State and Local Public Finance Professor Yinger Spring 2019

1. State and Local Public FinanceProfessor YingerSpring 2019 Lecture 7 PROPERTY TAX CAPITALIZATION

2. State and Local Public FinanceLecture 7: Property Tax Capitalization Class Outline • What Is Property Tax Capitalization? • How Does Property Tax Capitalization Arise? • What Are the Implications of Property Tax Capitalization for Public Policy?

3. State and Local Public FinanceLecture 7: Property Tax Capitalization Tiebout and Oates • In 1969 an economist named Oates (my professor) tested Tiebout’spositive hypothesis that people care about services in their community. • Tiebout’s hypothesis implies, said Oates, that better public services and lower property taxes will lead to higher property values. • This phenomenon is known as capitalization. • Using data for suburbs in NJ, Oates found evidence of capitalization—and inspired a huge literature.

4. State and Local Public FinanceLecture 7: Property Tax Capitalization What Is Property Tax Capitalization? • This class explains property tax capitalization and discusses its policy implications. • A more detailed discussion of property tax capitalization is available on the class Blackboard page and in • Yinger, J. “Property Tax Capitalization,” Chapter 14 in Housing and Commuting: The Theory of Urban Residential Structure (World Scientific, 2018).

5. State and Local Public FinanceLecture 7: Property Tax Capitalization Asset Pricing • The value of an asset equals the present value of the expected net benefits from owning it. • Without property taxes, the amount someone is willing to pay for a house is the expected present value of the rental benefits, or • where P is the pre-tax price of housing services, His housing services,ris the real discount rate, and L is the expected lifetime of a house.

6. State and Local Public FinanceLecture 7: Property Tax Capitalization The Pricing of a Long-Lived Asset • If the expected real value of rental services is constant over time and L is large, this equation reduces to: • The value of a house equals its expected annual rental value divided by a discount rate. • Because housing lasts a long time, this is a reasonable—and obviously helpful—simplification.

7. State and Local Public FinanceLecture 7: Property Tax Capitalization Property Taxes • A property tax payment, T, is the product of a nominal tax rate, m, and an assessed value,A. • It is also the product of an effective tax rate, t, and a market value, V • In symbols • Property taxes represent an annual expense for a homeowner.

8. State and Local Public FinanceLecture 7: Property Tax Capitalization House Values with Property Taxes • Adding property taxes as an expense, the house value equation becomes: • Note that property taxes are added as a flowbecause they must be paid every year.

9. State and Local Public FinanceLecture 7: Property Tax Capitalization What is Capitalization? • Now you can see the source of the term “capitalization.” • The annual flow of property tax payments shows up in a “capital” or asset value, namely V, using the logic of discounting. • The denominator in an asset pricing expression,rhere, is often called the capitalization rate.

10. State and Local Public FinanceLecture 7: Property Tax Capitalization The Degree of Property Tax Capitalization • This equation assumes that property taxes are fully capitalized. • As we will see, this might not be the case, so a more general form is: • whereβis the “degree of property tax capitalization;” i.e., the impact of a $1 increase in the present value of property taxes on the value of a house.

11. State and Local Public FinanceLecture 7: Property Tax Capitalization Interpreting β • A value of β equal to 1.0 corresponds to full capitalization. • A value of βequal to 0.0 corresponds to no capitalization. • If βequals 0.5 a $1 increase in the present value of property taxes leads to a $0.50 decrease in the value of a house. • The value ofβneed not be the same under all circumstances.

12. State and Local Public FinanceLecture 7: Property Tax Capitalization The Capitalization Equation • Solving the above for V yields the final capitalization equation: • Thus, houses with higher effective property tax rates (t) will have lower values (V). • The strength of this relationship depends on β.

13. State and Local Public FinanceLecture 7: Property Tax Capitalization A Change Form for the Capitalization Equation • One can also derive a change form of the capitalization equation: • whereΔstands for change and 1 and 2 indicate time periods. • Thus, an increase in t (relative to other houses) will result in a decrease in V.

14. State and Local Public FinanceLecture 7: Property Tax Capitalization Sources of Variation in t • These equations apply within a community. • Recall that for homeowner i, • Poor assessments result in higher assessment-sales ratios, and hence higher effective tax rates, for some houses than for others. • These equations also apply across communities, which may have very different effective tax rates due, for example, to differences in commercial and industrial property.

15. State and Local Public FinanceLecture 7: Property Tax Capitalization How Does Tax Capitalization Arise? • Real estate brokers indicate anticipated property tax payments so buyers can make comparisons across houses. • Lenders require mortgage plus tax payments to equal a fixed percentage of an applicant’s income. • An increase in Tmust be offset by a drop in the mortgage, and hence a drop in how much the applicant can pay for the house, V.

16. State and Local Public FinanceLecture 7: Property Tax Capitalization Evidence on Property Tax Capitalization • Every reasonable study of property tax capitalization finds a statistically significant negative impact of property taxes on house values. • Estimates of β vary from 15 to 100 percent. • The main reason for this variation appears to involve expectations.

17. State and Local Public FinanceLecture 7: Property Tax Capitalization The Role of Expectations • So far, current tax differences across houses are implicitly assumed to persist indefinitely. • But if tax differences are not expected to persist, the capitalization of current differences,β, declines. • A difference observed today that will disappear upon sale has no impact on V. • A difference observed today that is expected to last one year will have only a small impact on sales price.

18. State and Local Public FinanceLecture 7: Property Tax Capitalization The Case of Massachusetts • In Massachusetts, revaluations were required by the state supreme court, but enforcement was weak. • Communities knew they could avoid revaluation for many years. • Existing tax differences were expected to persist, but not forever. • A study of capitalization in Massachusetts (by myself and three other scholars) found that current tax differences were capitalized at a rate of 32 percent (Yinger et al., Prop. Taxes & House Values, 1988). • This is consistent with the expectation that current tax differences would disappear in 13 years.

19. State and Local Public FinanceLecture 7: Property Tax Capitalization The Case of Syracuse • In Syracuse in the early 1990s, revaluation had not occurred for decades and did not appear likely to happen any time soon. • But the city council unexpectedly decided to revalue. • A study of capitalization in Syracuse by Eisenberg (in his PA Ph.D. dissertation) found capitalization rates near 100%—exactly what the theory predicts when tax differences are expected to persist.

20. State and Local Public FinanceLecture 7: Property Tax Capitalization The Capitalization Trap • If property taxes are fully capitalized, then any tax changes show up in house values immediately and there is no way to escape them. • An owner with a tax increase must either stay and pay the higher tax or leave and suffer a capital loss. • An owner with a tax cut gets a capital gain. • Moreover, the loss is the full present value of the future increases intaxes.      

21. State and Local Public FinanceLecture 7: Property Tax Capitalization Property Tax Capitalization and Public Policy • Because of these gains and losses, tax capitalization has bizarre implications for public policy. • Consider revaluation, which is a systematic revision of all assessed values. • Revaluation leads to capital gains for homeowners who were over-assessed and to capital losses for homeowners who were under-assessed.

22. State and Local Public FinanceLecture 7: Property Tax Capitalization Capitalization and Fairness • For long-term residents, these changes are fair. • A resident who has been under-assessed for a long time has been given, in effect, a loan from the city and revaluation just claims back this “loan.” • But for new residents, these changes are not fair. • If someone bought an under-assessed house one day and the change is announced the next, this person has a capital loss even though she did not benefit from the poor assessment system.

23. State and Local Public FinanceLecture 7: Property Tax Capitalization Minimizing the Impact of Capitalization • Two ways to minimize this fairness problem: • First, introduce a long lag between announcement and implementation. This lag allows owners at the time of announcement to escape some of the burden of the tax changes. • Second, make sure houses are revalued upon re-sale, which they were not in Massachusetts or Syracuse.

24. State and Local Public FinanceLecture 7: Property Tax Capitalization The Case for Regular Assessments • So a revaluation imposes some unfair gains and losses but restores fairness in the near term and boosts faith in local government. • This trade only makes sense if assessments are updated regularly. • Otherwise, gains and losses are handed out each year as assessment errors mount. • Poor assessments also lead to court cases, which the city usually loses. • People who buy over-assessed property pay low prices—and then can sue the city for a rebate because of unfairly high taxes. • This happened in Boston, to the tune of tens of millions of dollars. • The only way to avoid this crazy situation is to keep assessments up to date!

25. State and Local Public FinanceLecture 7: Property Tax Capitalization Proposition 13 • Proposition 13 in California represents another unusual case. • The proposition fixes assessment growth at 2%, so the assessment/sales ratio, and hence t, declines over time for long-term owners. • This cannot be turned into a capital gain because houses are revalued upon sale. • But it represents a gift to long-term owners and it discourages mobility. • The U.S. Supreme Court said this was legal. Voters in California and a few other states like this reward to long-term residents; I don’t.

26. State and Local Public FinanceLecture 7: Property Tax Capitalization Looking Ahead • Property tax capitalization is a critical issue in economic development policy. • If property tax breaks are capitalized into the price of business property, then owners of this property at the time a tax break is announced may receive all the benefits even if they do not change their behavior, • And future owners (exactly the people the policy is intended to attract) may receive no benefits at all.