Solving for Solvency

Barring movement on the property tax reform bills that are currently being discussed in the state legislature, I anticipate this will be my final blog on school finance for the year. I am somewhat skeptical they will be able to get a law passed this session. There are too many unknowns, and with just two weeks remaining in the legislative session it would seem unreasonable to fully vet these proposals. The stakes for getting it wrong are incredibly high. Understandably we are all eager for property tax relief. But at the same time we must ensure it is done correctly. It would be wise during this interim period to study the issue in greater depth so we can hit the ground running in January of 2026 with a proposal that has been fully vetted.

Today I want to focus on the concept of financial solvency in school districts. But before we get there, a brief primer on 'unspent balance' (USB). As I have hammered home time and again, the most important financial metric in school districts is 'unspent balance'. Unspent balance is the measure of unspent budget authority that either accumulates or deteriorates dependent on the fiscal discipline of the school district. This metric rises to the top of fiscal measures in a school district because it is a violation of state law to have a negative unspent balance. In fact, one can be held legally responsible for cratering an unspent balance. But even more ominous: a school district can be forced to dissolve. The way one increases budget capacity, or spending authority is simply to spend less than the full capacity year over year. In Hudson, we are in very good shape in terms of our unspent balance. In that past decade, this measure has grown from $1.3 million to $5.3 million for the fiscal year ending June 30, 2024. During fiscal year 2024, our expenses accounted for 94.4% of that years budget capacity, hence our improving USB metric. Over the next five years, I anticipate expenditures will be in the range of 96%-98.1% of [budget year] capacity, which suggests our unspent balance will continue to grow. The caveat though, is this capacity is not all funded by cash. 

Which brings us to the second most important financial metric: the solvency ratio. The calculation is rather simple: ending fund balance divided by total revenue for the fiscal year. The target range for this calculation is between 5%-10%. In the fiscal year that ended on June 30, 2024 our ratio was at 16.82%, well above the target range. The challenge however is the trendline is heading in the wrong direction, and it is heading in the wrong direction fast. Why? Well, there are two primary reasons for this.

First is very rapid residential enrollment growth. For the year that we are currently in, our residential enrollment count increased by 50 students. Because of this growth, we had to add staffing to the school district and those students were subsequently counted as part of our enrollment certification process in the fall. As you know, that number forms the basis of our budget a year from now. So, while the cost to employ those additional staff is a real time expenditure, the funding is delayed by a year. This means that cost has to be paid for with cash on hand, causing the cash balance to deteriorate which negatively impacts the district solvency ratio. It is also important to point out, and in fact underscore the impact open enrollment has on this metric. It actually helps. Funding for enrollment growth due to open enrollment isn't delayed, it is on time. If the increase in enrollment was limited to open enrolled students, the impact on the solvency ratio would be blunted because the revenue generated by those students is realized during the current fiscal year. 

The second reason our solvency ratio is headed in the wrong direction is because of special education cost overruns. You see, special education isn't bound by the same 'per pupil' limitations as regular education programming. Students who are served by special education programs are governed by the federal 'Individuals with Disabilities in Education Act', or IDEA. This law requires that each student served receive individual and specialized instruction. Oftentimes these cases can be quite complex, requiring 1:1 support services in the form of paraprofessionals, nurses, specialized transportation; or in the most complex of cases specialized schools. The challenge is that the funding for these programs falls far short of what is needed to fund the students' IEP. Because of this, most school districts in Iowa deficit spend special education programs in Iowa. Hudson is no different, to the tune of more than $650,000 annually. Because the state isn't properly funding special education services, the burden of doing so falls on the local community in the form of property taxes. 

Solvency is really just a fancy word that tells us how much cash is remaining at the end of the fiscal year once all expenses have been encumbered. It's important because Iowa public school districts will continue to operate for approximately 90 days over the summer months without an infusion of capital. Less than 5% may mean the district doesn't have enough cash on hand to fund the operation over the summer months. So we need to ensure our solvency ratio stays above 5%, which means we would need to have no less than $800,000 in the bank once we've solved for all expenditures. That may seem like a lot, but it really isn't for an operation this size. 

Without intervention, our solvency ratio will drop below 5% in fiscal year 2027. However, there is a remedy that includes two parts. First, we need to slow the rate by which our expenditures are growing to just 4%. Now, 4% may still seem like a pretty rapid rate of increase, but keep in mind that at that rate we will still expend just 98% of our capacity. In other words, our budgeted expenditures could grow in excess of 4% and we would still be under the current budget capacity for that fiscal year! (We would just use more cash, which doesn't solve the problem at hand.) Moreover, the rate by which our enrollment has been increasing over the last two years has caused our expenditures grow in excess of 8%. To reduce that growth rate by half is a tall order. However, we are making moves in fiscal year 2026 that should enable us to execute a 'soft landing'. Second, we need to increase our cash flow and fund part of that unspent balance. The way we do that is through a cash reserve levy. I hope you picked up a couple of key words: increase levy.

All of this will need to be done under the context of property tax reform. Now, those who we look to for advice and analysis point out that if the goal of the reform is to simply the property tax system this would accomplish that. It would also provide property tax relief across the state in aggregate. But in reality, it may simply shift the burden from your right front pocket to your left. Instead of this complex bill, if the legislature would simply fund SSA at 3% and meet their obligation for special education funding it would fix our solvency ratio problem: and it would take pressure off of property owners. 

Property Tax Reform

I think everyone can agree that Iowa's property tax system is complicated. Here are a few examples that confound the general public whenever this topic comes up: Taxable valuation isn't the same as assessed valuation. TIF (Tax Increment Financing) districts are economic development tools that incentivize development while suppressing the increased property value of that development until expiration of the TIF district. Depending on what kind of property you own: residential, commercial, industrial, or agriculture; you may be subject to a 'rollback'. Then to confuse everyone a little more, just last week we all received new assessments for our property that didn't match anything that we have been discussing over the last several weeks. That is because those assessments are what will be used for FY2027.

Your property taxes are subject to multiple taxing authorities: school, city, and county; and not all taxing authorities are equal. Taxing authorities that are considered 'property rich' are those with more valuable property such as commercial or industrial. Oftentimes property taxes in those taxing districts are lower because commercial properties have expanded the tax base in way that has brought down property taxes for everyone. On the other hand, a 'property poor' district is not a measure of socio-economics. Quite the contrary. It simply means that taxing authority has a smaller tax base without a lot of valuable commercial property. A smaller tax base simply means it takes greater 'rate' effort to generate the revenue needed to fund the program. Think about our case here in Hudson. Sometimes people will look at their tax bill for Hudson, compare it to surrounding areas and wonder why it's higher in Hudson. Well, there are a lot of reasons for this (hence the complication in our property tax system). Yet in keeping with this idea of 'property poor' we are geographically very small: only 57 square miles. And, our property tax base relies heavily on residential property owners. Compared to many around the state, we have few commercial enterprises to help ease the burden. And those that have come to our community in recent years are in TIF districts so it will be awhile before we are able to benefit from the increased valuation of this property.

Think about this: there are currently 325 school districts in Iowa. If you were to rank them 1-325 with '1' begin the highest property valuation and 325 being the lowest, Hudson would rank 300. But if you include the TIF districts in that same ranking, it would improve our position to 273. I'll concede that's not a lot, but it would absolutely make a difference in the property taxes we all pay. 

If you are confused at this point, you are not alone. That is one of the reasons why the Iowa General Assembly is proposing to simplify the property tax system with an end goal of lowering property taxes. Two identical versions of a property tax reform bill are currently working their way through both the House and Senate. The legislators sponsoring the bills have approached this work collaboratively, asking for feedback and input from the public. At this point, they have taken that feedback seriously and the versions of the bills that are currently being discussed are different from the original proposals. I am grateful they are taking a thoughtful approach to this work. There is a keen understanding that while property tax relief is needed it is paramount they get it right. With that stated, it is unclear (and perhaps unlikely?) this legislation will be enacted during this legislative session. 

Because the proposal continues to be modified based on the feedback our legislators are receiving, I'll avoid getting too deep in the weeds. This is because the legislation continues to evolve. However, I'll start with just one quick observation and theme that everyone will need to keep in mind. If the idea is to provide property tax relief and lower property taxes, we must be clear eyed of what the by-product of this work will be: if the taxing authority is generating less in revenue, it will need to be balanced on the expenditure side of the ledger. I suppose that is a technical way of stating the obvious: budget cuts will be necessary in many taxing authorities. The top news of the day will include even more stories about school districts (big and small), communities, and counties making budget cuts. 

With that context, I'll give you three big ideas to think about with these proposals: the elimination of the rollback, reduction of the uniform levy, and revenue restriction instead of rate restriction. Keep in mind there are other concepts in the property reform proposals that are also incredibly important, but for the sake of this discussion I want to focus on just a few concepts. 

From previous posts, I have explained to you that each year, the property taxes each of us pay are dependent on 3 separate variables: the rate, the rollback, and the value. (See 'Understanding Your Property Tax Statement' from March 19th for a detailed explanation.) In that article, I shared that even if the property tax rate remained exactly the same from one year to the next; the rollback does not. In fiscal year 2025, property owners' taxable valuation was calculated on 46.34% of the value, whereas in fiscal year 2026, taxable valuation is calculated on 47.43% of the value. So, your property taxes will go up even if the rate is the same. Under the proposed legislation, the rollback is eliminated. In short, you will pay property tax on 100% of the value, less the homestead credit. Now logic would suggest this would cause a spike in property taxes, and it would, unless you consider the other two big ideas that are part of this proposal. 

Reducing both the uniform and additional levy in the school funding formula would definitely lower property tax. It's called a uniform levy because its uniform across every school district in the state. Currently, the uniform levy of $5.40 is applied to all property and is the first layer of funding for a school district's annual budget. The second layer is school foundation aid, and it funds up to 88.4% of the capacity, and the remainder, or what is needed to get to 100% is funded through an additional levy. Under this proposal, the uniform levy would be reduced to $2.97 and the additional levy would all but be eliminated with the exception of some special purpose general fund levies like instructional support and dropout prevention. By reducing these levies, it shifts that burden from local property tax to the state. Estimates put that shift north of $400 million. While this would definitely lower property taxes, the unknown variable is affordability. We have already put a lot of stress on the state budget with other priorities, and as such I am skeptical this is sustainable. One unintended side-effect would likely be continued or even compounded underfunding of SSA. Underfunding that fails to keep up with inflationary costs. 

Finally, the property tax reform shifts from a 'rate limited' property tax to a 'revenue limited' concept. Essentially, what this would do is limit the growth of school district special revenue levies to 2% per annum. In so doing, this would appear to suppress the tax base while forcing the levy downward. Think about this. Assume you have a year with a lot of tax base growth. When you apply a rate limited tax to that tax base growth, it will capture the benefit, and revenue of that growth. However, if you limit that growth, regardless of how much the tax base grows to 2%, it will suppress the taxing authorities ability to fund facility improvements and capital projects. It may also impact the bond rating of the authority and make it more difficult to pay off debt quicker. Yet on the other hand, it will force that rate down. 

I agree with the position that our property tax system is in need of reform. I'll even go so far as to say that it is entirely appropriate to justify and explain to the public why property taxes are going up or going down. It is also incumbent on us to be able to share with our stakeholders how those tax dollars are being invested on behalf of the public good and to share a coherent strategy in terms of long term planning. For too long, taxing authorities have looked the taxpayer in the eye and shifted the blame elsewhere; with a shrug of the shoulders would say, 'our tax rate is exactly the same as it was last year, so our taxes didn't go up'. Making this claim illustrates ignorance on the part of the authority at best; malpractice at it's worst. I am grateful the legislature is taking its time on this. We all just need to be prepared that, if we reduce the revenue side of the ledger, we act in concert when it comes to the expense side.