The IBM Ruling: Could the State Have Avoided a Potential $1 Billion Problem?

The state’s budget outlook just got significantly cloudier with a July ruling by the Michigan Supreme Court that the state must refund to the IBM Corporation around $4.7 million in Michigan Business Tax (MBT) payments made in 2008. The court agreed with IBM that the corporation had the legal authority to calculate its liability under the MBT using a three-factor formula as allowed for within the state’s Multistate Tax Compact Act.

Compared to a $53 billion state budget, $4.7 million is little more than a rounding error. However, IBM is not the only out-of-state corporation standing in line for a refund. According to court documents, the state is involved in 134 other open cases regarding this same issue and acknowledges the potential for many other claims. Extrapolating the IBM settlement to a few other multistate corporations easily gets us to a number that represents a very significant one-time hit to the state budget. The Department of Treasury’s Office of Revenue and Tax Analysis currently estimates the potential revenue impact on the state to be around $1.1 billion plus interest.

However, the state has appealed to the Supreme Court to rehear the case, a request that is still pending. A review of the legislative history of the related legislation, however, raises another question: Could the Legislature have avoided this problem altogether back in 2011? It appears an 11th-hour language change may have contributed to the current problem.

Background on Tax Apportionment: the MBT and the Multistate Tax Compact
In 2008, the state legislature made sweeping changes to Michigan’s system of business taxation by replacing the often-criticized Single Business Tax with a new Michigan Business Tax, which itself was composed of separate taxes on both business income and on gross receipts.

All forms of state business taxation have to deal with an important question: How should tax liability be allocated to a firm that operates across many states? For instance, IBM is an international corporation with both physical offices and product sales spread across the globe. What portion of their business activity should be subject to taxes in Michigan? Typically, this question is addressed through the establishment of an “apportionment” formula contained in state law.

The new Michigan Business Tax created its own apportionment formula. Businesses were required under the new law to apportion both their income and gross receipts to Michigan based on a single factor: their gross sales within Michigan. So, if 10 percent of a firm’s gross sales were within Michigan, 10 percent of their income and gross receipts were to be apportioned to Michigan for the purposes of paying the MBT.

However, while enacting the MBT changes in 2008, the legislature made no changes to another state law relevant to business taxation – the Multistate Tax Compact (MTC) Act. Michigan established the MTC Act in 1969 as part of a joint effort by states to coordinate their tax policies and fend off federal efforts to preempt some state control over business tax provisions that were the subject of debate at that time. Michigan is one of 16 states and the District of Columbia that are currently members of the compact – all of these jurisdictions having enacted a MTC Act into their state laws.

Significantly, the MTC Act has its own provision regarding apportionment. The act allows multi-state firms that operate in two or more compact states to elect, at the firm’s discretion, to apportion any “income tax” imposed by the state according to a three-factor apportionment that includes sales, property, and payroll. Clearly, this holds an advantage over the sales-only approach of the MBT to any firm that sells in Michigan but does not retain a significant business presence in terms of offices, equipment, and employees.

This advantage was not lost on IBM as the corporation in 2008 asserted its authority under the MTC Act to apportion its income and gross receipts using the three-factor approach rather than the MBT Act’s sales-only approach when it filed its first MBT return. The Michigan Department of Treasury, however, rejected IBM’s election, asserting that the newly enacted MBT Act precluded the firm from this option by specifically requiring the one-factor method under the MBT. This dispute precipitated the court action on which the Supreme Court issued its July ruling.

Michigan Supreme Court’s Finding: IBM Prevails
After losing in the lower courts, IBM’s contention prevailed before Michigan’s Supreme Court. In a split 4-3 ruling, the court agreed that both the income and gross receipts components of the MBT represented an “income tax” subject to the apportionment option under the state’s MTC Act and that the elective three-factor apportionment was available to IBM. The lead opinion in the case rejected the state’s arguments that the strict one-factor apportionment language contained in the MBT Act effectively repealed the MTC’s apportionment provisions by implication.

The swing vote in the court’s decision was Justice Brian Zahra. In a separate concurring opinion, Justice Zahra indicated the question of whether the new MBT law repealed the MTC’s elective apportionment provision was “a very close question” but one that he did not have to reach. His opinion was based specifically on actions taken by the legislature in 2011 when the Michigan Business Tax itself was repealed and replaced by the state’s new Corporate Income Tax – part of major tax restructuring that also involved changes to the treatment of pension and retirement income under the state’s Personal Income Tax.

As part of that package, changes were made to the MTC Act to eliminate the three-factor apportionment option for businesses subject to either the MBT or the new Corporate Income Tax. However, the legislation did not apply this change retroactively. Instead, it specifically eliminated the option “beginning January 1, 2011”. Justice Zahra’s opinion points to that language from Article III of the MTC Act:

“…except that beginning January 1, 2011 any taxpayer subject to the Michigan business tax act, 2007 PA 36, MCL 208.1101 to 208.1601, or the income tax act of 1967, 1967 PA 281, MCL 206.1 to 206.697, shall, for purposes of that act, apportion and allocate in accordance with the provisions of that act and shall not apportion or allocate in accordance with article IV.” (Emphasis added)

Thus, the inclusion of this date in the MTC Act appears to have played a very significant role in Justice Zahra’s legal thinking on the matter. In effect, he states the legislature intended to create a window from the initiation of the MBT in tax year 2008 through tax year 2010 during which the election provision would still apply; otherwise, the legislature would not have included this specific starting date.

But, what prompted the legislature to include the date? That’s not clear. What is clear is that this date was added very late in the legislative process. House Bill 4479 was introduced on March 23, 2011, was reported from the House Tax Policy Committee on April 27, and was passed by the Michigan House on April 28. At no time during the House’s consideration of the bill did Article III include the date reference pointed to in the court opinions. The bill moved to the Senate and was reported favorably without amendment by the Senate Reforms, Restructuring, and Reinventing Committee on May 12, 2011 – again, with no date reference. Later that same day, during Senate floor deliberations, the Senate adopted a substitute bill, and that substitute was the first instance in which House Bill 4479 contained the January 1, 2011 starting date for the elimination of this tax apportionment option. Neither the analysis of the bill nor the record of the debate elaborate on the rationale for this new language. Shortly thereafter, the bill was passed by the Senate. It was then re-transmitted to the House, where it was concurred in on the same day. The bill was enrolled, and Governor Snyder signed it into law on May 25, 2011.

Is there a remedy?
Attorney General Bill Schuette has already filed a motion with the Supreme Court to stay the July 14 decision and to grant a re-hearing of the case, citing the potentially significant revenue implications. In the meantime, the legislature is pondering its own next steps.

Media reports suggest the legislature may move to undo what the legislature did in 2011 and strip away the January 1, 2011 starting date on the statutory elimination of the elective apportionment provision in the MTC Act. That would appear to address a key concern of Justice Zahra, perhaps in a manner which would cause him to rule in favor of the state in a future hearing on this issue. Still, his opinion called the broader question of whether the new apportionment language of the MBT Act implied a repeal of the MTC provisions a “very close” – but not a settled – question.

Even if this legislative fix succeeded with the Michigan Supreme Court, it may not put an end to the legal wranglings. The California Court of Appeals in a similar case involving the Gillette Corporation found that the Multistate Tax Compact represented a binding contract to states; in their opinion, only a withdrawal from the compact would negate issues such as the MTC’s apportionment option. That case is now pending before California’s Supreme Court. So, in the end, a favorable decision for the state by the Michigan Supreme Court on re-hearing may simply move the question into the federal courts.

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Why Obesity is Michigan’s Problem

The scales have tipped and Michigan can no longer afford to ignore its costly weight problem.  With nearly one in every three adults classified as obese, Michigan is one of the heaviest states in the nation.   The primary cost of obesity is higher medical spending: research has shown that obesity accounts for roughly 10 percent of medical expenditures in the state.  Other research shows that average annual medical costs for a severely obese individual are nearly twice that of a healthy weight individual.  Obesity is especially costly to the state’s Medicaid program where obesity is more prevalent than among enrollees of other types of insurance.

Obesity also adds costs to employers through higher health, disability, and life insurance premiums, more employee absences, and reduced employee productivity when employees are present.  A 2002 study calculated that physical inactivity, a risk factor for obesity, results in 20 days of lost work annually, costing Michigan employers $8.7 million.  Obesity also limits the number of people who are physically able to serve in the military, police and fire positions, and jobs requiring manual labor.

Roughly 15 percent of Michigan’s children are classified as obese, putting them on target to add to the obesity problem when they reach adulthood.  Childhood obesity comes with its own set of problems.  Obese children miss more days of school, have higher dropout rates, and are more likely to complete fewer total grades in school.  Obesity among children as young as two and three years old is associated with lower functioning in verbal, social, and motor skills.

While problems related to this excess weight are shared by all Michigan residents, the problem itself is not evenly distributed across the state.  Some counties, namely Washtenaw and Ottawa, have below average rates of obesity; only one-quarter of their residents are obese.  Conversely, nearly 40 percent of Saginaw County’s residents are obese.

What is driving obesity and what should be done to fix it are certainly interrelated but neither the cause nor the solution are clear.  Starting in early childhood, child care facilities in Michigan are not required to provide physical activity opportunities to children in their care and only some child care facilities are subject to nutrition rules.  When children enter school, they are required to receive health and physical education, but the content, frequency, and quality of these courses is not specified and therefore varies across the state.  It isn’t until high school that state policymakers have set minimum time requirements for physical education, though the standards are below federal recommendations.  Additionally, most schools, but not all, are required to adhere to federal nutrition standards for school meals, and those that do not contribute to varying access to nutritious foods.

In adulthood and for families, low access to grocery stores that carry a variety of fruits and vegetables is a problem in some of Michigan’s urban and rural areas.  More children and adults are consuming excess calories from sugar-sweetened beverages such as soda and many of Michigan’s communities were not designed for active transportation such as biking and walking, reducing opportunities for residents to engage in physical activity.

In a recently released paper, the Citizens Research Council of Michigan has considered these risk factors and identified roughly a dozen potential policy actions that could be implemented at the school, state, and local levels of government to reverse this course.  Instituting required comprehensive physical and health education programs that meet federal recommendations, increasing state-level public health funding, mandating nutrition and activity standards for all child care facilities, helping to make fruits and vegetables more accessible and affordable, and focusing resources on community-level programs that can better target specific obesity risk factors are all solutions that have proven to be effective in preventing and, in some cases, reducing obesity.  Obesity is not a problem that only impacts 31 percent of the Michigan’s population; it impacts every child, family, and business, and is too costly to ignore.

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Huh? Why am I Voting to Modernize the Tax System?

“What is Proposal 14-1 and why am I voting to modernize the tax system?”  This might be the response many voters have when they enter the voting booth at the August 5 primary election and confront the one and only statewide ballot question.  While a number of voters will prepare in advance by reviewing the actual ballot language and/or consulting CRC’s impartial summary of the proposal, others will be seeing the language for the first time on August 5.  For voters reading the ballot language for the first time, it may be difficult to understand; and for some, it may be downright confusing.

Part of the reason for this confusion lies in the unusual method by which the question is appearing on the ballot.  The vote serves two distinct purposes; it is the result of a unique combination of 1) the constitutional requirement to get voter approval of a new local tax, and 2) the legislature’s decision to subject a recently passed law to a vote of the people.  While legislative referenda have occurred in the past, they are extremely rare.  Voter approval of new or increased local taxes occurs frequently at the city, township, and school level; however, Proposal 14-1 represents the first time a statewide vote is required to authorize such a local tax.  Below is an explanation of the “why” associated with the question posed above.  For a detailed explanation of the substance, or the “what,” behind Proposal 14-1, read CRC’s analysis of Proposal 14-1.

Two Reasons Why a Vote is Required

There are two reasons why voters are being asked to vote on Proposal 14-1.  First, the vote is required because of a tax limitation contained in the state constitution.  Article IX, Section 31 of the Michigan Constitution requires that any new local tax, or increase to an existing tax, first gain approval from the voters.  Section 31 is part of the 1978 Headlee Amendment to the Michigan Constitution and since its adoption, local votes to approve new taxes or increased taxes have been commonplace for local governments, such as cities, townships, schools, etc.  However, because of the way the legislature has proposed to modify the state use tax, Proposal 14-1 represents a first-of-its-kind Headlee vote; it is a statewide vote to authorize a local tax.

Public Act 80 is one piece of a package of laws enacted in 2012 and 2014 that is designed to provide substantial personal property tax relief to Michigan businesses.  Specifically, Public Act 80 redirects a portion of the state’s current use tax to create a new local tax (note: the combined rate of the two taxes will not exceed the current 6 percent rate), the proceeds of which would be used to reimburse local governments for lost personal property tax revenues.  The conversion of a portion of the existing state use tax to a new local tax must comport with the Section 31 constitutional provisions of the Headlee Amendment that require voter approval.

The second reason for the statewide vote is because the legislature has asked the people of the State of Michigan to approve legislation it recently passed.  Without this approval, the legislation will not take effect.  Article IV, Section 34 of the Michigan Constitution permits the legislature to ask voters to approve legislation via such a referendum.   While the legislature could have enacted personal property tax reforms on its own, it has asked voters to weigh in.

Specifically, Proposal 14-1 is a legislative referendum on Public Act 80; however, because the other pieces of legislation needed to implement the personal property tax reforms are “tie-barred” to Public Act 80, the public vote on Public Act 80 effectively serves as a referendum on the entire package of personal property tax reforms.  In a nutshell, the legislature is asking voters, via the legislative referendum, to decide the ultimate fate of the 2012/2014 personal property tax reforms.  A “yes” vote would enact the package of tax reforms, while a “no” vote would reject all the tax reforms.

Although legislative referenda are allowed by the 1963 Constitution, they are a rare occurrence.  Since the adoption of the Constitution, electors have been asked to vote on specific legislation only on 13 occurrences; however, in all but three of the occurrences, voter approval was requested for the state government to issue general obligation long term debt.  The issuance of debt is something for which the drafters of the 1963 Constitution thought voters should have a direct say and therefore they required a public vote (Article IX, Section 15).  The three previous legislative referenda not dealing with state debt asked voters to approve 1) a proposed income tax rate increase (1980), 2) proposed revisions to public utility rate procedures (1982), and 3) granting exclusive authority for hunting regulations to the Natural Resources Commission.

The Result:  Confusing Language

Many people have pointed out that the ballot language (see below) is complex and confusing.  This stems, in part, from the fact that the subject material is technical in nature and difficult to comprehend.  Another reason for this is because the legislature decided to prescribe the specific ballot question language to be used, bypassing the normal process for crafting language.  While nothing in state law prohibits the legislature from doing so, the legislature did not offer precise ballot language for the previous three legislative referenda that did not deal with debt issuance.  Instead, in each case, the legislature allowed the language to be drafted through the standard process spelled out in state law regarding proposed amendments to the state constitution or special questions.

Both the Michigan Constitution and the Michigan Election Law (PA 116 of 1954) contain provisions related to the processes, criteria, duties, and responsibilities associated with the development of ballot question language, both for constitutional amendments and special questions such as Proposal 14-1.  The Secretary of State is the agent normally responsible for drafting ballot question language.  Article XII, Section 2 of the Constitution requires that questions pertaining to proposed constitutional amendments be described in not more than 100 words and “consist of a true and impartial statement of the purpose of the amendment.”  Further, Section 485 of the Michigan Election Law states, “The question shall be clearly written using words that have a common everyday meaning to the general public.  The language used shall not create prejudice for or against the issue or proposal.”

While the proposal is not a constitutional amendment but rather a special question, the legislature attended to the 100-word limit for constitutional amendment questions when it drafted the Proposal 14-1 language.  However, the drafters seem to have paid less attention to the other provisions of the law.  For example, the proposal does not mention the main topic of the tax changes, specifically the personal property tax reforms that are at the center of the package of laws tied to the referendum on Public Act 80.  While the language discusses the state use tax changes contemplated, it contains nothing about how the personal property tax would be affected.

Also, one phrase in the language could be interpreted to advocate for passage of the proposal, “. . . modernizing the tax system to help small business grow and create jobs in Michigan.”  Further, some people have pointed out that this phrase is not entirely clear and vague.  It is not clear the phrase comports with the “common everyday meaning” requirement of state law.

Additionally, the language does not make it clear that this is a Headlee vote pursuant to the Michigan Constitution.  While the language mentions that the proposal would “reduce” a state tax and “replace” it with a local share of the same tax, it does not reference the constitutional requirement that such a conversion must be approved by the voters.

Finally, the language states that there is a constitutional 6 percent cap on the state use tax.  This is incorrect.  While there is such a cap on the state sales tax, the use tax is a different tax and no such cap exists.  Both taxes consist of two separate pieces; constitutional rates and a statutory rates.  The sales tax is comprised of a 4 percent rate, which is established in law within the confines of a 4 percent limitation placed in the Michigan Constitution (Article IX, Section 8), and a 2 percent rate added as part of the Proposal A school finance reforms in 1994.  The Constitution states that the additional 2 percent tax “shall be imposed.”  Thus, the legislature must impose a sales tax at a rate at least equal to 2 percent, but no more than 6 percent under the Constitution.

The use tax is comprised of a statutory 4 percent rate, and, similar to the sales tax, a constitutional 2 percent rate.  While the total use tax rate is currently set at 6 percent to mirror the sales tax, there is no maximum cap on the tax rate like there is for the sales tax.  The 2 percent use tax rate was added as part of Proposal A and must be levied by the legislature.  The Use Tax Act (Public Act 94 of 1937) authorizes the additional 4 percent rate, but the legislature could increase this without violating the Constitution.

Summary

Through Proposal 14-1, voters are being asked to approve major tax policy changes for the entire state.  This proposal is on the ballot because the legislature, while within its authority to enact these changes on its own, has deferred responsibility for such statutory changes to the citizens of Michigan through a legislative referendum.  The proposal also serves a second purpose.  Ultimately, voters must approve, or reject, new local taxes as required under the Headlee Amendment to the Michigan Constitution and the new use tax will be levied and revenues distributed by a special authority created as a unit of local government.  The 1963 Constitution provides citizens with avenues for direct democracy (e.g., initiative and referendum) and the ability to control the size of government through certain tax limitations (e.g., Headlee Amendment).  Proposal 14-1 encapsulates a rare opportunity for voters to do both at the same time; however, the ballot language is likely to confuse many voters.  This confusion stems, in part, from the complex nature of the subject material but also because the legislature drafted specific language instead of allowing the Secretary of State to draft the language as has happened with all other statewide ballot questions.

PROPOSAL 14-1

APPROVAL OR DISAPPROVAL OF AMENDATORY ACT TO REDUCE STATE USE TAX AND REPLACE WITH A LOCAL COMMUNITY STABILIZATION SHARE TO MODERNIZE THE TAX SYSTEM TO HELP SMALL BUSINESSES GROW AND CREATE JOBS

The amendatory act adopted by the Legislature would:

1. Reduce the state use tax and replace with a local community stabilization share of the tax for the purpose of modernizing the tax system to help small businesses grow and create jobs in Michigan.

2. Require Local Community Stabilization Authority to provide revenue to local governments dedicated for local purposes, including police safety, fire protection, and ambulance emergency services.

3. Increase portion of state use tax dedicated for aid to local school districts.

4. Prohibit Authority from increasing taxes.

5. Prohibit total use tax rate from exceeding existing constitutional 6% limitation.

Should this law be approved?

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Student Assessment Merry-Go-Round

Deliberations between members of the Michigan Legislature and officials from the Michigan Department of Education (MDE) over the future of student assessments, including the decision about which specific test to administer next year, have reached somewhat of a boiling point in recent days.  The ongoing debate about MDE’s plans to implement new state assessments aligned with the Common Core State Standards (adopted by the state in 2010) has led some lawmakers to call for a fundamental shift in the responsibility for administering these assessments by transferring authority out of MDE.

Interest in the administrative organization of state education functions is not new.  The current legislative proposal can be seen as another installment in a much longer running discussion about education governance and functions.  Our 2003 report, Organization of State of Michigan Education Functions, explored some of the issues currently being debated and recommended that, with respect to K-12 education functions handled by the state, accountability and efficiency are best served when certification/accreditation, evaluation, and curriculum leadership and development are housed within the same organizational structure.  While other policy goals may be achieved if these functions are organizationally separated, some degree of accountability and/or efficiency is likely to be sacrificed.

Background

The crux of the current debate and apparent stalemate between lawmakers and MDE over student assessments lies in the state’s governance structure of K-12 education and its basic organization of education functions.  Although K-12 education is delivered by local school districts, state level officials provide policy direction, determine funding, and exercise oversight.  Michigan’s system entrusts the legislature, the Governor, the State Board of Education, and the Superintendent of Public Instruction with different, but sometimes overlapping, roles and responsibilities.  The potential for disagreement among these actors in carrying out their duties has its roots in the organizational structures established in the 1963 Michigan Constitution.

Many education functions, including student assessments currently, are carried out by MDE, an executive branch department headed by the Superintendent of Public Instruction, a constitutional officer (Article VII, Section 3). Unlike other department heads that are appointed by the Governor, the Superintendent is appointed by the eight-member State Board of Education, which is elected at a statewide election.  The Governor serves on the Board as an ex-officio member without the right to vote.  Michigan is one of seven states where the state board of education is elected and the chief state school officer (Superintendent in Michigan’s case) is appointed by the board.  Under this arrangement, the Superintendent does not directly report to the Governor, but instead is tasked with carrying out the policy directives established by the Board.

The legislature plays an important role too.  While Section 3 grants MDE constitutional status, its powers and duties are to be provided by law.  The current proposal to transfer assessment functions to the Department of Treasury is contemplated in amendments to the Revised School Code (House Bill 5581).

It is worth noting that the Governor, through his executive branch reorganization powers (Article V, Section 2), also can effect changes to MDE’s responsibilities.  In fact, between 1993 and 2001, Governor Engler invoked these powers numerous times to remove primary responsibility for various educational functions from MDE and move those functions to other state agencies.

Recommendations for Organizing Education Functions

CRC’s 2003 report, Organization of State of Michigan Education Functions, examined the organization of state education functions and made a number of reorganization recommendations.  This report was requested by the Superintendent of Public Instruction.  At the time, various K-12 education functions were not housed at MDE, but scattered throughout the executive branch in a number of state departments.  This disorganization of education functions was the result of a period of intense efforts by Governor Engler throughout the 1990s to shrink the role of MDE.  Of particular note, the report argued that the administration of student assessment functions should be returned to MDE from the Department of Treasury.  This recommendation remains relevant today.

In making our recommendations for reorganizational changes, we opined that justification for any change in government organization should be premised on two principles, efficiency and accountability.  We reasoned that changes to educational functions should provide an opportunity to improve efficiency, increase accountability, or both.  We also made it clear that changes must comport with existing constitutional provisions, as these represent the will of the people.  Our recommendations were informed by other states’ organizational structures, but cautioned that each state’s situation is unique.

With respect to assessment functions strewn about state government, the report argued that locating education-related functions in the MDE improves accountability and efficiency by grouping like functions together where they can be more readily coordinated and where a single entity can be held responsible.  Specifically, we called for the creation of the Office of Standards, Assessment and Accreditation Services under the MDE Chief Academic Officer to align the responsibilities for three functions: certification, evaluation, and curriculum leadership.  Further, we argued that this office should be in charge of all educational (non-financial) aspects of the MEAP.

We recommended that assessment functions housed within Treasury be transferred back to MDE.  Administration of student assessments requires staff with educational development, test development, and other skill sets conducive to measuring the educational progress of children.  MDE, not Treasury, staff possessed these skills.  We found that this recommendation would align with the experience in other states.  At the time, of the 31 other states examined, primary responsibility for devising and administering statewide assessment programs was universally housed within state departments of education.  Compared to these other states, Michigan was an outlier.  It was the only state where primary responsibility for assessments was located outside the education department.

In 2003, Governor Granholm acted on our recommendations and issued an executive order (EO 2003-20) to return assessment administration to MDE under the direction of the Superintendent of Public Instruction.

Conclusion

Legislators and MDE agree that the current iteration of state assessments, the MEAP, is not aligned to the Common Core State Standards and that a replacement is needed.   There is very little agreement, however, about what should replace the MEAP.  Whether the replacement will be the Smarter Balanced assessment that the MDE has been working towards, a re-vamped MEAP, or some other assessment is presently unknown.  One thing is clear; the policy debate in Lansing about the future of student assessments has hit a stalemate and the state needs a new test for next spring to comply with its current waiver from the federal No Child Left Behind law.  Some lawmakers would like to break the logjam and achieve their policy goals by moving control of state assessment functions away from MDE and place it in the hands of the Department of Treasury.  While this proposed solution may serve as an expeditious policy response and meet other priorities, it most likely would come at a cost of less efficiency and accountability in carrying out state education functions.

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May Revenue Estimates: Downward Revisions Create New Budget Challenges, but Growth Continues

New revenue estimates from state economists are likely to make things much tougher for lawmakers as they attempt to wrap up deliberations on the state’s FY2015 budget.   The annual Consensus Revenue Estimating Conference was held in the Capitol yesterday, and economists from the Department of Treasury and the legislative fiscal agencies agreed on revised revenue forecasts which are down significantly from their previous estimates in January.   However, while most press accounts have highlighted the downward revenue revisions, there was a silver lining as well: revenue growth is expected to continue to be healthy over the forecast period.

The January forecasts lead to headlines about expectations of a $1 billion state surplus.  Unfortunately, as shown in the table below, the new estimates will offset much of those projected gains.

Consensus May 2014

State general fund/general purpose (GF/GP) revenues – essentially the state’s base of discretionary revenues that drive budget decision-making – are now forecast to be $253 million lower than expected in the fiscal year that ends September 30.   Further, these revenues are estimated to be $221 million and $290 million lower than expected in FY2015 and FY2016, respectively.   Estimates of the amount of tax revenues deposited into the School Aid Fund – the state’s second major fund which is the backbone of K-12 education financing – are down $64 million from earlier estimates in the current fiscal year and down by close to $80 million in each of the two following years.

However, while the results of the revenue estimating conference will make matters more difficult for state policymakers as they attempt to wrap up FY2015 budget deliberations, the one positive that comes out of the conference is that future revenue growth remains strong.  The revenue revisions are largely due to adjustments to income tax projections tied to investors’ responses to proposed tax changes that were part of the federal “fiscal cliff” deliberations back in 2012.  After making this one-time adjustment, annual revenue growth is still anticipated to be in the neighborhood of 4 to 5 percent for the general fund and just over 3 percent for the School Aid Fund, consistent with the growth rates projected in January.

Adjusting the Budget to Reflect Revenues

That, however, won’t take the sting out of the budget adjustments that will be necessary to bring things back into balance for FY2015.   As lawmakers in Lansing attempt to conclude their deliberations on the FY2015 budget, the revisions create a new GF/GP budget hole for FY2015 that lawmakers will need to address.

The lower-than-expected revenues won’t pose an immediate problem for the FY2014 budget year that ends in September.   A $1.2 billion GF/GP balance coming into FY2014 will provide a buffer.   That balance was expected to decline to around $600 million by the end of FY2014 even before these revenue revisions.   Now, with lower revenues, current year spending will eat away a little further on this balance, with the year-end balance falling into the $350 to $400 million range depending on final state spending figures for the current year.

But that leaves less revenue to carry into FY2015, and this is where the new budget challenges begin.   Both the House and Senate have already passed their budgets based on the earlier revenue estimates.   Now, the FY2015 budget takes two hits based on these new estimates: (1) a loss of around $200-250 million in the state’s GF/GP “bank account” coming into the new fiscal year; and (2) the loss of $221 million in anticipated revenue for FY2015.   That means revenue resources for FY2015 are suddenly down by over $400 million.

CRC estimates that the GF/GP appropriations contained in House and Senate bills exceed available revenues for FY2015 by somewhere around $350 million – equivalent to roughly 3.5 percent of those totals.  That means some combination of difficult choices for lawmakers, including:

    • Raising revenues – Never popular in an election year, but an option nonetheless.   Among the options, a package of Senate bills to reinstate a use tax levy on Medicaid managed care organizations is currently before the House and would generate more than $150 million in additional net GF/GP revenue as well as over $190 million in new revenue for the School Aid Fund.
    • Cutting spending – The House budget exceeds the Governor’s original proposal by $115 million; the Senate budget is $92 million above the Governor’s proposal.   Lawmakers may need to give back some of these budget enhancements.  On the House side, however, that increase above the Governor’s proposed budget is driven largely by new GF/GP road funding.
    • Using “Rainy Day” revenues – The state’s Budget Stabilization Fund balance currently sits at $508 million with an additional $75 million deposit planned for the current year.   Both the House and Senate FY2015 budgets contain additional pay-ins of $100 million.  Eliminating (or reducing) these new deposits would free up revenue to address the looming shortfall.   However, with the potential for $192 million of the existing BSF balance being used as part of the Detroit bankruptcy deal, this would mean at least pausing the recent trend of building up rainy day reserves.

Next Steps

Legislative leaders are likely meeting even today to work out a “target agreement” for the state budget – essentially a road map for each budget subcommittee which sets a limit on GF/GP funding for each department.   If the Legislature is to meet it’s goal of completing the budget by June 1, that agreement will need to be completed soon, and it will tell the story as to how policymakers have decided to tackle this new budget hole.

Stay tuned.

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Charterized School District Needs State Loan to Avoid Mid-Year Deficit

UPDATED:  May 7, 2014 (see below)

It appears that a state-appointed emergency manager and private management of an academically and financially struggling school district has not been the answer in the Muskegon Heights community.  The chronically ailing school system will need additional financial resources in the form of an emergency state loan to remain open for the rest of the 2013-14 school year and repay its management company for services already rendered.  This new episode for the Muskegon Heights education community raises issues about the structure of Michigan’s school finance system, the operational and academic difficulties involved with managing declining student enrollment, and the policy options available to the state to deal with failing school districts.

In 2012, the Muskegon Heights School District emergency manager simultaneously converted the entire district into a charter school district (Muskegon Heights Public School Academy System).  The emergency manager selected Mosaica Education, Inc., a for-profit education service provider, to operate all four schools of the former Muskegon Heights Public School District.  The original public school district in Muskegon Heights remains in existence solely for the purpose of collecting a dedicated local school operating millage, which is used to eliminate the outstanding deficit and legacy costs of the former district instead of financing the local share of the district’s per-pupil foundation allowance.  Under this arrangement, the revenue from the local tax is replaced, dollar-for-dollar, with funds from the School Aid Fund such that state dollars finance 100 percent of the district’s foundation allowance.

On April 28 of this year, the Muskegon Heights School District received a $1.4 million emergency loan from the State of Michigan to avoid the possible mid-year closure of the Muskegon Heights Public School Academy System and to avoid a projected year-end operating deficit.  At the same time that the loan was approved, the emergency manager terminated the 5-year operating agreement with Mosaica Education, Inc., two years early.  As a result, students of the charter district will experience their second educational transition (i.e., new personnel, new curriculum, etc.) in the last two years.

The new loan represents the third emergency loan made to the financially and academically struggling school district in less than two years.  The first two were made to settle the district’s $12 million accumulated deficit and allow the new charter school district to start with a “clean slate.”  The recent loan is the first emergency loan effectively made to help balance the books of a charter school.  All previous loans were made to traditional public school districts.  Emergency loans to Muskegon Heights now claims over 25 percent of the maximum amount of loans ($50 million) allowed under state law.

Financial problems are not new for the charter school district.  The district ended its first year in operation (2012-13 school year) with a $500,000 deficit in its capital projects fund.  This year, despite receiving two advances totaling more than $400,000 earlier in April, it became clear in late April that the Muskegon Heights Public School Academy System would be unable to correct its finances to avoid ending the 2013-14 year with a general fund deficit.  The prospect of closing early or not being able to pay employees necessitated the new $1.4 million emergency operating loan.

One look at the district’s approved budgets for 2013-14 provides a clear indication of a major cause of the continued financial bleeding.  Even before being charterized, the district was plagued by constant annual student enrollment declines (i.e., enrollment declined by 273 students, or 15 percent, between 2007-08 and 2011-12) as students and families sought different educational options.  Michigan’s school finance system ensures that money follows the student; as Muskegon Heights students left for other schools they took their funding with them.  For years, the district was unable to keep up with the annual revenue reductions and shed costs fast enough.  As a result, the district was constantly operating in the red and had an accumulated general fund deficit of $12 million as of June 30, 2012, before being turned over to the emergency manager.

The declining enrollment trend continued under the emergency manager’s watch, but his original budget did not reflect this reality (and the amended budget does not either).  The district had 1,130 students in the 2012-13 school year.  This year, enrollment fell to 902 students, 20 percent lower.  More important to the current situation is the fact that the original spending plan for the current year was based on increase of 198 students for a total enrollment of 1,328 students.  Missing the enrollment estimate by this much (426 students) directly translated into a discrepancy in state revenue equal to nearly $3 million (based on $7,168 per pupil), requiring a budget adjustment in December of 2013 for the current year, six months into the fiscal year.  Effecting the appropriation reductions of this magnitude necessary to balance the budget, in a condensed time period, was deemed nearly impossible.

The Local Financial Stability and Choice Act (Public Act 436) requires that an emergency manager conduct “all aspects of the operations of the local government within the resources available. . .” The new emergency loan signals that the Muskegon Heights emergency manager is unable to manage the district within the resources available to him.  In light of the broader discussion of school finance statewide, this situation raises very important public policy questions.  If an emergency manager is unable to manage the affairs of the school district in accordance with the mandates of state law and within the resources available, should we expect the same of all other school districts?  Should all school districts be afforded the additional resources available to the Muskegon Heights emergency manager to help them with their finances?

As with the previous $11 million in loans made to the district, the cost of bailing out the charter school district this year will be spread across all other districts in the state.  The loan will be repaid over the next 30 years by diverting the local 18-mill property tax that is intended to finance the district’s per-pupil foundation grant.  Because these funds will be used to repay the loan, the state School Aid Fund will be responsible for covering the full amount of the foundation grant obligations.  As a result, there will be $1.4 million fewer state resources to share with other districts, including those that are financially struggling.

The academic and financial problems in the Muskegon Heights school district are not new.  Many had tried to address these problems and did not succeed.  Now, the emergency manager and his hand-picked educational service provider, while able to slightly improve the learning culture and academic performance in the district over the last two years, have been unable to fix the district’s finances.  It appears that the emergency manager was unable to address a key driver of the financial problem; declining student enrollment.  It is likely that until the manager can stabilize the loss of students, deficits will continue and additional emergency loans required.  Unfortunately, the Muskegon Heights school district is not alone; many more districts are finding it increasingly difficult to effectively manage through the fiscal effects of persistent declining enrollment.

May 7, 2014 UPDATE

At the time of posting (April 30), CRC did not have the documentation related to the $1.4 million emergency loan made on April 24.  According to the information provided by the State of Michigan and received on May 7, the $1.4 million loan will accrue interest over a 30-year period at the rate of 3.45%.  Based on the term and interest rate, the total cost of repaying the loan (principal and interest) will be $2.5 million.  Therefore, the State School Aid Fund will be shorted a total of $2.5 million (not $1.4 million cited in the original post) as the 18-mill local school operating tax is used to repay the loan and not finance the per-pupil foundation allowance.

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Taxpayer Bill for Dissolved School District Grows

New information recently made public reveals the extent of the decades long financial problems that plagued the Buena Vista school district and that, as a result of state policy, will be passed to all taxpayers to rectify.  The district, along with the Inkster school district, was dissolved in July 2013 under a new law when the state determined that the district was no longer “financially viable.”  We now know that the district’s accumulated debt is larger than originally anticipated, the taxpayer cost of repaying the debt is greater, and the time it will take to pay off the debt is longer.

The completed 2012-13 financial audit for the Buena Vista school district was recently sent to the State of Michigan.  Nearly all other school districts submitted their audits by mid November 2013, as required by state law.  It took the Saginaw Intermediate School District (ISD) and the private accountants working with the ISD quite a bit longer to sort through, organize, and make sense of the incomplete financial records of the school district.  The audit provides a clearer picture of the final taxpayer bill associated with shuttering the 432-student district that experienced years of declining enrollment, mismanagement, and financial challenges.  Specifically, it reveals that the bill for repaying Buena Vista’s debts will be nearly ($4.0 million), approximately $1.0 more than originally projected.  Because of the way that the new state policy for school dissolutions works, these costs will be borne directly by other school districts in the state through decreased allocations from the State School Aid Fund over the next three years.

CRC analyzed the new state law allowing for school district dissolutions and discussed the specifics of the Buena Vista case in a December 2013 report.  In that report, CRC highlighted some of the problems created by the law itself and cautioned lawmakers to weigh carefully a number of issues before deciding to pursue another school dissolution.  One key aspect of the law allows an existing 18-mill, locally levied school operating tax to be used to repay school debts instead of being used to fund the per-pupil grants of former Buena Vista students.  Instead, these students’ grants will be financed entirely by state funds.  The Buena Vista district remains in existence solely as a taxing entity until the debts are repaid.  The practical effect of this provision is that fewer dollars are available to all other school districts from the School Aid Fund; the provision effectively socializes the costs of repaying a dissolved district’s debts.  Without dissolution, the district would have been forced to repay its debts from the resources it annually receives from the state, likely over a number of years.

The specifics of the Buena Vista case and the authorization to levy the debt repayment tax is another issue raised with the new law.  Currently, the 18-mill tax levied on nonhomestead (primarily business) property is authorized through 2015, meaning that both the 2014 and 2015 levies will be used to repay district debts (estimated $3.2 million).  Initially, it was estimated that the two levies would be sufficient to satisfy the total outstanding debt; however, it now appears that the tax will fall short, by about $800,000, of the $4.0 million required to repay all district debts.  By law, the Saginaw ISD will be required to ask voters in the geographic area of the former Buena Vista school district to renew the tax, or part of it, for another year to generate the needed funds to fully satisfy the district’s debts.  If the voters do not approve to renew the tax, it is unclear how the remaining debt obligation will be satisfied.

While the audit revealed the extent of the debt the Buena Vista school district accumulated, the state recently acknowledged that there will be additional costs associated with handling district property that was transferred to other school districts as part of the dissolution.  Early this month, the state legislature approved a $5 million appropriation from the School Aid Fund to help other districts with the costs of building maintenance, utility bills, insurance, and security associated with former Buena Vista capital stock.  This cost also will come at the expense of reduced state allocations to all other districts.

The completed 2012-13 audit of the Buena Vista school district reveals that the district’s finances were in more disarray than originally thought and that it will take longer to repay the district’s outstanding debts.  What has not changed with the publication of the audit is the fact that other school districts will be responsible for footing this larger bill; the state will have $9 million less in School Aid Fund dollars to allocate across all other school districts in the state.   Policymakers and others should recognize where the costs and benefits of the state’s school dissolution policy lie.  The benefits, to the degree there are any, are entirely localized; district debts are repaid and former Buena Vista students receive their public education from “better” school districts.  However, the costs of dissolving the district and repaying its debts are spread across all other districts in the state.

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Dissolve Local School Districts with Care

Reflecting on the recent dissolutions of the Buena Vista and Inkster public school districts, the Detroit News cautions state officials, acting under a new law, to take heed of problems created when the state considers future dissolutions.  These concerns were the subject of  CRC’s recent report, School District Dissolutions, and highlighted in the Detroit News’ opinion piece.  The paper recommends that the state should proceed with caution and reserve the new law’s authority for extreme emergencies only.

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“Re-voting” on Michigan’s Medicaid Expansion: What’s Behind the Medicaid Budget Shortfall?

With the legislature perhaps only days away from adjourning for 2013, legislative leaders are busy making decisions on final agenda items for the year.   One of the more significant pending matters involves a supplemental appropriation to address a budget shortfall that developed following enactment in August of legislation that expanded Michigan’s Medicaid program.

The issue first came to light in October, when the Department of Community Health (DCH) revealed that the failure to garner immediate effect on the Medicaid expansion legislation created a $70 million shortfall in the FY2014 budget.  A number of news outlets reported that the Legislature would need to “re-vote” on the contentious Medicaid expansion, and some opponents of the expansion suggested that this “re-vote” presented a second opportunity to block the expansion.

With the Senate signaling that action on the supplemental is possible this week, CRC looks at a three key questions related to the vote and what it means (and doesn’t mean) regarding the state’s Medicaid expansion.

Question 1:  What exactly happened?   Why does the Legislature need to vote again in the first place?

After contentious debate in both the House and Senate, the legislature passed House Bill 4714 in late August.   The bill authorized the expansion of Medicaid eligibility to adults less than 65 years of age with annual incomes up to 133% of the federal poverty guidelines.   The expansion is contingent on the eventual approval by the federal government of two waiver requests that would essentially: (a) require the establishment of enrollee cost-sharing account; (b) increase cost-sharing requirements for enrollees with incomes between 100% and 133% of federal poverty guidelines (with offsetting credits for meeting healthy behavior standards); and (c) require these same enrollees to either leave Medicaid and purchase health insurance through the health care exchange or face a further increase in their cost sharing once they have received Medicaid coverage for 48 months.

The bill also made adjustments to the state budget to reflect the Medicaid expansion, including $1.7 billion in new budget authorization to spend the federal funds that will cover the actual costs of the expansion as well as another $192 million in statewide GF/GP savings tied to the expansion.   These savings arise within programs that currently use state dollars to provide medical and mental health services to adults who will now be shifted into federally-funded Medicaid under the expansion.

However, both the federal costs and state savings assumed in the bill were based on 9 months of expanded Medicaid in FY2014 starting this January.   The Senate withheld immediate effect from the bill, which delayed implementation until late March.   With that, both the budgeted costs and assumed savings from the expansion were no longer accurate; thus the need for corrective action.

Question 2:  So, if there’s no “re-vote” or the “re-vote” fails, does that stop the Medicaid expansion?

No.   The actual shortfall in the budget isn’t related to the appropriation of federal dollars to support the Medicaid expansion.   In fact, there’s more than enough money appropriated to take care of the added Medicaid caseload.   With only six months of expanded enrollment during FY2014, total costs of the Medicaid expansion in FY2014 will be smaller than what were anticipated when the bill was passed by the legislature.

So, in an odd twist, the corrective action needed on the budget may well reduce the appropriations to cover Medicaid expansion, effectively eliminating the surplus appropriations that won’t be needed because the Medicaid expansion will be pushed back.  Of the $1.7 billion included in HB 4714 to finance the expansion, CRC calculations suggest that only $1.1 billion will actually be needed.  Fortunately, this surplus isn’t really much of a problem.  If these excess federal appropriations aren’t directly reduced through a supplemental, they’ll simply go unused and lapse at the end of the fiscal year.

The real budget problem isn’t the excess federal appropriation; it is the lost state GF/GP savings from the delayed expansion.   As illustrated in the table below, House Bill 4714 assumed $168 million in net savings within the DCH budget and another $24 million in savings within the Corrections budget.  The bulk of the savings in the DCH budget is related to adults who receive state-funded mental health services, who will now instead be eligible for Medicaid services funded with federal dollars.   Likewise, the costs of off-site medical services for prisoners as well as substance abuse and other health services provided on behalf of parolees exiting the correctional system will now be met using federal funds under Medicaid, reducing GF/GP costs within the Corrections budget.   With only six months of expansion, however, these savings are reduced by $73 million in total according a recent House Fiscal Agency memo.   It is this GF/GP shortfall that must eventually be addressed to put the state budget back into balance.

Medicaid savings 2

But the key fact is this:   Regardless of whether or when any budgetary adjustment is implemented, there is more than enough appropriation authority to facilitate the added spending of federal funds that will be needed to cover the new Medicaid enrollees under the expanded eligibility provisions.

Question 3:  If the Medicaid expansion isn’t at risk, what’s the hurry on “re-voting”?

Strictly from a budgeting standpoint, there is no particular hurry.   The Legislature had added intent language to HB 4714 earmarking the expansion-related GF/GP savings to a new Roads and Risks Reserve Fund to help finance road repairs.   While the reduced savings mean less will be available in the fund, it also means other program cuts won’t be needed in order to fill the budget hole.   In the end, budget adjustments of some form to clear up the GF/GP shortfall are needed prior to the end of the fiscal year.  Technically, action could wait until closer to book closing next fall.

However, from a political perspective, action this year has one important advantage: an immediate effect vote is no longer relevant to passing the budget legislation.   If a supplemental appropriation bill is passed this week without immediate effect, it will still become effective in late March, well before the end of FY2014.   However, if the budget adjustments are implemented next year through an appropriations bill, immediate effect will become necessary once again.   Without it, the supplemental budget act wouldn’t actually become effective until late March 2015, months after state closes its books on FY2014.

If both the House and the Senate are prepared to grant immediate effect to whatever corrective action hits their desks, then the “hurry” goes away.   But if proponents of Medicaid expansion still have reason to worry about getting the votes needed for immediate effect, they’d be well advised to take care of this issue in 2013.

 

 

 

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The Role of Cost Shifting in No-Fault Policy Reforms

The Citizens Research Council of Michigan recently released the report Medical Costs of No-fault Automobile Insurance, which identifies a number of reform options policymakers could use to address medical prices and usage rates associated with auto accidents in Michigan.  The reform options presented in the paper range in how they impact the current features of no-fault and whom will be most affected.  Several policy options would reduce the prices paid by auto insurers and, if prices are set at reasonable levels, should not impact auto accident victims’ access to medical benefits in addition to maintaining most, if not all, of the other major features of Michigan’s current no-fault system.

However, even though the major features of no-fault are not impacted by some of these reform options, there will still likely be repercussions elsewhere in the health care system.  Reductions in prices would reduce the revenues received by providers, including hospitals.  The majority of health care claims are not due to auto accidents and the portion of revenues provided by auto insurance reimbursement will vary considerably by provider type and other factors.  How providers respond to reduced revenues will vary by provider but may include several scenarios.

First, in response to lower revenues from auto insurers, providers could reduce capacity which may include layoffs of staff, service reductions, or reductions in staff wages.  The scale of these reductions will be determined by the degree to which providers’ revenues are affected by lower prices or other policy reforms.

Second, providers may attempt to replace lost revenues through other means.  Cost-shifting, the practice of charging some customers more in order to cover lower rates paid by other customers, is often borne by private health insurers.  Providers are often unable to collect higher prices from public health insurers, such as Medicare and Medicaid, and from other insurers that pay according to a fee schedule, such as workers’ compensation.  Therefore, they may look to private health insurers as an avenue for recouping lost revenues.  If costs are shifted to private health insurers then it is possible that private health insurers will in turn raise premiums resulting in increased costs for employers and employees.  Each health insurer will have a different response based on their unique circumstances.

Policymakers should be aware of these potential impacts should they consider reforms to Michigan’s no-fault insurance.

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