TAXES ON PROPERTY AND WEALTH

TAXES ON PROPERTY AND WEALTH Prof. Dr. Yeşim Kuştepeli

TAXES ON PROPERTY AND WEALTH • Property taxes are widely used not only in developed industrial countries but also in the urban areas of less developed countries. • Property, especially “real” property (i.e., land and improvements) is one of the most visible and stationary of tax handles. • The property tax is the primary but not the only form of tax on wealth. • The poll tax is a very old tax on wealth in the form human beings, assessed at a flat rate per person or per household.

WHY TAX PROPERTY? • Property is singledout as an object of taxationforseveralreasons, includingabilityto pay, thebenefitprinciple, andtherelativeimmobility of thetaxbase. • Likepurchases(orconsumption) andincome, theownership of property, broadlydefinedtoincludeallassets, is a measure of abilityto pay taxes. • Assetsproduceincome, sometimesexplicitly (interest , dividends, rent) andsometimesimplicitly, in the form of servicesrendered.

Another aspect of the ability to pay argument is that the property tax is a way of ensuring that everyone pays at least some tax. • Those who can hide their income and make their purchases largely outside the realm of the tax collector can be compelled to make some contribution to the public treasury with property taxes. • The property tax narrowly defined(on land and improvements) has some elements of a benefit tax. • Many of the local services funded with property taxes are services to property , such as roads, fire and police protection, streetlights, and garbage pickup.

These services enhance or protect property values, so the value of the services could be considered to be roughly proportional to the value of the property being served. • Finally, real property is a much less mobile tax base than income or sales.It may decline in value , but real property is stuck inside the taxing jurisdiction. • Because local governments are in a highly competitive situation for attracting higher income residents and business firms, they will be sensitive to keeping their property tax rates somewhat in line with competing jurisdictions, but at least they can count on real property(land and improvements) staying put even if it is subjected to tax.

DRAWBACKS TO TAXING PROPERTY • Taxing property poses four major practical problems: • High Visibility The property tax is distinctly more visible than other kinds of taxes such as taxes on income and sales. It is often paid once a year in a large lump sum, whereas income taxes are witheld monthly and sales taxes are paid in small amounts, one purchase at a time. This differential visibility may discourage the use of property taxes relative to other kinds of taxes.

Narrow Base The use of a limited base that represents only a partial subset of total wealth or assets is the result of the difficulty of locating and valuing many kinds of assets, such as financial assets, commodities, precious metals, and jewelry. The property tax discourages investment in improving land or purchasing items subject to property tax relative to other kinds of assets.This is an undesirable efficiency consequence of property taxation.

Uncertain Market Value The third problem is how to establish a credible market value as a basis for taxation. It is easy to establish a value for property that is sold, but many parcels of property rarely change ownership. • Base Erosion This tax suffers to a greater than average degree from the general tendency of a tax to erode its own base over time. In the case of the property tax, this tendency can escalate to deterioration of whole neighborhoods or communities, especially in older cities.

As property values decline, a higher rate is necessary to raise the same amount of revenue. • As tax rates rise, middle and upper income families move to the suburbs, leaving only the poor and afew wealthy families in enclaves in the city. • As these inner-city properties decline in value, they become attractive for redevelopment, and young professionals are attracted to the convenient location and aesthetic appeal of older buildings. • Efforts by older cities to make their towns more livable and attractive have also made this kind of “second wave” development financially attractive ,rescuing some of the property base of older cities.

DEFINING TAXABLE PROPERTY • Real property is the most universal part of the base, consisting of land and improvements, mainly buildings.It is sometimes seperated into categories such as agricultural, owner-occupied residential, rental, commercial, industrial, and utility. • Personal property consists of other kinds of tangible property besides land and buildings that has been added to the tax base. • Automobiles, boats, airplanes, business equipment,business inventory are the common categories of taxable personal property. • Intangibles are the third major category of taxable property, which consist of assets such as stocks, bonds, jewelry, bank accounts, precious metals, other financial or physical assets that offer a way to store wealth.

The efficiency criterion suggests that to tax some forms of wealth and not others will distort consumer decisions, favoring those that are not subject to tax. • The equity criterion calls for a broad base of wealth so as not to discriminate against those whose wealth is primarily in the form of real or taxable personal property. • Collection and compliance costs can be very high if tax assessors have to track wealth in a large number of forms. • Taxes on intangibles and personal property are often easier to evade, and any tax that is easy to evade will eventually erode as more and more taxpayers join the stampede.

CAPITALIZATION OF PROPERTY TAXES • The level of and changes in property taxes as well as the quality and variety of local public services are reflected in the market value of taxable property. PV=Σ (B -C )/(1+r) i: particular year in life of the property (from 1 to n) B: benefit in the ith year (including both the use of the property and any public services), C: cost in the ith year (including property taxes as well as maintenace, depreciation, etc.), r: is the market rate of discount or “the interest rate”.

If the property has an extremely long lifetime and if the annual benefits and costs are the same in all future years (B1=B2=B3=………=Bn) then the formula simplifies to PV=(B-C)/r Property taxes are reflected in C. • An increase in property taxes that was not matched by increases in services (a part of B) that are equally valued by the present and prospective owners of the property will reduce the present(market) value of the property. • This process by which changes in taxes or public services are incorporated into the value of houses is called capitalization.

EFFICIENCY ISSUES IN PROPERTY TAXATION • Property taxation has two important efficiency issues. • One is the incentive to hold wealth in nontaxable form. • The second is the impact on location of households and business firms. • Efficiency issues, are particularly significant for the property tax because the effective tax rate is higher than it may appear. • The property tax is levied on wealth, but it is paid each year out of the income flow from the assets subject to the tax.

DistortingAssetPatterns • Households are reluctant to make major improvements in their property because of the property tax consequences. • Business firms must take property taxes into consideration in deciding what mix of assets to use, what kinds of plants to construct, what size facility to build, how much land to acquire, and so forth. • Firms have the choice of alternative production processes that may substitute labor or equipment for floor space and acreage. • If a property tax is imposed, the balance of the benefit-cost calculations will be altered in ways that might not be optimal from the standpoint of resource use.

Distorting Locational Decisions • Lower taxes for the same public services or better public services for the same taxes will cause decision makers to opt for one location over another. • A community that has some degree of monopoly power can levy a higher property tax rate and still be attractive to residents and investors in commercial and industrial firms. • Property owners in these communities may be more successful in shifting the burden of the property tax to tenants.

EQUITY ISSUES IN PROPERTY TAXATION • The incidence of the property tax is easy to determine for owner-occupied property or for personal property such as motor vehicles, because the “buyer” and “seller” of the services of the property are the same. • When it comes to other kinds of property, the incidence is more complex. Much residential and commercial property is rented. • If you rent an apartment, how much of the property tax falls on you in the form of higher rent and how much is absorbed by the landlord in the form of a lower return on investment?

The incidence of property taxes on commercial and industrial property is even more complex. • If the commercial or industrial firm owns the property, three possible parties could bear some part of the property tax burden: the owners of the firm(lower profits), the workers(lower wages and benefits), and the customers(higher prices). • If the commercial or industrial firm leases the property, the owner of the real property becomes a fourth candidate for bearing some of the burden in the form of lower lease payments received.

Incidence: TheRegressiveView • In the short run, the supply of apartment is fixed. With demand unchanged, the property tax falls entirely on the owner in the form of lower net rent. • Demand is represented by Do, while the impact of a property tax (or an increase in the property tax) can be represented by shadow demand curve D1 , which represents demand net of tax as seen by the owner of the taxed property. • The difference between the unchanged rental price Po and the net rent received by the owner P1 corresponds to the property tax per rental unit. • Revenue from the tax is rectangle P1Poba.(pg 257)

A lower return to rental property will result in a decrease in the supply, since it may no longer be profitable to maintain older apartment buildings. • With some supply elasticity, the burden of the property tax will eventually be shared between buyer and seller. • In larger cities, where apartments at desirable locations close to work or to public transportation are scarce, the owner of such properties possesses a degree of monopoly power that may make it possible to shift more of any change in property taxes forward to buyers. • Because this tax is levied on housing, which everyone consumes, and since spending on housing declines as a percent of income as income rises, one might conclude that the property tax is regressive.

Incidence: TheProgressiveView • This view is based on a broder perspective that looks at interrelated markets and flow of resources between them. • People in the business of constructing rental property must compete in financial markets for loanable funds with other borrowers borrowing for purposes that do not involve a property tax obligation, or a smaller property tax obligation. • The rate of return on constructing rental property will be lower than could be earned on other uses of the same funds.

Over time, existing properties will be allowed to deteriorate, and some will eventually be torn down. • The supply of rental property may decline, or at least grow more slowly than other kinds of investments not as heavily impacted by the property tax. • Initially, a lower rate of return on rental property compared to other invetsments implies that at least part of the property tax will fall on the owners of rental property. But rental property does not exist in isolation. • As investors move funds out of rental property into other kinds of assets with smaller tax burdens, the lower rate of return spreads to owners of all kinds of capital.

In a world with a property tax, there will be less investment in improvements to real estate and more investment in other, nontaxed assets than there would otherwise be. • Resorces will shift between the two groups of investments until their rates of return are equalized, fewer rental units will earn a higher rate of return than they did when the tax was first imposed. • According to this view, the property tax is a tax on capital. • Because ownership of capital is much greater at higher income levels, this view suggests that the property tax is progressive.

OtherConsiderations 1)real property receives some other tax breaks, which may mitigate the effects of property taxes. 2) markets may not function perfectly in terms of capital being totally fluid or fungible and flowing to more attractive uses. 3) other factors besides the property tax may affect the return to building, owning, or leasing real property that could offset the negative effect of the property tax. • One study , using data from Boston, finds that in the case of rental housing , landlords are only able to shift about 11% to 16% of any increase in property taxes forward to tenants, at least in the short run. • The short run burden is likely to be distributed differently from the long-term burden.

DESIGNING AND ADMINISTERING PROPERTY TAXES • Property taxation is a two-step process. • determine the value of the individual taxable properties and aggregate them into a tax base. • establish a tax rate, or mill rate, to apply to that base in order to raise the amount of revenue required. • Income tax rates and sales tax rates are stable for years while their bases grow at a steady if sometimes uneven pace. • For the property tax, with infrequent reassessment years, while the tax rate or mill rate is changed frequently in order to yield the amount of revenue needed to balance city, country, and school district budgets.

Valuing Property • The first step in levying a property tax is to identify all the taxable properties-land , buildings, and taxable personal property-and to determine a market value for each. This process is known as assessment. • Some properties, such as automobiles, are relatively easy to value because many similiar properties are being bought and sold on a national market and the assessor can determine the values from readily available sales information.

For land and improvements ,the assessment process is more complex. Assessors generally use a combination of three methods to assess real property: replacement cost, comparative sales prices, and regression analysis. • The replacement cost of structures is determined on the basis of current building costs per square foot and the size of the structure. • If the house is not new, depreciation is factored in for age to reduce the value. • The second method is to look at the sales prices of comparable properties in the neighborhood. • For areas with substantial turnover in real property, this market price method is useful, but it is less useful for rural areas, unusual or unique properties, or industrial properties.

The third method is regression analysis. • A regression equation for a house might include such variables as land(acreage), number of bathrooms, garage, and a dummy variable to represent location. • The resulting equation would be applied to valuing property that had not been sold recently. • Most states oversee the assessment process at the local level, providing training and checking to ensure that local valuations are not out of line with the actual market values of properties that are sold. • The state may require reassessment at regular intervals. Most local governments reassess every three to seven years.

Classified Tax Systems • Once the market value of a particular property is determined, it is added to the tax base at some percentage of that value. • If different kinds of property are included in the base at different percentages of their market value, then the state has a classified property tax system. • The intent of a classified system is to distribute the property tax burden in a way that is proportional to market value within a classification but not between classification. • The term mill rate reflects the English origins of the property tax. The mil, or spelled mill, was an old English monetary unit that was one-tenth of a cent. A tax rate of 70 mills, then, would, be 7% of the market value.

PROPERTY TAX REVOLT AND ITS AFTERMATH • Repeal Several states, attempted to repeal the property tax, to develop some other basis for local government funding, including funding for education. The failure to repeal the property tax reflects the fact that there are only a limited number of broad-based taxes to provide and adequate and stable revenue source for any government. The property tax is the one tax proved most suitable for local use both because property is immobile and because local governments provide services that benefit property owners.

Restraint Restraint refers to any method of tying the lands of local officials in order to limit growth in taxing and spending. Property tax restraints have included limits on increases in assessments or the use of reassessment to increase revenues, limits on the percentage value of the property that can be collected in tax, restrictions on increase in the mill rates. Restraint is a rather clumsy tool for containing the growth of government. It has encouraged the growing use of fees and charges.

Relief Groups asking for specific rather than general relief usually represent category of property or another segment of society that claims injury because of high property tax burdens. Farmers, owners of undeveloped land, and homeowners tend to receive the most favorable treatment in classified systems. All three of these groups are in a position to make an emotional appeal for special treatment based on the fact that their taxable property may not be yielding much of a cash income stream from which to pay taxes.

Property tax relief also comes in a number of other forms in nonclassified systems. • Exempt part or all of the value property for tax purposes, often called a homestead exemption in the case of owner-occupied housing or a business tax incentive in the case of industry. • Rebate part of the property tax burden to all taxpayers or to selected taxpayers. • Give income tax credits or other direct payments to reduce the property tax burden on housing, usually based on income. The income tax credit is called a circuit breaker.

Reform • Reform of the property tax is a slower, demanding, and difficult process of rethinking the property tax so as to make it more equitable, less inefficient, and also less costly to administer. • A number of reforms have been implemented in administration to improve the assessment process. • California’s change in the assessment process : residential property is only reassessed at the time of sale. If it is not sold, its value is increased at a rate of 2% a year. • This system , acquisitionvalue, results in substantial inequities in tax burdens between properties of similiar market value.

PollTaxes • A poll tax is a per capita or per household tax that is the same regardless of any measure of ability to pay. • Because the tax does not vary with income, it is the most regressive of all taxes. • Its primary appeal is that it does not distort any decisions, because the only way to avoid the tax is to die or disappear both actions that are too extreme for most people to consider as a form of tax avoidance! • Its other major attraction is simplicity.

Estate, Inheritance, and Gift Taxes • When the government levies a tax on the transfer of property at the time of death, it is called an estate tax, a tax on the net worth of the deceased. • Inheritance tax is a tax on the amount that heirs receive from an estate, which can be credited against the estate tax. • One of the reasons offered for eliminating the estate tax was that a great deal of effort is invested in methods of avoiding or minimizing estate and inheritance taxes. • The gift tax, which has the same rate as the estate tax, was instituted to limit this way of avoiding estate taxes. • Trusts and other devices take assets out of the estate and reduce the tax burden.

The estate and inheritance taxes are not a major source of government revenue, and in practice are paid by only a very small fraction of the population. • However, they have been very controversial. • One school of thought sees these taxes as an appropriate redistribution of wealth that somewhat levels the economic playing field within generations, as well as a potentially significant source of revenue as estates accumulated during the prosperous years. • Critics, claim that the estate tax is a confiscation of the result of a lifetime of hard work and wise management of resources, and a disincentive to save and invest in order to pass wealth on to one’s heirs.

TAXES ON PROPERTY AND WEALTH