Local Property Taxation
The property tax is, in my view, a good local tax, though it is far from perfect. Relative to the other tax bases available to local government, I think the property tax gets high marks, in spite of some telling but, in part, misplaced criticism.
Traditional Tax Theory
Public finance economists have historically evaluated taxes in terms of their efficiency properties, their incidence and their ease of administration. From the perspective of economic efficiency, the basic issue is the extent to which a tax introduces distortions into the economic system, thereby creating an “excess burden” in addition to the basic burden of payment of the tax. On this matter, there is currently a lively controversy. On one side, Bruce Hamilton, William Fischel and others argue (persuasively, I believe) that local property taxation, in conjunction with local zoning ordinances, produces what is effectively a system of benefit taxation that promotes efficient location and fiscal decisions on the part of households. On the opposing side, Peter Mieszkwoski and George Zodrow view local tax differentials much like excise taxes, which have a distorting effect on local decisions and tend to discourage the use of capital. Thus, the case for property taxation purely on efficiency grounds is not altogether clear (although it probably gets better marks than other available tax bases aside from user charges).
As to the incidence of the tax, the older view of the property tax, which saw it simply as an excise tax on housing and business structures, suggested that it was a regressive tax: housing expenditure, it was claimed, took a larger fraction of income from poorer rather than from wealthier households. Later studies of the income elasticity of demand for housing cast some doubt on this proposition. The finding that housing expenditure is roughly proportional to permanent income suggested that property taxation was something more akin to a proportional tax relative to income.
The more recent and so-called “new view” of the property tax sees the average tax rate across communities as essentially a tax on capital; as such, it is likely to be quite progressive in its incidence. The differentials across communities are another matter: they may function like excise taxes on specific factors, but overall this approach suggests that the property tax is likely to be a good deal more progressive than, say, a sales tax. The third issue, the administration of the property tax, raises one troublesome matter. Since housing units are sold only infrequently, tax liabilities must be based on an estimated or “assessed” value. The vagaries of assessment practices have been the source of some unhappiness with the tax, as the ratio of assessed value to true market value can sometimes vary widely within a single taxing jurisdiction. Reforms and improvement of assessment practices, however, have gone some distance in mitigating this problem.
A Public-Choice Perspective
The public-choice approach to issues in public finance has focused attention on another dimension of tax systems: their role in promoting effective decision making in the public sector. In this framework, a critical function of a tax system is to provide an accurate set of signals, or “tax-prices,” that make clear to local taxpayer-voters the costs of public programs on which they must make decisions. In a local context, this implies that the local tax system should generate tax bills that are highly visible and that provide a reasonable indication of costs so that individuals have a clear sense of the financial commitment implied by proposed programs of public expenditure. If taxes are largely hidden or don’t reflect the cost of local services, they are unlikely to provide the information needed for good fiscal decisions. For example, if a local government were to finance its budget through a local corporation income tax, the residents would have little idea of the true cost of local public programs to their household. Hidden taxes with uncertain incidence are not conducive to good fiscal choices. From this vantage point, the local property tax comes off quite well as a source of local revenues. Property tax bills are highly visible and they promote a high degree of voter awareness of the cost of local programs. In fact, local property tax rates are often tied directly to proposed programs on which the voters must decide in a local referendum. It is this high degree of visibility that, I think, explains much of the unpopularity of the tax!
The local property tax thus appears to function well in its public-choice role of providing a reasonably accurate set of tax-prices to residents. There is, however, one important reservation here: renters. Owner-occupants receive regular property tax bills that indicate the cost to them of the local services they receive, but occupants of rental dwellings receive no such tax bills. Under the present administration of the property tax, tax bills go to the owner of the unit, not the occupant, so that renters never see the exact amount of property tax assessed on their residence. This does not, of course, mean that renters avoid the burden of the property tax. There is good reason to believe that property taxes on rental units are (eventually at least) shifted onto tenants. The point is that renters do not face the same visible tax-prices that confront owner-occupants.
Moreover, there is considerable evidence to suggest that renters behave as if they think they pay no local property taxes. They appear to provide much more support for public expenditure programs than they would if they owned their own homes and knew exactly what they paid in property taxes. The impact of this “renter illusion” on local public budgets needs to be studied further. If it is large, there may be a strong case for reforming the administration of the tax so that property tax bills go directly to occupants rather than to landlords.
Interjurisdictional Fiscal Inequality
Over the past three decades, systems of local property taxation have been the subject of intense public attack accompanied in some instances by court decisions requiring their replacement or reform. The basis for these attacks is primarily an equity issue arising from disparities in the size of the tax base across different localities. In several states, the system of school finance, based on local property taxes, has been declared unconstitutional because of the sometimes large differences in the property tax base per pupil across local school districts; this can result in large differences in per-pupil expenditure. A little reflection, however, suggests that this problem of disparities is not a problem intrinsic to the property tax per se. It is really a result of virtually any system that relies heavily on local taxation. A system of local sales or income taxes, for example, would surely involve major disparities in tax bases across local jurisdictions-probably at least as large as those associated with local property taxes.
The basic point is that fiscal and other economic conditions vary across local areas. (This, incidentally, is a major rationale for local finance: to cater to these differences!) Thus, taxable resources at the local level are bound to vary significantly across jurisdictions. We may well wish to provide additional support to fiscally weak jurisdictions through some kind of intergovernmental fiscal assistance, but this will be true whether local tax systems rely on property taxation or some other local tax base.
Alternative Local Tax Bases
Two major tax bases offer themselves as alternatives: sales taxes and income taxes. Both, however, have serious shortcomings as the primary source of tax revenues in a nation of many small local governments.
The base of a local sales tax is likely to vary dramatically across local jurisdictions. Communities that are largely residential would have small bases and would have to set a relatively high rate to generate the requisite revenues. Significant sales tax differentials would give rise to costly trips among jurisdictions, as consumers seek to purchase goods and services in jurisdictions with low tax rates. Moreover, sales taxes do not get very good marks on a fairness or ability-to-pay criterion. In addition, they do not stack up at all well on the public-choice criterion of providing the electorate with accurate and visible signals of the costs of public programs. Income taxes have a good deal more appeal on equity grounds, although most state and local income taxes are not very progressive. They also have the advantage of visibility. But, like sales taxes, they encounter the mobility problem to some extent. A jurisdiction that opts for relatively high income tax rates runs the risk of deterring the entry of new households, especially those with above-average incomes that would face relatively large tax payments.
More generally, there is something to be said for avoiding excessive reliance in the economy as a whole on a single tax instrument. The federal and many state governments rely on income taxation as a primary source of revenue, and there is considerable concern that marginal tax rates on income have become sufficiently high to discourage various sorts of productive activity. From this perspective, local government may contribute to an improved overall tax system by avoiding heavy use of income taxation and staying instead with the revenue source that has been historically its own-the property tax.
The other appealing source of local revenues is user fees, which represent a form of benefit taxation and provide almost a kind of market test for the provision of the service. The problem is that they are limited in their application. It may be possible to charge for the use of certain public services like refuse collection, but it is much more difficult to employ charges for collectively consumed services like police protection and local roads. Fees can be used to finance a limited number of local services, but they cannot supplant the need for a major local tax.
For local fiscal choice to have real meaning, it is essential that local residents bear the costs of their decisions to adjust levels of local services. The populace must be in a position to weigh the benefits of public programs against their costs. For this to occur, local governments must have their own revenue systems with some discretion over tax rates. There is surely some scope for mitigating fiscal disparities across jurisdictions with an appropriately designed system of equalizing intergovernmental grants. However, the grants must not be so large as to undermine local fiscal autonomy, and they should, in principle, be lump-sum in form so that localities bear the cost of their fiscal decisions at the margin.
The question here is which of the available tax bases offers the greatest promise for effective local fiscal decision making. In my view, it is the property tax.
Wallace E. Oates is professor of economics at the University of Maryland and University Fellow at Resources for the Future in Washington, D.C. He is also a member of the Lincoln Institute Board of Directors. This article is adapted from a longer paper that he prepared for the Institute’s Fall 1998 Chairman’s Roundtable on property taxation and that he also presented as the Founder’s Day Lecture in January 1999. The original paper will be published in the Institute’s 1999 Annual Review.
Fischel, William. “Property Taxation and the Tiebout Model: Evidence for the Benefit View from Zoning and Voting,” Journal of Economic Literature 30 (March 1992): 171-7.
Hamilton, Bruce W. “Capitalization of Intrajurisdictional Differences in Local Tax Prices,” American Economic Review 66 (Dec. 1976): 743-53.
Mieszkowski, Peter, and Zodrow, George R. “Taxation and the Tiebout Model: The Differential Effects of Head Taxes, Taxes on Land, Rents, and Property Taxes,” Journal of Economic Literature 27 (Sept. 1989): 1098-1146.
Oates, Wallace E. “On the Nature and Measurement of Fiscal Illusion: A Survey,” in G. Brennan et al., eds., Taxation and Fiscal Federalism (Sydney: Australian National University Press, 1988): 65-83.
---. “The Theory and Rationale of Local Property Taxation,” in Therese J. McGuire and Dana Wolfe Naimark, eds., State and Local Finance for the 1990’s: A Case Study of Arizona (Tempe, Arizona: School of Public Affairs, Arizona State University, 1991): 407-24.