic changes for local governments and schools. They would face greater oversight by special county review boards, as well as restrictions on their spending plans and use of debt. The state would take over responsibility for the funding of local school general and transportation funds and local government child welfare funds.

Under the legislative proposals, local spending could not exceed a county’s average personal income growth over a rolling six-year period, and a voter referendum would be required on all bond issues over $10 million, or 1% of a government unit’s assessed value. If applied in 2007, that threshold would have meant that about 55% of bond projects would have been subject to a referendum, according to Ryan Kitchell, director of Indiana’s Office of Management and Budget.

The structure of bond issues would face new restrictions — with a 30-year cap on final debt maturity. Refundings could be undertaken only for savings and not for restructuring purposes where final maturities are pushed out, and issuers would be limited to spending any savings only to repay bonds or reduce levies.The Senate began committee meetings to consider the debt bills yesterday.

Enhancing property tax caps — also known as circuit breakers — as well as requiring referendums on spending plans could make it particularly difficult for urban issuers, such as school districts, to issue debt. In 2007, schools will collect nearly half of the total $6.17 billion collected in total property taxes.

“It would have a major impact on the real urban school districts,” Merten said, including Indianapolis, Fort Wayne, Gary, and South Bend. “It will have a dramatic impact on the city and school budgets.”

For example, Indianapolis Public Schools, the state’s largest school district, has already cancelled plans to sell about $475 million of debt next year, according to Mary Jane Michalak, director of communications for the Indiana Department of Local Government Finance, which currently approves all bond issues greater than $2 million. In 2007, the department approved 67 school building projects for about $1.7 billion.

“It will be impossible for IPS to raise any funds without triggering the circuit breaker,” Eugene White, the district’s superintendent, told a hearing of the House Ways and Means Committee on Monday. “There’s absolutely no way IPS can ever issue bonds to finish work on more than 40 schools that are trying to reach basic [Americans with Disabilities Act] requirements or get air conditioning or science labs.”

Offsetting any revenue reduction by raising the income tax in Indianapolis-Marion County is unlikely, where two-term incumbent Mayor Bart Peterson was recently defeated by a political newcomer who favors total elimination of property taxes.

The referendum requirement would also have a significant impact on debt issuance, according to Kitchell. “We’ve heard more noise about that than any of the others,” he said.

Though Daniels’ plan includes a referendum requirement, it is absent from another set of recommendations submitted to the General Assembly by the legislative tax policy committee.

Debt service payments under the plan would continue to be paid through local debt service funds, which are funded almost entirely from local property tax revenue that could decline under the proposed plan.

“The bill’s pretty specific about making sure that debt service gets covered first, and puts in some state intercepts,” Kitchell said. “We’ve tried to do everything we can so that bondholders will continue to get paid.” For example, under the plan the state treasurer would withhold distributions from a taxing unit and make debt payments on their behalf it they fail to make a payment.

A recently released fiscal analysis of the plan shows that residential property tax bills would drop an average of 38.6% in 2009 through a combination of tax caps, deductions, and levy reductions. Total property taxes from all properties would be reduced more than 27% to a net of $5.5 billion in 2009 from a current net of $7.6 billion. The circuit breakers are estimated to reduce property tax revenue by $703 million in 2009.

To make up for the loss in property tax revenue, the plan allows local governments to raise the local option income tax by 1%, which could generate an additional $1.27 billion statewide, according to the analysis.

Raising the state sales tax by 1% would generate an additional $151.1 million in the remaining months of fiscal 2008, $949.9 million in fiscal 2009, and $991.4 million in fiscal 2010, according to the analysis. Additionally the state would disburse roughly $1.557 billion in fiscal 2009 and $3.179 billion in fiscal 2010 to compensate for the elimination of levies.

Issuers in Indiana sold more than $8.577 billion of debt in 2006, of which $7.66 billion was revenue bonds and the remaining $826 million was general obligation debt, according to data from Thomson Financial. Of the total, $3.06 billion was for education purposes, $2.37 billion was for health care, and $580 million was general purpose debt.

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