The Local Property Tax Literature: 100 Years of Disagreement - KTH

The Local Property Tax Literature: 100 Years of Disagreement SVANTE MANDELL

Abstract This paper surveys some of the extensive number of works published in the field of local property taxes. The focus of this survey is on efficiency issues regarding local property taxes. A certain amount of attention is paid to the debate about the view of a local property tax as a pure fee for local public services as opposed to viewing it as a tax on capital. The main conclusion is that there is still major disagreement on central issues both in the theoretical and empirical research.

Keywords; Local property tax, literature, survey

Acknowledgement This paper has benefited considerably from comments by Mats Bohman, Hans Lind and Roland Andersson. The financial aid of the Swedish Council for Building Research (BFR) and the Swedish Housing industry is gratefully acknowledged. Any errors or shortcomings are naturally my own responsibility.

This paper is part of a doctoral thesis presented in year 2001: “Ground Leases & Local Property Taxes”, Memorandum 5:56, Department of Real Estate and Construction Management, Royal Institute of Technology.

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1. Introduction It is not easy to analyse property taxes. The vast number of articles written on different aspects of these taxes illustrates this. It is also illustrated by the fact that property taxes have been studied for a rather long time. The discussion can be traced back at least to the mid 19th century. Most strikingly however, despite the large number of articles and despite all the years of debate there is still a remarkable lack of agreement on fundamental issues regarding the property tax. In this paper I will try to review some of the property tax literature. The vast number of articles renders a complete review more or less impossible. I will limit my attention to questions regarding local property and land taxes. Of particular concern is the question of how to best view the local property tax – as a fee for public services or as a distorting tax on capital. As this question to a great extent depends on the incidence of the property tax I will begin with a brief review of the property tax incidence literature, before I address the question of how to view property taxes. Both the discussion about tax incidence and about how to view the property tax in many respects deal with whether or not a local property tax is a distorting tax. Many authors claim that a tax on the land value only, and not on the improvements on the land, has many advantages compared to property taxes. This claim is discussed in the section about land taxes. Following this is a presentation of some of the vast number of empirical works on the subject of property tax. I concentrate on studies dealing with capitalization of local property taxes and local public services into property values. This is of certain interest since it relates to a heavily debated question regarding if local property taxes can be designed such that no deadweight losses arise from them. Finally, I make some concluding remarks about what is achieved so far along with a few suggestions about where the research may be heading in the future.

2. Property tax incidence Property tax incidence literature deals with the question of who actually pays the property tax. The standard way of approaching the problem is to introduce a landlord and a tenant. The landlord owns the property on which the tenant resides. Then, the incidence question boils down to what extent the property tax will be paid by the landlord or the tenant.

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To illustrate this, consider a property that rents for 100 monetary units (mu) per year1. Additionally, assume that the discount rate is 10% and that the property has an infinite life and, hence, is worth 1000 mu. If a property tax of 10 mu is introduced two extreme cases may arise. In the first extreme case, the tax may be fully forward shifted. In that case the tenant will bear the entire tax and the rent will increase to 110 mu. In the second extreme case, the tax may be fully backward shifted. In that case the landlord bears the full tax2. The tenant still pays a rent of 100 mu annually but the landlord only receives 90 mu after tax. In turn, the value of the property will decrease to 900 mu, the property tax has been fully capitalized. As will be discussed in a subsequent section, this leads to an empirically testable hypothesis, which has been given much attention in the literature. There have been several theoretical discussions about property tax incidence. Marshall (1890) argued that a general property tax would be shifted to consumers. A local property tax, however, will result in residents moving to other locations unless the tax is accompanied by local services. This implies that such a tax ultimately would be borne by the landowners. Marshall also notes that some taxes may result in net benefits to those who pay them. In such a situation, an increased tax may attract population and industry instead of repelling it. Other examples include Netzer (1966) who argues that a property tax is shifted forward to the consumer through an increase in house prices and Rolph and Break (1969) who hold the opposite view, that a property tax may be shifted backwards to immobile capital. The differences are largely due to the model specifications and different definitions on what is to be taxed. As an example, Mieszkowski (1972) and Orr (1968) view the property tax as a tax on capital improvements while in Grieson (1974), Simon (1943) and Barr (1972) both land and structures are subject to a property tax (according to Polinsky and Rubinfeld (1978)) Furthermore, where Orr (1968) and Simon (1943) focus directly on the effect on house and land prices following from a property tax, Mieszkowski (1972) and Barr (1972) also allow for the tax to influence other factors, such as labour and capital. In much the same manner as with the incidence of a property tax, the effects of a change in local public services are also subject for debate. Some authors argue that an increase in public service will be partially capitalized into higher land and house prices. This

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I use the same values as Guilfoyle (2000) uses in a similar example.

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Let me make a brief note on the use of the term ”backward shifted”. If a landlord fully bears a tax that originally was levied upon the landlord, saying that the tax is ”backward shifted” is clearly not entirely correct. Rather, the tax is not shifted at all.

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view is held by Lind (1973), Strotz (1968), Kain and Quigley (1970), Oates (1969) and Ridker and Henning (1967). Another view of the matter is that, rather than being capitalized into land and house prices, an improvement in public service will result in a decrease in wage rates. This approach is adopted by Nordhaus and Tobin (1972) and Tolley (1974). Again, the conflicting results stem from differences in model specifications. In the theoretical models of Lind (1973) and Strotz (1968), the wage rate is implicitly assumed to be fixed. In Nordhaus and Tobin (1972), on the other hand, it is implicitly assumed that the property values are fixed. To illustrate why the different assumptions yield different results consider a standard model.3 Normally there are several communities in the models. These communities compete for residents. As a result there will be a lowest utility level necessary for a resident to choose a particular community. In equilibrium, the utility level will be the same in every community. Each resident’s utility typically depends on rents for housing, wages and the provision of public goods. Clearly, if the level of public goods increases either the wages must decrease or the rents must increase in order for the utility level to remain unchanged. There are many similarities between the question of tax incidence and the question as to whether a local property tax is best viewed as a benefit tax or as a tax on capital. This will be discussed in the next section. In particular, the same result as discussed above will arise – the differences in results are ultimately driven by underlying assumption, especially about the mobility of capital and residents.

3. The local property tax: a benefit tax or a capital tax? As we discussed above there is a vast literature on property tax incidence. A more recent branch of the literature has a somewhat broader approach aiming at understanding how to best view a local property tax. The two competing views are the “benefit view”, in which the local property tax is merely a fee for public services, and the “new view”, in which the local property tax is seen as a distorting tax on capital. The following section discusses these two views, beginning with the “benefit view”.4

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Also see the discussion about the Tiebout-model in the next section.

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As will be seen, the differences between these two are basically the underlying assumption used. The question is, therefore, rather how to best model the local property tax than how to ”view” it. However, since the terms ”benefit view” and ”new view” are well established in the literature I will conform to this.

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Bickerdike (1902), who in turn draws on Marshall (1897), noted that the public services presumably have an impact on the choice of residence. Since these papers are around 100 years old we can see that the subject of public service and choice of residence has been studied for some time. Around 50 years later, Bickerdike’s idea was used in a classic paper by Charles M. Tiebout (1956). Tiebout introduces what later is to be called Tiebout-choice as a solution to efficient provision of public goods. This was done as a reply to Paul A. Samuelson (1954) “The Pure Theory of Public Expenditure” in which Samuelson stated that no decentralized pricing system can serve to determine optimally the level of collective consumption. The Tiebout-model has had tremendous influence on the property tax literature since5 and is, hence, worth a closer description. Tiebout constructed a model in which there are several jurisdictions with independent local governments. He then lets perfectly mobile residents decide in which jurisdiction to live. The interesting conclusion is that the competition among jurisdiction will result in that each jurisdiction offers a tax/publicservice bundle and that this leads to an efficient provision of public goods. The key to this solution lies in the perfectly mobile residents. If there is another jurisdiction, which offers a more attractive bundle than the one in which they currently reside, they will simply move, a phenomenon known as “voting with one’s feet”. As pointed out by Wilson (1999), it is not surprising that Tiebout gets an efficient solution, since the model operates very similar to a perfectly competitive market model. In such a model there are many firms, none of which can influence the price – they are all price-takers. In Tiebout’s model there are many jurisdictions, none of which can influence the utility level needed to get residents to choose their jurisdictions to reside in. The jurisdictions are “utility-takers”. Just as the perfect competition model achieves an efficient allocation, so will the Tiebout model.6 The many similarities between the Tiebout model and the perfect competition model leads Dowding and John (1994) to conclude that much of the criticism against the Tiebout model as being too unrealistic (Dowding and John mentions Brazer (1964), McLean (1987) and Sharpe and Newton (1984) as examples) is rather criticism against the competitive model in general, than against the Tiebout model in particular. It must be noted that Tiebout does not assume the use of any kind of property taxes. Rather, he uses head-taxes in his model. The step from head-taxes to property taxes,

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As well as on urban economics and policies in general. An indication of this is perhaps that when Dowding and John (1994) counted the number of citations of Tiebout in articles and books since 1970 they found more than 1000 citations.

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There is a recent branch of the literature dealing with tax-competition, which argues that there are market failures at work here (mainly inter-jurisdictional externalities). Under such market failures the Tiebout result that tax-competition is welfare enhancing does no longer hold. There is an extensive and highly readable review of the tax-competition literature in Wilson (1999).

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which seems to be more extensively used, at least in the US, was taken by Hamilton (1975, 1976)7. Hamilton studies what is needed to construct a Tiebout-like model using property taxes instead of head taxes. The conclusion is that it is possible to achieve an efficient level of public services (just as in the Tiebout model) using property taxes if the local government can use zoning ordinances. The reason for the need of zoning is that, if there were no zoning, there would be an incentive to construct a small (inexpensive) house in a big-house (expensive) area and thereby free-ride on the public goods provided. Or as Fischel (1992, p. 171) so nicely sums it up: “The family of eight that wants to rent part of a lot in Scarsdale and park two house trailers on it and send their kids to Scarsdale’s fine schools is apt to find a few regulations in the way”. The essence of the Hamiltonian view is that a local property tax operates as a benefit tax. That is, the tax will simply be a fee for public services. In equilibrium each consumer will receive exactly the amount of public services he demands and will also pay in accordance to this. As a result, the local property tax will not be associated with any dead-weight losses. This benefit-view of the local property tax was criticized by Mieszkowski and Zodrow (1989). They have two main objections against the benefit-view, both associated with the assumption of zoning. The first is that such extensive zoning that is needed in the Hamilton model does not exist in the real world8 and, thus, the benefit-view is not realistic. The second source of criticism is that the zoning will be binding in Hamilton’s model. As a consequence the residents have no possibility to change behaviour to avoid the tax (apart from moving). Mieszkowski and Zodrow conclude that under such circumstances any tax can be transformed into a head tax. The alternative view of the local property tax is the “new view”, which was developed by Thomson (1965), Mieszkowski (1972) and Aaron (1975)9. The model used in the new view consists of a nation containing several independent jurisdictions. Rather than viewing the local property tax as a fee for local public services, the tax is viewed mainly as a tax on capital. In particular the average property tax in the nation is borne by owners of capital. The local differences in tax compared to the national average are borne, to a varying degree, by consumers or suppliers of housing. It simplifies the presentation if the average effect is separated from the effect of differences in property tax among jurisdictions. Starting with the average effect, the most striking result from the new view is that the average property tax will affect all capital in the nation in such a way that the return to capital falls approximately with the

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In Hamilton (1975) each community is homogenous with respect to house values. This assumption is relaxed in Hamilton (1976), which allows heterogeneous communities with respect to house values. 8

This statement is heavily criticized in Fischel (1992).

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I follow Mieszkowski and Zodrow (1989) in the section about the new view.

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average property tax rate in the nation. The idea is that the property tax results in a decrease of return to capital in the housing sector. In turn, this results in an outflow of capital from the housing sector into other sectors, pushing down the rate of return in these sectors. This reallocation of capital continues until all sectors have the same aftertax rate of return. The fundamental reason for the effects of the average property tax found in the new view stems from two assumptions regarding capital. First, the capital stock in the nation is assumed to be fixed. Second, capital is assumed to be perfectly mobile. The differences in property tax between the jurisdictions result in what Mieszkowski (1972) calls the “excise tax effect”. Consider two jurisdictions, one with relatively high property tax and one with relatively low tax. The result of the excise tax effect is that, in the high tax jurisdiction, housing prices will be higher while wages and land rents will be lower than in the low tax jurisdiction. Another interesting implication is that the local governments will generally under-provide public goods in fear of losing mobile capital due to the necessary high property tax rate. This is in contrast to the benefit-view where the fundamental result is that the provision of public goods will be efficient. In addition to the benefit view and the new view there is also the so-called “classical view”. This classical view focuses on a single jurisdiction, and is thus a partial equilibrium model rather than a general equilibrium model as the new view; Simon (1943) and Netzer (1966). The classical view bears many resemblances with the new view – in particular the assumption of perfectly mobile capital. In fact, Mieszkowki and Zodrow (1989) argue that the classical view is only a special case of the new view, with the main difference that the classical view only focuses on the excise effect and not the effect following from the average property tax in the nation. From this presentation of proposed views of the property tax, it seems clear that, even though the subject has been investigated for some time, there is very little consensus on the question of how to view the property taxes. It also seems clear that the conflicting results stem from differences in underlying assumptions. The benefit view assumes perfectly mobile residents and, through zoning, immobile capital. The new view assumes perfectly mobile capital but immobile residents. It is probably not very controversial to suggest that in the real world neither capital nor residents are neither perfectly mobile nor perfectly immobile. As a consequence, two things seem necessary. First, a combined model using both the benefit view and the new view ought to be constructed. This is also suggested in Wildasin (1986) and Kotlikoff and Summers (1987). Second, the fundamental differences seem hard to approach through purely theoretical studies. Hence, there is a need for empirical studies of the matter, a conclusion also drawn by Zodrow (2001) and Nechyba (2001).

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4. Are land taxes neutral? Above the subject of interest was property taxes, and in particular local property taxes. In this section I will briefly address another branch of the tax literature, which deals with taxing only the land – not its improvements. This literature is of particular interest since land taxes have often been claimed to be neutral. Land has some distinct features distinguishing it from other goods; see Roakes (1996). First, its value depends on locational advantages, which is mainly outside the landowner’s control. Second, land is durable and, hence, its supply is more or less constant over time. Third, land is immobile. These features underlie the claim that a tax on land value cannot be shifted backwards or forwards and that it does not (under some circumstances, see below) distort the choice of land usage. James Mill is the earliest reference I have found. In 1848 he claimed that a tax on land rent10 can never be shifted forward to the consumer, Mill (1900). This claim builds on the Ricardo (1817) principle. However, the most classical reference when discussing land taxes is Henry George (1881) who argued that a land tax is the only price neutral tax and therefore the only tax that should be used. This is known as the Henry George theorem and it has been subject of much interest in the literature. However, both Mill and George consider a land tax levied on all land and that the tax will not result in withdrawal of land from production. Needham (2000) makes two remarks about this. First, the effect of a land tax depends on the price elasticity of demand and supply. Mill and George both used, through the assumptions made, a price elasticity of demand equal to zero. Needham argues that this is not necessarily the case (a high enough land tax will cause withdrawal of the land from production). Second, when looking at the supply of land for a particular use, rather than all land, a land tax on some use will influence the conversion to an alternative use. Needham (2000) is an interesting study since it looks at the possibility of using land taxes to influence land use. That is, to use land taxes as a complement to zoning.11 This is in contrast to the literature focusing on property or land taxes as a way for the government (or municipality) to raise revenues, in which the effect on land use from the tax should be as limited as possible. Even though Needham argues against the classic view of land taxes being price neutral and having no impact on land use he also states that land taxes will have small effects on price and virtually no effect on use. Hence, the use of land taxes as planning instruments is not recommended.

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Note that this claim builds on land rents not land values.

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It has been claimed that, as a complement or substitute to planning, there is need for a financial instrument to influence land use, (Delogu (1972), Netzer (1975) and Needham (1982) chapter 1).

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A special branch of the tax neutrality literature concerns the influence of taxes on the timing of development. Bentick and Pogue (1988) construct three different models to illustrate that the effects of a land tax and/or a capital gains tax is specific to the model. This is in contrast to general view that a tax on the land’s market value pushes redevelopment forward in time and that a capital gains tax (if correctly set) will have no impact on timing.12 In the studies on the neutrality of land taxes it is important whether or not the land’s current use influences the land value. If this is the case a land value tax may be nonneutral. If the land value is based on “highest and best” use, the land tax is neutral, see Bentick and Pogue (1988), Bourassa (1992) and Bentick (1997). To conclude, a tax only on land values is often suggested as an alternative to property taxes. There seems to be strong consensus about that a land tax cannot be shifted. However, there is still some disagreement among researchers as to whether or not the land tax will influence the land use. Primarily, the dispute is whether or not the land tax will influence the timing of development.

5. Empirical studies13 There is a vast literature trying to test empirically different implications of the Tiebout model. An extensive review is found in Dowding and Peter (1994), who surveys not only economic studies but also studies made by political scientists and demographers. Dowding and Peter list eleven testable hypotheses following from the Tiebout model and sorts them into five headings.14 I will deal with only one of these headings, namely the question to what extent differentials15 in property taxes and public services are capitalized into housing values. The classic empirical study on capitalization is Oates (1969). The majority of studies conducted after Oates are either extensions of Oates’ study or replicates thereof.

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According to Roakes (1996) proponents to this view include Skouras (1978), Bentick (1979), Mills (1981), Noguchi (1982) and Wildasin (1982).

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The review of empirical work draws on Guilfoyle (2000), which in turn acknowledge Bloom, Ladd and Yinger (1983) and Yinger, Bloom, Börsch-Supan and Ladd (1988) as being excellent review studies of empirical work in the field of property tax.

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The five headings are city-size interpretations, homogeneity interpretations, capitalisation studies, migration studies and micro-level studies.

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The lack of variation in average property tax rate makes it hard to conduct empirical studies on its implications. Therefore, the studies made have in general focused on the effects of differences in property taxes and public service levels.

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Oates (1969) carries out an empirical study in which it is shown that an increase in property tax not accompanied by an increase in output of local expenditure is highly correlated with a decrease in property values. If, however, the tax increase is accompanied by an increase in local expenditures the correlation with property values is limited or even reversed. This result is consistent with the Tiebout hypothesis. A difficulty with these kinds of studies is how to measure local expenditure (or, to be more precise, local public service). Oates uses expenditure per pupil in public schools as a measure on local expenditures. Pollakowski (1973) criticizes this proxy for public service arguing that Oates’ conclusion is only valid under very restrictive circumstances. Oates (1969) also recognizes that the causality is unclear. The theory generally assumes that higher tax rates will capitalize into lower house prices, if the possible increase in public services is left aside. However, in a community with low housing values a relatively high tax rate is needed to finance a given level of public service. Hence, it is hard to establish whether a high tax rate gives low housing values (through capitalization) or low housing values results in a need for high tax rates. Oates uses several instruments to check for this, but the results suggest that the causality problem is not very well dealt with by these instruments (Guilfoyle, 2000). King (1977) argues that Oates’ use of tax rate as a variable is unfortunate since the monetary effect of this is higher for more expensive housing. Instead King suggests the use of tax payment as dependent variable. Applying this to Oates’ sample results in a lower capitalization than the one found by Oates. Both Oates and King use expenditure per pupil in public schools as a proxy for public service quality. Other studies use other measures16, but in many cases they are still associated with expenditure. Rosen and Fullerton (1977) claim that public expenditure is not necessarily a good measure of public service quality. Replacing this with fourth grade student scores results in a slightly lower capitalization than in Oates (1969). Rosen and Fullerton do not, however, use the King (1977) view of tax. A study that does not look at house owners but at renters is Carroll and Yinger (1994). This study pays much attention to the mobility of the renters. An interesting result is

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Dowding and John (1994) list the following: Education expenditure per pupil, as Oates (1969) and King (1977), include Case (1978), Edel and Sclar (1974), Gronberg (1979), Heinberg and Oates (1970), Meadows (1976) and Pollakowski (1973). Total non-school expenditure per capita is used by Gustely (1976), Meadows (1976) and Oates (1973). Crime rates and recreational-quality index is used by McDougall (1976). Highway-maintenance expenditure per square mile is used by Edel and Sclar (1974).

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that, even if the renters are mobile, they will bear some of the (differential17) property tax. All of the empirical studies mentioned above have used aggregate data. There are also some studies using non-aggregate, micro-level, data. That is, data on the housing level. Examples of such include Krantz, Weaver and Alter (1982), Lea (1982), Richardson and Thalheimer (1981) and Palmon and Smith (1998). Another approach is to take advantage of large changes in tax-structure and study the effects thereof in, what may be viewed as, a full-scale experiment. Several authors have paid attention to Proposition 13 that was approved in California in 1978. Proposition 13 stated that the tax rate must not exceed 1% of the property’s value. Two examples on this are Rosen (1982) and Gabriel (1981). Both these studies examine the effect of the tax cut on average housing prices in the San Francisco Bay Area. Gabriel finds a higher degree of capitalization than Rosen. According to Guilfoyle (2000) this is due to Gabriel suppressing the constant term in the regression, which would capture any changes in overall prices in the region. Hence, the two studies do not measure the same thing. Yinger, Bloom, Börsch-Supan and Ladd (1988) utilize another large tax reform, namely a major property revaluation in Massachusetts in the early 1970’s. Their result suggests that tax differences do not fully capitalize into housing values. However, they claim that this is due to uncertainties surrounding the reform and, without these uncertainties, a full capitalization would have been found. A recent study by Bradbury, Mayer and Case (2001) looks at another tax reform in Massachusetts known as Proposition 2½, which limits the effective property tax to 2.5% and limits the annual growth in property tax revenues to 2.5%. This study is primarily concerned with the fiscal behaviour of local governments under the tax constraint and not so much with capitalization. One interesting conclusion, in the light of the discussion above, is however that changes in non-school spending seem to have very small impact on property values.

6. Concluding remarks Above I have discussed different branches of the property tax literature in general with emphasis on local property taxes. The most striking impression from this discussion must be the lack of agreement on several issues. In my view, all the theoretical models

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Only the part of the property tax that differs from other communities is of interest. If all communities use the same tax rate renter mobility will have no impact on these models.

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discussed above make very good sense. But they cannot all be correct at the same time since, in many cases, they provide opposite results. A natural step then would be to conduct empirical studies. Unfortunately, the empirical work also yields very diverse results. Consequently, there is still lot of work to be done. New theoretical models need to be developed and even more sophisticated empirical studies need to be conducted. I am not able to guide the direction of such studies, but I do agree with two suggestions made in the literature. First, the different views on the property tax (mainly the benefit view and the new view) should, in some way, be merged (Wildasin; 1986, Kotlikoff and Summers; 1987). Second, in many of the models above there seems to be room for strategic choice. This calls for models taking advantage of game theory to model local government and other agents. This is also suggested in Dowding and John (1994). I have not found any studies that explicitly try to merge the different views on property taxes. However, in the tax competition literature there are recent studies in which both capital and consumers are mobile.18 Also, in the tax competition literature there seems to be a strong tendency towards models utilizing game theoretic approaches. Studies where tax competition among communities is imperfect are not uncommon; see Henderson (1995) for a discussion. A recent study using Nash tax competition19 is Kunce (2000), in which the Henry George theorem, see above, is extended. An interesting approach is found in Hoxby (1999) in which the focus is on information asymmetries. Hoxby constructs a model where local property taxes and Tiebout choices yield at least as good results as would be the case with a centralized social planner. What makes Hoxby’s approach interesting is the reason for the results, namely that the Tiebout mechanism will reveal more information than the social planner has access to and that some information vital for the social planner is not necessary with Tiebout choices. To conclude, even though a lot of work concerning local property taxes has been done, there seems to be room for a great array of interesting research associated with property taxes yet to be conducted. I would not be surprised if this issue turns out to be subject to another hundred years of interesting studies.

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It is beyond the scope of this paper to discuss the tax competition literature. However, Brueckner (2000) mentions Hoyt (1991, 1993), Burbridge and Myers (1994), Henderson (1994, 1995) and Wilson (1997) as examples on studies assuming both mobile capital and mobile consumers.

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Jurisdictions play a Cournot / Nash game in tax rate. Each jurisdiction set taxes to maximize its residents’ utility, given the tax policies of other competing jurisdictions.

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