Do the right thing.

This is a story about federalism with an unusual twist: It may be on its way to a happy ending

For some time now, the federal government has been asking state and local governments to report the amount of property taxes residents pay each year that are deductible from federal income taxes.

The reports from the state and local governments are intended to enable the Internal Revenue Service to spot anyone who overreports property taxes by identifying user fees and other payments that are not eligible for the tax deduction. The IRS estimates that in 1992 alone taxpayers' overreporting cost the federal government $400 million.

Cities, counties, and states have resisted the requirement. They claim it would saddle them with an expensive and unworkable new administrative burden.

It now appears as if Washington is listening to those concerns, and the various levels of government seem amenable to a compromise.

"All of us are interested in more compliance," said Ralph Tabor, a lobbyist for the National Association of Counties, which has been a strong opponent of a mandatory reporting requirement. Federal officials "are saying it would increase their revenues and we're saying it would increase our costs more than the revenue that would probably be produced."

The outlook for a solution that would not burden local and state governments wasn't always so rosy. Last year, a proposal that would have mandated information reporting on property taxes reached the House floor before state and local opponents were able to defeat it.

The proposal surfaced in June 1992, when the House Ways and Means Committee passed a slew of small bills that included a proposal by Rep. William Coyne, D-Pa., to remove a volume cap restriction on high-speed rail bonds.

Because the high-speed rail proposal would cost the federal government revenues, Coyne attached to it a proposal to require local governments to notify taxpayers and the IRS of the amount of property tax paid by residents each year that is deductible for federal income tax purposes.

When the bill reached the House floor a month later, it ran into a buzz-saw. In the intervening weeks, state and local governments marshalled their forces and told their representatives to reject the measure. Reject it they did, by a vote of 368 to 48.

Despite such a resounding defeat in 1992, local officials have watched Congress closely to see if a reporting requirement could reemerge. Municipal officials are still concerned because the proposal would produce revenue for the federal government and could be attached to various tax breaks that members of Congress would like to see approved.

The reporting requirement issue returned to the spotlight briefly this year, when a Ways and Means subcommittee held a series of hearings on miscellaneous proposals by tax lawmakers. Rep. Sander Levin, D-Mich. offered the property tax proposal for discussion.

Aware of the impact

This time, however, federal officials seemed to be cognizant of the concerns of cities and counties. Though amenable to the plan, the Clinton Administration acknowledged the impact it would have on city and county governments, said Leslie Samuels, the Treasury assistant secretary for tax policy.

Treasury officials, Samuels said, are concerned about "the ability of local taxing jurisdictions to comply with this proposal. This concern should be addressed in the general design ... of the proposal." Samuels did not elaborate. Levin's proposal and many other tax items offered by panel members were never acted on by the committee.

The Government Finance Officers Association noted in a recent statement opposing the requirement that it would not be "operationally feasible." Local governments levy property taxes against a given property, not on a particular individual, and thus do not use Social Security numbers as identification on their tax bills. For the system to work, local governments would have to spend time and money obtaining those numbers.

The GFOA also said that the cost of postage, processing, and restructuring computer programs to implement the requirement "would divert state and local funds from revenue-producing enforcement activities to expenditures that produce no state or local revenue."

Although properly taxes are the domain of local governments, 36 state governments would also be affected by a reporting requirement because they offer property tax relief programs. Rebates received from those states should be reported as income, but often are not. Thus states would also nave to become involved in making sure correct information in this area is sent to the IRS, the Federation of Tax Administrators said in a statement.

The federation "does not believe that any [such] information reports will serve the federal purpose, and they will place significant administrative burdens on the state and local tax authorities."

Credit for making the federal government understand the problems that the requirement poses, several lobbyists say, goes to the General Accounting Office, the research arm of Congress. Earlier this year, the GAO released a report documenting the problems and proposing some solutions.

In September, a top GAO official outlined the office's findings for the Ways and Means subcommittee.

"GAO believes that IRS can improve taxpayer compliance by cooperatively working with local officials to simplify tax documents and to redirect enforcement efforts," said Natwar M. Gandhi, an associate director in the GAO's general government division.

The GAO found that 57% of the 1 million taxpayers in its survey did not properly report $105 million in property tax rebates in 1988, resulting in an estimated loss to the federal government of $25 million. The study focused on New Jersey and Minnesota.

The GAO suggested that one reason the rebates went unreported was that taxpayers forgot about them. Even if they remembered, federal income tax forms were not clear on how the rebates should be reported, the GAO said.

The GAO also found that in Montgomery County, Md., 83,000 of the 92,000 taxpayers studied erroneously deducted $21.6 million in user fees, such as those for trash collection, in 1988. The estimated tax revenue loss from the underreporting was $7.6 million, the GAO said.

Again, the GAO cited unclear tax forms as a possible reason for the underreporting. Another possibility is that "some taxpayers may have realized that they could overstate their deductions without IRS detecting it, except in an audit," the GAO report states.

~Take Action'

The GAO concluded that the IRS "needs to take action to reduce over-stated real estate tax deductions." For example, the agency needs to clearly define user fees and other nondeductible fees in the instructions for the basic federal tax form, Form 1040.

In addition, the IRS should "work cooperatively with local governments on revising [their] bills to clearly distinguish user fees and special assessments and label them as ~nondeductible.'"

To help track down taxpayers who do not comply, the IRS could negotiate information-sharing arrangements with local governments whose tax bills include user fees, the GAO said.

"Under these agreements, IRS could work out cost-effective ways to obtain data on individuals' real estate tax payments to local governments," the GAO said.

For the system to be improved, the IRS probably does not need to develop such agreements with all 66,000 local governments, the GAO said.

Initial information sharing could focus "on the less than 1% of local governments that collect $100 million or more annually," the agency said. "The large local governments collect more real estate taxes nationally and are more likely to have the automated capability to track and share data with IRS."

State and local officials said they welcomed the perspective offered by the GAO report. "I think the GAO report helps a great deal because it really shift a lot of the effort back to the IRS," said Tabor, the counties association lobbyist.

Tabor's group has offered a two-tiered proposal. The plan would require the IRS to clarify its tax return instructions and force local governments and mortgate companies to clarify their bills and statements. In his September testimony, the GAO's Gandhi said that if the proposal failed, Congress might have to step in and legislate the reporting requirement after all.

With Congress adjourned for the year, concern about a reappearance of any reporting requirement has abated. State and local officials say that if and when Congress addresses the issue, it will not be as quick as it was last year to propose mandatory reporting. Instead, they say, Congress will be willing to try a compromise, such as what the counties' group is proposing.

"I think we made it pretty clear last year" in the House vote that state and local officials will fight hard against a reporting requirement, said Frank Shafroth, the director of policy and federal relations for the National League of Cities. "I think it's low in terms of a possibility. It's not high on my radar screen."

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