Proposed Texas tax shift may kill certificates of obligation

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Texas lawmakers are considering a historic shift in the source of school funding and a cap on local property taxes as they near the final month of their 2019 session.

In the process, the legislation could effectively end the use of certificates of obligation, an alternative to general obligation bonds that does not require voter approval, according to the Texas Municipal League.

Under House Joint Resolution 3, some revenue for Texas’s 1,031 public school districts would come — for the first time — from statewide sales taxes, a shift designed to ease the pressure on local property taxes. Texas is one of seven states with no income tax. The constitutional amendment would require the state's voters to approve a sales tax increase to 7.25% from 6.25%.

At the same time, lawmakers are considering a cap on local property taxes that has brought bitter protests from leaders of the state’s largest cities and counties. Ultimately, the legislative maneuver poses a threat to local governments that issued most of the state’s $31 billion of debt in 2018, ratings analysts say.

“This reduction in revenue-raising flexibility could lead to pronounced operational stress and exacerbate growing operating costs for local governments, including increased infrastructure demands, public safety service expenditures, and additional investment in long-term liabilities,” said S&P Global Ratings analyst Oscar Padilla.

Republican leaders tout what they call a tax swap as meaningful property tax reform after previous efforts were eroded by rising values and a growing population.

“We all know what happens when we pass statutory bills: Money starts getting diverted,” said Rep. Dan Huberty, R-Kingwood, who sponsored HJR 3 calling for voter approval of the sales tax increase. “This is a constitutional amendment. This legislation gives a choice to your constituents and asks them if this is what they want to do, if this is how they want to fund schools on a go-forward basis.”

Huberty, who chairs the House Education Committee, outlined HJR 3 and its enabling legislation, House Bill 4621, to the House Ways and Means Committee last week.

“The question we’ve been asking is: How do we find ongoing real property tax relief, at the same time reducing the state’s reliance on property taxes for funding education?” Huberty told the committee. “The only way we can do that is with this new revenue source.”

With no statewide tax other than sales tax, Texas must shift local property tax revenues between property wealthy and property poor school districts to equalize funding per student. The property tax revenue shifted between districts is called “recapture” payments. Some property wealthy districts, such as Houston Independent School District, serve some of the poorest students in the state and struggle to meet needs but still must sacrifice millions of dollars each year to other districts.

Each district levies two property tax revenue rates. One rate is set for maintenance and operations or M&O. The other is designated for interest and sinking fund, I&S, that supports bond debt. Districts do not have to share revenue that supports their bonds.

In recent years, the state’s share of public education support has slipped to about 33%, leaving 67% of the burden on local property taxes. One of the goals of HJR 3 is to increase the state’s share of the burden to the more appropriate level of 50%, Huberty said.

Huberty also authored House Bill 3, which would add about $9 billion in education funding above enrollment growth and current law entitlement over the next two years. HB 3 would also allow local school districts to put more money in their classrooms by raising the basic allotment to $6,030 from $5,140, an $890 increase per student. HB 3 won passage on April 3 and is now under consideration in the Senate.

“Without HJR 3, we [the state] would be funding about 33% of education, which is obviously unacceptable,” Huberty said. “So, this 1-cent increase means more than $10 billion to lower property taxes and help our schools. HB 3 reduces recapture by $3 billion. HJR 3 reduces recapture by $5 billion.”

Gov. Greg Abbott, who supports the sales tax increase, along with Lt. Gov. Dan Patrick, presiding officer of the Texas Senate, and House Speaker Dennis Bonnen, praised the House for passage of HB 3.

“Texans are demanding meaningful reforms to our school finance system, and today’s passage of HB 3 in the House is a vital step toward that goal,” Abbott said on April 3. “By reducing recapture, investing more money in our schools and in our teachers, the Legislature is making changes that will have a lasting impact on our education system, and more importantly, our students.”

Between 2007 and 2014, property tax levies increased by an estimated $14.1 billion, to $49.1 billion, according to the Texas Comptroller’s office. School districts accounted for about 57% of that growth, with cities, counties and special-purpose districts responsible for about 14% each.

In response to the continued rise in local property taxes, the 2015 Legislature increased the homestead exemption to $25,000. The increase cost the state about $3.2 billion over five years, while providing the average homeowner about $120 annually in tax relief.

On April 15, the state Senate passed Senate Bill 2, which contains a property tax cap of 3.5%, raised from the original 2.5%.

Under the new version, SB 2 would force cities, counties and other taxing entities to receive voter approval before raising 3.5% more property tax revenue than the previous year. However, school districts would still face the 2.5% threshold under the approved version. Under current law, voters can petition for an election if revenue from property taxes exceeds 8%. The new legislation requires the local government to call the election without the need for a petition.

Revenue derived from new construction would not count toward the cap. And small taxing units, with sales and property tax levies under $15 million annually, would be exempted from the cap. That would include the numerous municipal utility districts across the state.

The House version of the bill, House Bill 2, still contains the 2.5% cap but exempts community colleges and small taxing districts.

Under HB 2, certificates of obligation that typically do not require voter approval would count toward the 2.5% cap. COs would no longer be classified as “debt” for purposes of the property tax rate calculations. That means that COs would have to be financed through a city’s maintenance and operations tax rate.

Bennett Sandlin, executive director of the Texas Municipal League, said that HB 2 would render certificates of obligation "almost unusable."

COs provide local governments with important flexibility when they need to finance projects quickly, as with reconstruction after a disaster or as a response to a court decision requiring capital spending. But the fact that local issuers can bypass voters through the certificates led to 2015 legislation restricting their use. COs were first authorized in Texas in 1971.

COs are issued for terms of up to 40 years and usually are supported by property taxes or other local revenues and can be used for public works. COs do not require voter approval unless 5% of qualified voters within the jurisdiction petition for an election on the spending in question.

“COs can be particularly attractive when a local government wishes to, for example, take quick advantage of lower interest rates, purchase a newly available property or come into compliance with a federal or state regulation,” according to the Texas Comptroller’s office.

According to the Texas Bond Review Board, CO debt held by cities, counties and hospital/health districts made up 16% of their total debt obligations in 2015, but just 6% of all local government debt.

In 2012, the Commissioner’s Court in Montgomery County north of Houston issued $30 million in COs for a road project in Conroe, less than a year after voters rejected a $200 million bond proposal including the same project.

Montgomery County citizens sought legislation to curtail CO usage, leading to 2015’s House Bill 1378 banning the issuance of COs for any project voters rejected in the preceding three years. Exceptions include a “public calamity” that threatens property or public health, or the immediate need to comply with a state or federal regulation, rule or law.

Dallas Mayor Mike Rawlings, one of several leaders of the state’s largest cities opposing the property tax cap, said the measure would be “catastrophically harmful” and would prevent the city from hiring 100 police officers needed to deal with a shortage of emergency workers.

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