Property Taxes and Tax Revolts: The Legacy of Proposition 13

Property tax revolts have been a much publicized feature of contemporary political life in the United States and abroad. Focusing on California's experience with Proposition 13, which has had potentially far-reaching political ramifications yet whose effects and possible alternatives have been little understood, this book examines the causes and consequences of property tax revolts. The authors begin by discussing the origins of four different historical episodes with property tax revolts and the nature of property tax systems throughout the world. They then examine the consequences of property tax limitations with a detailed analysis of the acquisition-value tax system put into place in California by Proposition 13. New theoretical approaches and new evidence from a comprehensive empirical study are brought to bear on the California experience in order to highlight the equity and efficiency of the property tax system. Since property taxes are the primary source of revenue for local governments, the authors compare and contrast the experiences of Massachusetts and California with regard to the evolution of local government following property tax limitations. Finally, the book considers alternatives for reform and lessons to avoid future property tax revolts.

PROPERTY TAXES AND TAX REVOLTS

Property taxes and tax revolts The legacy of Proposition 13

ARTHUR O'SULLIVAN Oregon State University

TERRI A. SEXTON California State University, Sacramento

STEVEN M. SHEFFRIN University of California, Davis

CAMBRIDGE UNIVERSITY PRESS

Published by the Press Syndicate of the University of Cambridge The Pitt Building, Trumpington Street, Cambridge CB2 1RP 40 West 20th Street, New York, NY 10011-4211, USA 10 Stamford Road, Oakleigh, Melbourne 3166, Australia © Cambridge University Press 1995 First published 1995 Library of Congress Cataloging-in-Publication Data O' Sullivan, Arthur. Property taxes and tax revolts : the legacy of Proposition 13 / Arthur O'Sullivan, Terri A. Sexton, Steven M. Sheffrin. p.

cm.

Includes bibliographical references and index. ISBN 0-521-46159-6 (he) 1. Real property tax - California. 2. Real property tax - United States. 3. Tax and expenditure limitations - California. 4. Tax and expenditure limitations - United States. I. Sexton, Terri A. II. Sheffrin, Steven M. III. Title. HJ4191.085 1995 336.22'09794 - dc20 94-6770 CIP A catalog record for this book is available from the British Library. ISBN 0-521-46159-6 hardback

Transferred to digital printing 2004

CONTENTS

List of tables, figures, and boxes Preface 1 2 3 4 5 6 7 8

The context and significance of tax revolts The diversity of property tax systems The simple analytics of an acquisition-value tax system Measuring the disparities Incidence, mobility, ownership, and capitalization Tax limitation and local government Revenue projections and policy alternatives The future of the property tax

Notes References Index

page vi ix 1 15 39 55 71 94 121 136 146 151 155

TABLES, FIGURES, AND BOXES

Tables 1.1 Acquisition-value taxation 2.1 Average effective property tax rates, existing singlefamily homes with FHA-insured mortgages, by state and region 2.2 Assessment practices 3.1 Renewal theory functions 3.2 Algebraic relationships 3.3 Functions for the mixed exponential 3.4 Base-year distributions and disparity ratios 4.1 Base-year distribution and disparity ratios for two counties 4.2 Disparity ratios and base-year distributions 4.3 Calculating average effective tax rates 4.4 Modified and nonmodifled properties 4.5 Other residential property 4.6 Commercial and industrial property 4.7 Tax rates across properties 5.1 Average change in tax liability for different income groups 5.2 Variation in changes in taxes within selected income groups 5.3 Percentages of homeowners with 1975 base years, by income and senior status 5.4 Tax change for senior and nonsenior households 5.5 Effects of switch to the market-value tax 5.6 Excess burden per household for different appreciation rates and decay rates

page 1

25 36 43 43 45 48 59 60 61 63 65 68 69 74 75 77 78 86 86

VI

List of tables and figures 6.1 6.2 6.3 6.4 6.A

6.B 7.1 7.2 7.3 7.4 7.5 7.6

7.A 7.B 7.C 7.D 7.E

3.1 3.2 3.3 3.4 3.5 4.1

Revenue transfers under SB 154: an example 1992 revenue ratios by class of property County data matches Statewide revenue ratios San Bernardino County revenue-ratio computation, nonmodified single-family residential property with homeowner's exemptions Colusa County revenue-ratio computation, single-family residential and commercial/industrial property Projected tax revenue from current tax system and a market-value system: medium appreciation rate Projected tax revenue from alternative tax systems: medium appreciation rate Revenue-neutral tax rates for different tax systems: medium appreciation rate Revenue from transfer tax as percentage of revenue from current tax system: medium appreciation rate Mechanics of deferred tax for property purchased before tax reform Revenue from simple deferred market-value tax as percentage of revenue from current tax system: medium appreciation rate Projected tax revenue from current tax system, 1992, 2000,2008 Projected tax revenue from market-value tax system, 1992, 2000, 2008 Projected tax revenue from alternative tax systems, 1992, 2000,2008 Revenue-neutral tax rates for different tax systems, 1992, 2000,2008 Revenue from acquisition-value tax, transfer tax, and deferred market-value taxes: medium appreciation value Figures Hazard and survivor functions for the baseline model Age distribution for properties at t = 0 Age distribution for properties at t = 17 Age distribution in the long run Survivor functions for different inflation rates Disparity ratios for homeowner property in Los Angeles County

vii 100 111 112 113

118 120 125 126 127 129 130

130 132 133 133 134 135

46 47 47 48 53 64

List of tables and figures 5.1

6.3

Average change in tax liability for different income groups in Alameda County Distribution of tax changes within different income groups in Alameda County Percentages of homeowners in Alameda County with 1975 base years, by income: seniors and nonseniors Average tax change: senior versus nonsenior households Time per dwelling under market-value and acquisitionvalue systems, appreciation rate equal to 6% Gains and losses from switch to market-value tax system for different decay rates and appreciation rates Household utility for ownership and renting under the market and acquisition-value tax systems Percentage of county revenue by source Outstanding benefit assessment bonds in millions of dollars Mello-Roos financing

3.1

Boxes The tax premium and mobility for an L.A. homeowner

5.2 5.3 5.4 5.5 5.6 5.7 6.1 6.2

viii 74 75 76 78 83 85 88 103 106 107

51

PREFACE

The research for this book began with a very practical question. What would happen if the United States Supreme Court overturned the entire property tax system in California that was swept in by Proposition 13? When our research began in 1991 this was a very real possibility. Officials and staff in state government were extremely nervous. Not only would there be considerable political turmoil if Proposition 13 were overturned, but the factual basis for analyzing alternative property tax systems was scarce. There was a desperate need for research on the effects of Proposition 13 and its possible replacements. It was in this context that we began our research. A large part of our initial task was gathering great amounts of data from the counties on sales and property tax assessments in California. But as we began this task, we also realized that we needed to address a series of broader questions as well. How do other states and countries manage property taxes? What are the reasons for property tax revolts? How does a property tax system based on the purchase price of property work? How large are the inefficiencies associated with a property tax system that creates a penalty upon sale? Who were the real winners and losers from California's unique property tax system? This book addresses these questions as well as providing a detailed assessment of California's experience with Proposition 13. It is written for the broad audience of those interested in fiscal affairs and taxation. We explore the nature of tax revolts and property tax systems throughout the world, the nature of California's tax system, and the consequences of the tax system for taxpayer equity and economic efficiency. We also discuss how Proposition 13 and other tax revolts affected the structure of local governments. Finally, based on our analysis, we analyze options for property tax reform in California. In a presidential address to the American Economic Association, Nobel Prize winner Wassily Leontief lamented the fact that so few economists collect their own data. This work is a grand counterexample to Leontief's generalization. Records for property representing more than half the market value of real estate in California (more than 5% for the entire United States) resided IX

Preface

x

in our computers at one time or another. Because our work was of direct interest to policymakers, we had the full cooperation of county assessors and state tax authorities. This allowed us to obtain access to computer files for property tax records and to eventually match some of these records with income tax returns. As Leontief knew, collecting vast amounts of original data is difficult, but the rewards in terms of new insights are high, especially when state-ofthe-art social-science methods are also employed. In conducting this research, we had assistance and advice (often unsolicited) from a wide range of informed individuals whom we cannot even begin to name. County assessors, legislative staff, and experts in taxation in Sacramento, as well as academic economists, advised us at many stages on the availability of data and the appropriateness of our methods. In particular, Jeff Reynolds of the Board of Equalization of California shared his work and insights into the property tax with us at a very early stage. Phil Spilberg from the California Franchise Tax Board worked with us on matching tax returns to property tax records. Ellen Worcester of the Assembly Office of Research in California served as our guardian angel for this project. She was omnipresent. A talk she gave suggested the research needed. She helped us secure funding for the project, organized advisory-group meetings, and used her political connections to give us access and credibility with key groups. Most important, she was a fountain of original ideas on the execution of the project. Without her, this research would not have been conducted. We were also blessed with two superb research assistants, Steve Perez and Bob Cenzer. Bob became an expert in deciphering property tax files and transforming them into a usable form whereas Steve helped develop the analytical models that we used throughout our work. Both were full partners in the project. We also wish to thank Jenny Swenson, who organized teams of graduate students to sample the property tax records of two counties whose computer systems did not contain all the information we needed. Funding for the research was provided through grants from the California Policy Seminar and the California Assembly Office of Research. We also drew on the resources of the Center for State and Local Taxation at UC Davis. Finally, we are grateful for the support and advice given to us by Scott Parris, our editor from Cambridge, as he helped us develop the format for this book and urged us to place our research into the broadest context.

The context and significance of tax revolts

The first major tax revolt in postwar United States history took place in California in June of 1978. Voters approved by overwhelming majority Proposition 13, which amended the state constitution. In the next several years, the taxlimitation movement swept the country, with more than 58 separate ballot measures appearing throughout the country between 1979 and 1984. In 1980, in another major episode, voters in Massachusetts approved Proposition 2Vi, which limited both the rate and growth of property taxes to 2.5%. What were the origin and significance of the tax revolts that shook the United States in the late 1970s and early 1980s? Some observers believed that these tax uprisings signaled a new relationship between government and the citizenry, a revolt against government in general. Contrary to their predictions, however, government continued to grow throughout the 1980s and 1990s. It is more instructive to view the tax revolts as reactions against perceived abuses of a particular tax, the property tax. Revolts against the property tax are not new phenomena and have taken place throughout the world. In order to gain a better appreciation for the context of tax revolts and Proposition 13, it is valuable to examine four distinct episodes of revolts against the property tax: the limitation movement during the Great Depression, Proposition 13, Proposition 2V2, and the revolt against the poll tax in the late 1980s in the United Kingdom. Four tax revolts The tax revolts of recent years pale in comparison to the activities that took place during the Great Depression. In 1932 and 1933 alone, 16 states and numerous localities enacted property tax limitations. Perhaps more significant were organized tax-resistance movements throughout the country. In Chicago, there was even a virulent tax strike that lasted from 1930 to 1933.l The origins of the tax revolt during the early days of the Great Depression are not hard to fathom. As real income fell by 33% over the first three years of 1

Property taxes and tax revolts

2

the Depression and unemployment soared to more than 25%, many owners of property became unable to finance the taxes on their property. The median delinquency rate for cities with populations greater than 50,000 rose from 10.1% in 1930 to a high of 26.3% in 1933.2 In some cities in the country, delinquency rates exceeded 50%. Prior to the Great Depression, local governments became highly dependent on the property tax for their revenues. Although in many states, all property (including financial property such as stocks and bonds) was supposed to be taxed, in reality, the burden fell almost exclusively on real properties, that is, real estate and land. As incomes fell, taxpayers found that real-estate taxes became an unacceptable burden. State legislatures were slow to react to the increased burden of property taxes because any reductions in property taxes would require new sources of revenue in order to avoid drastically cutting service levels. In fact, as voters took matters into their own hands and voted for property tax limitations, states began to enact sales and income taxes to partially compensate for the loss of property tax revenues. While the sharply deteriorating economic conditions led to property tax limitations, the tax strike in Chicago bore the stamp of that city's machine politics. Prior to the Great Depression, tax assessments were part of the local political machine. "Tax fixing," or adjusting assessments as payoffs for cooperating with the political machine, was rampant. When tax assessments were made public in 1928, the extent to which assessment percentages varied as a percentage of market value created a public outrage and led to a two-year tax holiday until new assessments could be made. When the bills came due, taxpayers were required to pay three years' worth of property taxes in a period of only 16 months. Meanwhile, a well-organized real-estate group promoted tax resistance and the withholding of tax payments. Their rallying cry was that Illinois law required equal assessment of all property but that financial property was not being assessed. Early court victories spurred the strike, but later losses in court, plus a vigorous campaign against the group, broke the strike. If deflation and falling real-estate values and income were the problem during the Great Depression, the reverse was true during the 1970s in California. Inflation was troublesome. Housing prices soared in many places in California, and local governments were slow to lower tax rates. The result was rapidly increasing tax bills for many homeowners, upward of 20-30% per year. Moreover, it was not just the level of taxes but their uncertainty that upset the payers. Taxpayers had no assurance that their property tax burdens would not eventually force them out of their property. Looking back, the complex origins of Proposition 13 are not too difficult to discern.3 Total tax burdens in California were growing more rapidly than in other states. In particular, the extremely rapid rate of housing inflation led to dramatic increases in property taxation. The share of the property tax directly

The context and significance of tax revolts

3

levied on homeowners also increased from approximately 34% in 1970-71 to more than 44% in 1978-79. Finally, the state had been accumulating a large surplus that would have reached $10 billion in 1979 if Proposition 13 had not passed. The surplus emerged as rapid inflation led to a sharp increase in state revenues, and the legislature and government could not agree on a formula to cut tax rates. All these factors, plus some dramatic increases in assessments just prior to the vote, contributed to the passage of Proposition 13. In addition, the voters perceived that the state legislature was simply not taking their demands for property tax relief seriously. After Proposition 13 qualified for the ballot, the legislature scrambled to field a competing measure. This alternative would have taxed business property at a higher rate than that of homeowners, dramatically cut the tax bills of homeowners, and provided explicit tax relief for renters and the low-income elderly. However, this measure was more complex than Proposition 13 and was tainted by its affiliation with the legislature, which had dragged its feet in adopting tax relief. Proposition 13 passed by the overwhelming margin of 65% to 35%. Contemporary survey evidence suggests that voters did not desire largescale cutbacks in services when they voted for Proposition 13. Just before the election, 38% of the electorate believed that state and local governments could continue their current service levels with 40% cuts in revenues. Only waste and inefficiency would be eliminated by the budget cuts. Moreover, a detailed survey of voters revealed that Proposition 13 was supported by a large segment of the electorate that favored increasing spending in most areas of government.4 In an intriguing argument, William Fischel has argued that the California Supreme Court's ruling on educational finance cases inevitably led to the property tax revolt that culminated in Proposition 13.5 The California Supreme Court ruled that using the property tax to finance local education violated California's constitution because it allegedly discriminated against children who lived in districts with lower property tax bases. Residents of these areas would have to have a higher property tax rate to provide the same level of educational services enjoyed by residents of districts with higher property values. Although the wisdom of this ruling has been challenged (many poor children live in cities that have high property tax bases), the state was required to equalize expenditures across districts. Local residents, therefore, could no longer use their property taxes to improve the schools. However, most residents are willing to tolerate high rates of property taxation only if the proceeds are used for education - a publicly provided good that they value highly. With education funding no longer a function of their local property tax rate, there was no longer a good rationale in the minds of many for a property tax. A tax revolt, such as Proposition 13, was inevitable. Although Proposition 2l/i, which was enacted in Massachusetts in Novem-

Property taxes and tax revolts

4

ber 1980, is often associated with Proposition 13 in California, the actual context and causes are quite different. Unlike the case of California, it was not a dramatic increase in assessments that brought on the Massachusetts tax revolt, but rather a persistent overreliance on the property tax. By 1978, property taxes in Massachusetts were the second-highest in the country, but they had been only the eighth-highest in the country in 1957.6 By 1980 property taxes in Massachusetts were 70% above the national average and provided virtually all the revenues for cities and towns.7 The first initiative to limit real estate taxes to 2.5% was actually proposed in 1936 but did not qualify for the ballot. Massachusetts has an extremely elaborate initiative process that allows the legislature to respond to proposals through alternatives and modifications. After Proposition 13 passed in California, the first modern version of Proposition 2l/i was introduced. Over the next two years, there was a flurry of initiative activity from several taxpayer and business groups and within the legislature. Political pressure finally forced a recalcitrant legislature to allow the final version of Proposition 2Vi to be on the November 1980 ballot. Voters were given a choice to enact changes or remain with the status quo as the legislature again failed to propose alternative reforms that would reduce the overreliance on the property tax. Faced with a political system that failed to act, voters took the only possible action that would lead to a reduction in property taxes and passed the initiative by a vote of59%to41%. Surveys taken after the passage of Proposition 2l/i revealed a pattern similar to that in California. Voters believed that there was substantial waste and inefficiency in government and that Proposition 2lA would help eliminate it. They did want to reduce spending on welfare (which was under state control and had little to do with the property tax) but had no desire to reduce other levels of services. Perceived government inefficiency, not a desire to reduce the services provided by the government, provided support for the initiative.8 The surveys in California and Massachusetts do not provide an explanation for the timing and precipitating factors that led to the property tax limitations, but they do provide some clues as to why voters ultimately supported them. The United Kingdom had the dubious distinction of having a tax revolt after it essentially eliminated its residential property tax! The problem was that the replacement tax was the notorious "poll tax" instituted by Prime Minister Margaret Thatcher in 1988. The tax revolt in this case even led to violence, with a dramatic riot in Trafalgar Square in London. The poll tax replaced a property tax system known as the "rates," which based property taxes on the rental value of property. Under the rates, business property was taxed along with residential property, but only local residents could vote on the level of taxation. The Thatcher government decried what they perceived as the lack of accountability in local government and saw the

The context and significance of tax revolts

5

property tax structure as a fundamental flaw in the system. Their solution was to institute a nationwide system of business taxation and to levy a fixed charge per adult in each taxing jurisdiction, which they dubbed the "Community Charge," but which commonly became known as the poll tax.9 The poll tax was immediately labeled as unfair and regressive. Clearly its regressivity was an important part of its unpopularity; but several other factors contributed to its ultimate demise. First, it is much more difficult to levy taxes on mobile adults than it is on fixed structures. Compliance became an important issue as new taxpayers were brought into the system, and one out of five adults in England and Wales had to be issued a summons for payment. Second, the overall level of the poll tax in its initial year was substantially higher than had been anticipated, partly because of local spending increases and partly because of a shortfall in funding from the central government. Third, prior changes in law, unrelated to the poll tax, limited the rebates available to taxpayers. Finally, the complex system of grants from the central government coupled with historical differences in local spending patterns created wide disparities in the level of the poll tax across jurisdictions. This contributed to a deep sense of horizontal inequity. By March of 1991, the government had given up on the poll tax and announced it would substitute a new system. The replacement, known as the Council Tax, placed properties in eight categories according to their market value and levied afixedcharge for each category. This had the effect of limiting property taxes at the upper end of the spectrum, and studies have revealed that it is also quite regressive.10 Lasting consequences: acquisition-value taxation All tax revolts have some consequences. The limits on property taxes in the Great Depression led to the introduction of new tax sources. The poll tax was replaced by a unique property tax system, and the property tax burden was sharply reduced in Massachusetts. However, the most dramatic changes came in California. It was not the property tax limitation per se, but the manner in which it was imposed, that had profound long-term consequences. To understand these consequences, it is important to examine the explicit provisions of Proposition 13. Four key property tax provisions were contained in it: 1. The maximum rate of property taxation was limited to 1%, not including preexisting indebtedness. 2. The assessed value of all property was "rolled back" to its value in 1975-76. 3. Assessed value for property could increase with inflation, but only at 2% a year. If there was a change of ownership, the property would

Property taxes and tax revolts

6

be assessed at its market value, which was usually the purchase price. 4. State and local government could not impose any other property taxes, sales taxes, or transactions taxes on real property. In later years, two amendments were added to these provisions. The voters allowed taxpayers over the age of 55 to move within their county while retaining their property tax assessments as long as they purchased a house of lesser value than their current residence. Intercounty reciprocity agreements have extended the scope of this amendment. The voters also allowed for property to pass within families without triggering a reassessment. The property tax provisions of Proposition 13 had three main effects. First, there was an immediate reduction in property tax revenue in 1978 of about 57%. The average effective property tax rate was approximately 2.5% of market value at the time of the passage of Proposition 13. The 1% limitation and the rollback to 1975-76 assessed values led to this sharp decrease. In order to avoid massive disruptions in the provision of services, the state government replaced most of these funds. Second, the state had to design an entirely new system of local property taxation. Prior to Proposition 13, each local government agency or district would levy its own tax rate, and the property in that district would pay the total of these separate levies. For example, if the rates for the city, school district, and mosquito district were 1.5%, 0.8%, and 0.3% respectively, the taxpayer would face a total 2.6% property tax rate. However, under Proposition 13, the total property tax rate was limited to 1%. Rates could no longer be set at the level of each district and then simply aggregated. Instead, a system had to be developed to share or partition total property tax revenues within each county to all of the separate districts. A complex system for sharing these revenues is in place today. Finally, perhaps the most important consequence of Proposition 13 was a fundamental change in the nature of property taxation itself. Prior to Proposition 13, California had a traditional ad valorem property tax, in which a rate was applied to an estimate of the market value of the property. After Proposition 13, the best way to think of the property tax is as an "acquisition value" property tax. Except for the maximum 2% adjustment for inflation, the property tax was based on the acquisition or purchase price of the property. Even if the property sharply appreciated in value, the property tax of any owner was based on the purchase price plus a maximum of 2% a year. Table 1.1 illustrates the operation of an acquisition-value system. In year 0, a property is purchased for $100,000. Assuming a 10% inflation rate, after 10 years the property will be worth $259,000. However, its assessed value can only increase by 2% per year. After 10 years, the assessed value is only $121,900. The ratio of the market value to the assessed value is known as the

The context and significance of tax revolts Table 1.1. Acquisition-value taxation Assessed Value

Market Value

YearO

$100,000

$100,000

Year 10

$121,900

$259,000

Disparity ratio = 2.12 This example assumes 10 percent inflation.

disparity ratio, and is 2.12. If someone else purchased an identical property in year 10, they would pay a tax based on the $259,000 purchase price, whereas the original owner paid a tax on only the $121,900 assessed value. Legal issues There had always been some doubt about whether an acquisitionvalue tax system was legal under the United States Constitution. As the example illustrates, because property taxes in this system are based primarily on purchase price, two taxpayers can easily face radically different taxes for virtually identical properties simply because they bought their properties at different times. Does this feature of an acquisition-value tax system violate the Equal Protection Clause of the Constitution? The Supreme Court gave a definitive answer to this question in 1992 in its judgment in Nordlinger v. Hahn (U.S. Law Week, 60 LW 4563-4574). In an 8-1 ruling, the Court found that the assessment features of Proposition 13 did not violate the Equal Protection Clause of the Constitution. The Supreme Court essentially told California residents that if they wanted to change Proposition 13, they would have to do so through the political process and not through the courts. Shakespeare wrote about the "law's delay," but why did it take 14 years before there was a final verdict about the constitutionality of an acquisition-value system? Actually, this feature of Proposition 13 was challenged in California courts immediately after its passage. In 1978, the California Supreme Court, relying on traditional Equal Protection jurisprudence, found that acquisitionvalue taxation did not violate the U. S. Constitution (Amador Valley v. State Board of Equalization).11 In 1989, however, the Supreme Court appeared to take a different approach to Equal Protection analysis in Allegheny Pittsburgh v. Webster County, West Virginia (488 U.S. 336). The assessor in Webster County acted in a manner similar to that required in California under Proposition 13. If properties changed owners, the new assessment would be at market value; but if a property did not change hands, the assessor made only modest adjustments to its

Property taxes and tax revolts

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assessed value. Allegheny Pittsburgh, a coal company subject to a marketvalue assessment, sued on Equal Protection grounds. It lost in West Virginia courts, but the U.S. Supreme Court agreed to hear its claim. In a sweeping 9-0 verdict, the Supreme Court held in favor of Allegheny Pittsburgh. According to the Court, property tax assessment did not require perfection, but "the constitutional requirement is the seasonable attainment of rough equality in tax treatment of similarly situated owners." By the word "seasonable" the Court meant that property would be reassessed within a reasonable time frame. Reassessment only upon sale would not achieve this "seasonable attainment of rough equality," and thus the policy in Webster County violated Equal Protection standards. However, the Court noted that the situation of Proposition 13 was not perfectly analogous. The West Virginia constitution stated that property taxation should be at market value, but this practice was not followed in Webster County. In California, the voters brought in acquisition-value taxation with a constitutional amendment. The Supreme Court clearly invited a challenge to Proposition 13. The first case to reach the US Supreme Court was brought by Macy's Inc. Macy's was involved in a leveraged buyout in 1985 that triggered a reassessment under the change-of-ownership rules of Proposition 13. The Macy's store in Sun Valley Mall in Concord, California, had been there, along with J.C. Penney and Sears, since the mid-1970s. The reassessment of Macy's property led to property tax bills that were multiples of those of their competitors. However, after the Supreme Court agreed to hear Macy's claim, the company was deluged with adverse publicity and threats of a consumer boycott. In an unusual move, they withdrew their case from the Supreme Court docket. Stephanie Nordlinger, a first-time home buyer in Los Angeles County, brought the case on which the Supreme Court eventually ruled. Nordlinger bought a house for approximately $170,000 in Los Angeles County and received a property tax bill of about $1,700. Her neighbors in virtually identical tract homes were longtime residents and paid between $400 and $500 per year in property taxes. These disparities were common in Los Angeles County because, on average, property appreciated 13% per year between 1975 and 1990.12 Because Proposition 13 allows only a 2% annual adjustment in assessed values, the result was disparities such as those between Nordlinger and her neighbors. Nordlinger challenged the assessment provisions that led to these disparate property tax bills on Equal Protection grounds as well as on infringements of her right to travel. The Supreme Court upheld Proposition 13 and backed away from its sweeping language in the Webster decision. Under Proposition 13, new owners of property are treated differently than existing owners. The majority opinion, written by Justice Blackmun, noted that the appropriate standard of review in Equal Protection for classifications that involve purely economic matters is

The context and significance of tax revolts

9

whether a policy furthers a legitimate state interest. This is an extremely weak standard of review that is "especially deferential in the context of classifications made by complex tax laws." This standard of review will be satisfied if there is a plausible policy rationale for the classification, which could have been (but need not actually have been) considered by legislators, and which was based on factual considerations that may have been considered true. Finally, Blackmun stated, the relationship of the classification to its goal should not be arbitrary or irrational. Using this framework, Blackmun argued that the differential treatment of new and existing owners of property under Proposition 13 furthered two legitimate policy goals. The first was that the state "had a legitimate interest in local neighborhood preservation, continuity, and stability." This was an ingenious and unexpected rationale that turned arguments by critics of Proposition 13 on their heads. Such critics had pointed out that it created a "lock-in" effect for homeowners precisely like the lock-in effect created by capital-gains taxation. If an owner of an existing property decided to move, that owner would forfeit the benefits of a lower property tax assessment. This was regarded as a tax on mobility, which interfered with the housing market. Blackmun regarded this mobility tax as a virtue in that it helped to preserve neighborhoods! This "virtue" of Proposition 13 was never mentioned during its passage or even by its supporters during the numerous years of court battles. This argument clearly demonstrates how weak the standard for Equal Protection cases in purely economic matters really is. Blackmun's other argument concerned "reliance interests." Existing homeowners have more of a vested interest or a "reliance interest" in state policy. It is legitimate to treat existing owners who have made investments in their property differently than new property owners. A potential property owner can always choose whether or not to buy, but an "existing owner, already saddled with his purchase, does not have the option of deciding not to buy his home if taxes become prohibitively high. . . . In short, the State may decide that it is worse to have owned and lost, than never to have owned at all" The Court tried to distinguish this ruling from its finding of an Equal Protection violation in Allegheny. The legal problem that the Court had to solve was that its Equal Protection reasoning did not require that Webster County articulate an acquisition-value rationale for its practices, and that its practice mirrored that of California. The Court turned Webster County's own words against it, noting that, in fact, the county had tried to justify its practice as an approximation to market-value taxation. The Court conceded that Allegheny Pittsburgh was the "rare case where the facts precluded any plausible inference" that their policy was based on an acquisition-value system. Finally, the court chose not to rule on the right-to-travel argument because they claimed that Nordlinger did not have standing. She had previously rented

Property taxes and tax revolts

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a property in Los Angeles County and thus had no legal standing to raise this argument. Justice Thomas wrote a concurring opinion in which he argued that the Court should have overturned its precedent in Webster. Thomas noted the West Virginia Supreme Court did not find a violation of its own state constitution, and violations of state law cannot be challenged on Equal Protection grounds. He furthermore argued that the Supreme Court should not be in the business of second-guessing potential state rationales for policy, particularly because they need not be explicitly stated in any case. The only dissenter was Justice Stevens. He also argued that the Nordlinger decision was inconsistent with the Allegheny Pittsburgh decision, which, in his opinion, had been correctly decided. Moreover, he found that the method of meeting the alleged goals of Proposition 13 were not rational. How does the neighborhood-preservation rationale apply to commercial property or vacant land? Stevens also questioned the reliance rationale; but he was clearly the lone voice on the Court wishing to rule against California's assessment practice. The remainder of the Court decided that if Proposition 13 created inequalities, they were constitutionally permissible. After the Supreme Court ruling, other states began to consider acquisitionvalue tax systems. In 1992, voters in Florida enacted an acquisition-value tax system for homeowner property with a 3% limitation on increases in assessed value. Similar limitations were on the ballots in other states but did not pass. There are currently popular movements in other states, particularly those with rapid appreciation of housing prices, to enact similar limitations. Although questions concerning the origin or inevitability of a tax revolt are fascinating for historians, sociologists and economists, much less attention has been paid to the particular features of Proposition 13, namely the establishment of an acquisition-value tax system. Little academic scrutiny was given to the long-term implications of the assessment system. Indeed, in a distinguished academic symposium on Proposition 13, only one extended reference was made to the new assessment system. Alan Post, who at the time was the legislative analyst for the state of California, wrote, "The monstrosity of a reassessment of property to its current value when it is sold, along side of similar property being assessed at 1975-76 levels plus only 2 percent annual increments, will prove economically, socially, and politically intolerable. It may take a few years for this to become clear, but Proposition 13 must be modified in this respect."13 Overview of book As Post recognized, the assessment provisions of Proposition 13 have become its dominant feature. This book is designed to provide a fuller understanding of the assessment system, and thus of the consequences of a unique

The context and significance of tax revolts

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tax revolt. The theory of an acquisition-value system and its impact on property taxation in California are interwoven to provide a deeper understanding of this unique form of taxation and its implications for the fiscal structure of California. The book draws on a comprehensive body of data collected specifically to understand the consequences of an acquisition-value tax system, and to place it in the context of property tax systems throughout the world. Our discussion begins in Chapter 2 with an overview of property tax systems. The property tax has always been among the least popular of taxes. There are three essential reasons for this persistent unpopularity. First, it is a highly visible tax that a property owner often has to pay directly; it is not hidden in the manner of a sales tax or value-added tax. Second, it is a tax on wealth, not on income. Not all taxpayers with highly valued property also have high incomes. This naturally leads to resentments and social tensions. Finally, the property tax (outside of California) is typically based on estimated market value and not on a particular transaction. This leads to disputes between taxpayers and assessors over the true value of the property. Moreover, in most jurisdictions, assessments are conducted on regular cycles, which allows for additional inequities to creep in during an often lengthy assessment cycle. Chapter 2 reviews the national and international experience with the property tax. It describes the various types of property tax systems that operate within the United States and abroad. It discusses evidence on the inequities of property taxation, the safeguards and protections that have been built into the system, and the variety of limitations that have been imposed on the property tax. This review provides important context for analyzing the consequences of Proposition 13. However, the types of inequities that do appear in most traditional property tax systems are quite different from those that emerge in an acquisition-value tax system. In such a system, the inequities arise due to housing-price inflation and differential turnover rates of property. Chapter 3 develops an analytical approach to an acquisition-value tax system. For any given rate of housing-price inflation, differences in property taxes for similarly situated owners depend on the time of their acquisition of the property. The dynamics of the turnover rates of property is therefore a key factor in understanding the operation of an acquisition-value tax system. In this chapter, we draw on a well-established statistical literature on turnover models to analyze the characteristics of an acquisition-value tax system. In particular, we use a body of statistical theory known as renewal theory. This theory was originally developed in industrial applications to understand replacement investment. Consider, for example, a factory using many light bulbs. Not all the light bulbs fail at once; instead, it is more useful to think of them failing according to a fixed probability distribution. Once a light bulb fails, it is replaced by a new one to which the same probability distribution of

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12

failure applies. Statisticians have developed tools that relate this probability distribution to a number of important variables, including the replacement rate for light bulbs and the age distribution of the light bulbs at any point in time. The analysis can be adapted to analyze turnover under an acquisition-value property tax system. Property is assumed to turn over according to a given probability distribution that typically can be estimated from the data. Until the property turns over, its assessed value can increase by only 2% a year; but when it finally does turn over, it will be assessed at its true market value. The statistical tools of renewal theory can be applied to address several important questions concerning an acquisition tax system. For a given inflation rate, how does the revenue collected under an acquisition-value system compare to a market-value system? How sensitive is this relationship to turnover rates of property and the rate of housing-price inflation? How do different inflation rates affect the incentive to move, that is, the probability distribution of turnovers? In addition to addressing these questions, renewal theory is also used in the construction of a statewide property tax model and for long-term projections. Chapter 3 provides a self-contained explanation of the key results from renewal theory and its applications in this book. However, because some of the material in this chapter is technical, some readers may wish to skip it, at least on a first reading, and proceed to our analysis of California's experience with an acquisition-value tax. The core data for our work is described in Chapter 4. In this chapter, we present detailed estimates for nine major counties in California of key statistics pertaining to the operation of Proposition 13. For each county, property is divided into four basic types (homeowner, other single family, commercial and industrial, and multifamily) and further subdivided as to whether or not the property has been substantially modified. For each classification, we present the distribution of property by what is known as its "base year." The base year of the property is the year the property was last sold—or 1975 if a property has not been sold since then. For each base year, we then present estimates of the "disparity ratio," which is the ratio of true market value to assessed value. The procedures for estimating these disparity ratios are described in detail in the chapter. The distributions of property by type and base year, as well as the corresponding disparity ratios, convey in detail the actual operation of the assessment system in California. They reveal, for example, that the Nordlinger case was quite typical. In Los Angeles County, more than 43% of homeowners have resided in their current home since 1975. These individuals, on average, are underassessed relative to market value by a factor of five. The data in this chapter can also be used to address many important questions. For example, contrary to popular belief, residential property and commercial property have

The context and significance of tax revolts

13

fared equally well under Proposition 13; on average, both types are underassessed by the same percentage. On the other hand, within the class of commercial property there are some important differences. Large properties fare better than smaller properties as the large properties are less likely to turn over and be reassessed at market value. Chapter 5 examines the winners and losers from Proposition 13, drawing on a unique data set as well as an economic analysis. In cooperation with the Franchise Tax Board of California, we were able to match our individual property tax records with tax returns. Using our estimates of disparity ratios (the ratio of market to assessed values), we can examine the characteristics of the winners and losers from Proposition 13 compared to a market-value property tax system that raises an equivalent amount of revenue. We explore how the winners and losers vary across income classes, as well as the impact of Proposition 13 on senior citizens. Our findings are quite striking. On average, homeowners with lower income benefit more from the assessment provisions of Proposition 13 than do households with more income. However, there are considerable differences among households within each income class. Elderly homeowners are heavily concentrated in earlier base-year properties and thus are clear winners from Proposition 13. The remainder of Chapter 5 explores the economic impacts of Proposition 13. It examines in detail such issues as the "moving penalty" associated with an acquisition-value tax system; the efficiency loss of an acquisition-value tax system; the relationship between the price of housing and the system of taxation (capitalization); and the links between household and firm mobility and winners and losers under Proposition 13. We develop a comprehensive analytical model to address these questions. The analysis provides several alternative perspectives on the equity and efficiency of an acquisition-value tax system, and is also applied to other property tax systems as well. Chapter 6 is devoted to the impact of tax limitations on local government. The first part of the chapter reviews the experience of Massachusetts with Proposition 2V2, and of California with Proposition 13. In Massachusetts, local governments cushioned the initial shocks from the tax-limitation measure by reassessing property and enacting preferential treatment for homeowner property. Local governments learned how to use fees to partly substitute for reduced property taxation. The real-estate boom in the mid-1980s and state support also assisted local governments. But by the end of the decade, as real-estate markets collapsed and state support decreased, local governments found themselves with virtually no growth in their own revenues, and more dependent on the state. In California, Proposition 13 required a new system to allocate property tax revenue to local governments. Chapter 6 explains how this system operates, and the tensions that have arisen because of it, as state support for local govern-

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ment has ebbed and flowed. Initially the state had a surplus, and transferred property tax revenues from the schools to ease the burden on local governments. Schools, in turn, were supported from general funds. Fifteen years later, as the state faced severe financial difficulties, it essentially reversed this flow, restoring property tax revenue to the schools while reducing state support for them. Chapter 6 also discusses the new and creative financial mechanisms that local governments have employed. Cities have been most adept at using new fees, user charges, and other mechanisms to supplement their revenues. Counties and special districts have had fewer options in the aftermath of Proposition 13. The second part of Chapter 6 estimates what effects an acquisition-value system has had on the county revenues in California compared to a marketvalue system. Detailed estimates are presented for a number of counties, and a statewide model is used to highlight the impact on other counties in California. The nature of the winner and loser counties (relative to a market-value system) is discussed in detail. Chapter 7 uses our statewide model to analyze the revenue consequences of possible reforms in the property tax system in California. These proposals are analyzed in the context of the total revenue picture in California and an emerging structural state budget deficit. Several alternatives are considered. First, we examine a complete switch to a market-value system and calculate the reduction in tax rates that would raise equivalent revenue. Second, we explore alternative versions of "split rolls," which would maintain the assessment provisions for residential property but tax all other property at market value. Finally, we consider several other alternatives, such as transfer taxes and deferral of taxes until sale. Finally, in Chapter 8, we discuss alternative strategies to reform the property tax system. The analysis takes into account what we learned about the equity and efficiency of California's system in the worldwide context, the responses of local governments to reduced property tax revenues, the dislocations that would occur from any reform efforts, and the potential revenue gains to the state from alternative proposals. These ingredients allow an intelligent assessment of the benefits and costs from engaging in a serious reform of the property tax system.

The diversity of property tax systems

Introduction As early as the 1930s critics were predicting the demise of the property tax based on the Depression-era tax revolt discussed in the previous chapter. In the 1970s taxpayers again began rebelling against the property tax, and many thought it was finally headed for oblivion. But it has survived, and recently it has even begun to stage a comeback. The long-term pattern of decreased reliance on the property tax was arrested in the 1980s, and the property tax share actually increased at the end of the decade. Perhaps the myriad of reforms over the past two decades have actually helped to ensure preservation of the property tax. The property tax is still the largest source of local-government tax revenue throughout much of the world. It is essential that local governments have their own source of revenue if they are to preserve local autonomy, and the property tax is better suited to local use than other major taxes. It doesn't compete with tax bases preferred by higher levels of government, it can be integrated with local planning and zoning systems, and it generates a predictable and stable revenue stream. Theoretically, the property tax is consistent with both the ability-to-pay principle and the benefit principle of taxation. Property values constitute the tax base, and to the extent that property ownership increases with income, those with greater ability to pay will pay higher taxes. The property tax also provides a method for indirectly taxing certain types of income, such as the imputed rental income of owner-occupants, that escape income taxation. The property tax also serves as a benefit tax. Property tax revenues are used to finance localgovernment expenditures on police and fire protection, streets, parks, and so forth, that benefit local property owners and increase the value of their properties. In practice, it is not hard to find fault with the property tax. First, wealth is 15

Property taxes and tax revolts

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not always closely tied to income; as a result, many taxpayers find that property tax payments are especially burdensome. As discussed in Chapter 1, either depressions or sudden inflations can distort the relationship of property tax payments to income and lead to widespread taxpayer dissatisfaction. Second, inequities that arise due to a lack of uniformity in assessments are also a problem. Assessments fail to be uniform for several reasons: infrequent reassessments, assessment error, or because some property tax systems actually impose discriminatory assessment requirements. This chapter provides important background information concerning property taxation. In the first two sections we examine the historical trends in property tax reliance and compare property tax systems in the United States and other countries. Differences in tax bases, tax-rate schedules, and tax-relief programs are highlighted. In the third section we examine the variety of tax limitations imposed during the 1970s, and finally, in the last section, we discuss the types and sources of unequal treatment under the property tax. Historical trends United States Despite strong criticism and predictions of its eventual demise, the property tax has exhibited remarkable growth in revenues. Local property tax revenues increased from $50 billion in 1975 to nearly $150 billion in 1990. The average annual growth rate over this 15-year period was 7.6%. The slowest growth period occurred between 1977 and 1980. This was the period of major tax-revolt activities, including passage of Proposition 13 in California. In fact, property tax revenues actually declined 2.5% from FY 1977-78 to FY 197879, but grew in excess of 5% in the subsequent year. Since 1980 the property tax has rebounded, with an average annual growth rate of 8.6% over the 10year period from 1980 through 1990.1 Growth in absolute terms does not provide any indication of trends in the relative growth of the property tax. How does growth in property tax revenues compare to growth in the economy? Over the past 40 years the property tax has maintained a surprisingly stable relationship with gross national product (GNP). In 1948 property tax revenues represented 2.2% of GNP, and since the mid-1950s have fluctuated between 2.5% and 3.2% of GNP. In the five-year period from 1982 to 1987, property taxes remained at 2.5% of GNP, and increased slightly to 2.7% in 1990.2 This does not seem to support the contention that the property tax is headed for extinction. During FY 1990, property tax collections represented 3.4% of personal income and averaged $602 per capita in the United States.3 There was, however, considerable variation across states in these measures of the relative importance of the property tax. In New Hampshire, property taxes represented 5.7%

The diversity of property tax systems

17

of personal income and averaged $1,146 per capita, whereas Alabama collected 1.0% of personal income or $141 per capita in the form of property taxes. These numbers are indicative of the greater reliance on the property tax in the New England states compared with states in the Southeast. The property tax is primarily a local-government revenue source. This was not always the case. In fact, in the early 1900s the property tax provided more than half of state government revenues in the United States. As the nation grew, the increased demands placed on state governments required diversification and expansion of their revenue sources, and as a consequence the share of tax revenue from property taxes declined. The Great Depression of the 1930s accelerated this decline so that by 1940 the property tax provided less than 8% of state tax revenue.4 By 1980 the share had fallen to 2% and remained virtually unchanged throughout the 1980s.5 Local governments receive the majority of property tax revenues, more than 96%. Local governments have also expanded and diversified their tax structures. Most notable have been increases in sales and income taxes. The shares of local tax revenues from sales and income taxes have more than doubled since the mid-1950s, but they still constitute only 15% and 6% respectively of local tax revenue. The growth in such taxes has reduced the property tax share, but it still accounts for nearly three-fourths of local-government tax revenue.6 Although the property tax has grown absolutely over the past 30 years, local reliance on this source of revenue has declined. The relative decline of the property tax began long before the tax revolt era in the late 1970s. In 1948, the property tax generated more than 88% of local-government tax revenues. By 1977, its share had declined to just over 80%. Property tax limitation measures such as California's Proposition 13 and Massachusetts^ Proposition IVi forced a change in local-government revenue structures in many states, which contributed to the further decline in the property tax share. As of 1990 the property tax accounted for just over 74% of local tax revenue nationwide.7 This relative decline has not occurred uniformly across the United States. In fact, in the New England states the property tax has maintained its share of local tax revenues at 98% with New Hampshire, Maine, and Vermont still obtaining 99% or more of their local tax revenues from the property tax in 1990. These states have not undertaken the same degree of diversification of their tax bases as has occurred elsewhere in the United States. None of the New England states levy local individual or corporate income taxes; Maine levies a local sales tax, but it accounts for a negligible amount of local tax revenue. This contrasts sharply with the degree of reliance on the property tax in the Southeast and far West states (70%). The property tax accounted for 69% of 1990 local tax revenue in California, whereas in Alabama and Louisiana it accounted for less than half (36.7% and 43.4% respectively).8 When viewed as a percentage of all local own-source revenue, the property

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tax share declined even more. In 1948 the property tax generated almost threefourths of all local own-source revenue. By 1977 the share had fallen to 59%; by 1990 property taxes accounted for less than half (46.6% in 1990) of revenues raised by local governments. This trend reflects the growing local government reliance on nontax revenues such as user fees and charges.9 During the 30-year period from 1950 through 1980, local governments received an increasing percentage of their revenue in the form of state or federal aid. Intergovernmental transfers accounted for 31 % of local general revenue in 1950 and nearly 45% in 1979. As a result, property tax collections as a share of total local revenue declined significantly from roughly 50% in 1950 to 28% in 1980. Over the past 10 years, however, the property tax share of local revenues has recovered slowly (29.2% in 1990) due in large part to reductions in federal aid to local governments.10 The most recent five-year period has seen a slow but steady increase in reliance on the property tax. This is true whether we consider its share of total general revenue, own-source revenue, or tax revenue of local governments. Using the narrowest of viewpoints, the property tax increased from 73.7% of local tax revenue in 1987 to 74.5% in 1990.11 Although this may not constitute a resurgence, it clearly suggests that the decline in the property tax has ended, at least temporarily. Although the property tax still dominates local revenue structures, there is a substantial degree of variation in reliance by type of local government (counties, cities, school districts, and special districts). Throughout the 1980s the distribution of the property tax pie remained fairly stable, with school districts getting the largest piece, 43%. Cities and counties each received roughly 23% of all local property tax revenues, whereas townships got 6% and special districts received 3%.12 Although cities and counties received equal shares of local property tax revenues, counties are generally more dependent on this source of revenue. In 1957, property taxes accounted for 93.7% of county tax revenue and, despite the trend of decreasing reliance on the property tax, still represented more than 73% of county tax revenue in 1990. For cities, property taxes generated 73% of tax revenue in 1957 and 51% in 1990.13 The greater reliance on property taxes on the part of counties is due to their less diversified tax structures; they have fewer other sources of tax revenue available to them. Among all types of local governments, school districts are the most heavily reliant on the property tax. In 1957, property taxes accounted for almost 99% of school-district tax revenues. The property tax share declined to 96% in 1981 due to reforms in school funding often resulting from court decisions. Since the early 1980s however, the property tax share gradually increased to 97.5% of school-district revenues in 1990.14 Townships are more reliant on property taxes than are either cities or counties. However, their share of the property tax pie is considerably smaller. For

The diversity of property tax systems

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more than 30 years property taxes have generated between 92% and 94% of all tax revenue of townships.15 Their tax structures are even less diversified than those of counties, hence the heavy reliance on this revenue source. Nevertheless, they account for only about 6% of all property taxes collected.16 Although they are nearly as numerous as cities, the range and level of services provided in these unincorporated areas tend to be much lower. Finally, we have the most numerous of all units of local government, special districts, which receive the smallest share of local property tax collections, 3.4% in 1987.17 These are generally single-purpose units of government such as fire, sewer, water, parks, and library districts. Only about half of such districts, generally referred to as nonenterprise special districts, have authority to collect property taxes. The remaining districts, enterprise special districts, rely primarily on nontax revenues such as charges and fees. In 1990 property taxes accounted for 70% of all special-district tax revenues.18 Other countries The property tax is an important source of local government tax revenue not only in the United States but throughout the world, in both industrial and developing countries. Because of the tremendous diversity in property tax systems throughout the world a comprehensive international comparison is beyond the scope of this work. Instead, we draw on three studies, Bahl and Linn (1992), Beaumont (1989), and McCluskey (1991), to provide an indication of the role and structure of the property tax in other countries. The past decade has been a period of increased interest in the property tax due to a growing interest in local autonomy. The basis of the interest lies in the belief that local governments can provide public services more efficiently. This requires decentralization of both revenue and expenditure functions, and has brought major reforms in local government finance in many countries. This renewed interest in the property tax is not, however, fully reflected in available quantitative measures of its importance in national, state, or local revenue structures. Throughout the 1980s, property tax revenues were a small but stable fraction of gross domestic product (GDP). They amounted to less than 1% of GDP in developing countries and ranged from 0.1% to 3% in the 24 countries belonging to the Organization for Economic Cooperation and Development (OECD), with the average for Federal countries (1.3%) almost twice that for Unitary countries (0.7%).19 The property tax share of all government tax revenue declined between 1975 and 1980 in OECD Federal countries (from 10.4% to 8.0%), whereas it remained essentially unchanged in the OECD Unitary countries (almost 6%). Since 1980 the property tax share has risen in all OECD countries, to 8.6% in 1989 in Federal countries and 7.0% in Unitary countries.20 As in the United States, the property tax is a far more important component

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of local - as opposed to state or federal - tax structures in other countries. When viewed as a percentage of local-government tax revenue, the property tax share in OECD Federal countries decreased from 68.9% in 1975 to 60.7% in 1980, but then increased to 63% in 1989. Local governments in Unitary countries do not rely as heavily on the property tax, and have in fact decreased their reliance on the tax since 1975. The property tax share declined in these countries from an average 28.5% of local tax revenue in 1975 to 27% in 1989.21 Much of the decline recorded in OECD countries was due to infrequent reevaluations of the tax base, and to central government imposition of various tax-relief measures designed to shift the property tax burden from households to businesses. Some countries actually abolished their property taxes during the period from 1975 to 1989. The United Kingdom, in 1989, replaced their property tax with a poll tax levied as a fixed fee on each adult, and only later, after fierce opposition, returned to another form of the property tax.22 In 1978, Ireland abandoned its residential property tax and later (1983) replaced it with a tax on the imputed rental income of residential property. During the same period, however, other countries introduced new local property taxes (Portugal in 1989) or modified existing taxes (Spain and Greece) so as to increase the role of local government. Developing countries are characterized by a relatively smaller role of state and local governments, and hence the property tax has historically been a less important component of the revenue structure. However, the growing need for revenue to finance the local services demanded by rapidly increasing urban populations has led to an increase in the number of countries that levy taxes on real property. Although property tax collections represent an almost negligible share of GDP in most developing countries, in others they contribute as much as 99% of municipal tax revenue and more than one-third of total municipal revenues. Among the developing countries most reliant on the property tax as a source of municipal revenue are Kenya (99%), India (92% in Calcutta), the Philippines (70%) and Mexico (55%).23

Structure United States The property tax is intended to be a tax on wealth. Initially, the property tax in the United States was a specific tax - so many dollars per unit applied to ownership of very specific types of property such as cattle, land, and improvements. As new forms of wealth, both tangible and intangible, began to appear in the early nineteenth century, the structure of the property tax was altered. The base was expanded to include most varieties of property, which necessitated a switch to ad valorem - percentage of value - taxation. The last

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several decades have brought a reversal of this trend toward a more general tax, back to a more specific one. The emphasis today is clearly on real property - land and improvements. Tangible personal property, especially household furnishings, is seldom included in the tax base because of the difficulty associated with locating such easily movable property. Even less likely to be taxed today is intangible personal property, which consists mainly of corporate stocks, bonds, bank deposits, and mortgages, which are difficult to discover and value. Unlike several other taxes levied against property owners, such as property transfer taxes, real estate and gift taxes, and capital gains taxes, the property tax is recurrent and must be paid on an annual basis. The tax liability of a property owner is determined by the product of the tax base - a measure of the property's value - and the tax rate expressed as a percentage of value. The property tax in the United States is far from uniform. There is significant variation in the definition and scope of the tax base, and in the magnitude of tax rates across states (and even within states across local taxing jurisdictions). Tax base Real property is the principal component of the property tax base in all states. Land and buildings are subject to tax in all states, but even this is not uniform, due to exemptions. As of 1992, all states exempt government-owned property, all but Georgia exempt property used for educational or religious purposes, and all but Georgia and Wyoming exempt charitable properties. Other classes of exempt property include cemeteries (42 states), hospitals (40 states), historical properties (13 states), residential property (7 states), and agricultural property (4 states).24 There is even more variation in the treatment of personal property. There has been a long-term trend toward exempting personal property from taxation. In fact, since 1956, the personal-property share of the property tax base has fallen from 25.5% to less than 10% nationwide. All personal property is currently exempt in 20 states. This number increased from five states in 1979 and eight states in 1986. Motor vehicles are subject to tax in seven states, business inventories in four states, and household furnishings in three states.25 Intangible personal property is only a small percentage of all personal property. Difficulties in identifying and valuing intangibles, and the apparent double taxation that occurs when income resulting from their ownership is subject to tax under state and/or local income tax laws, have convinced many states to either repeal or limit the taxation of intangibles. Only nine states tax intangibles as part of the general property tax, and in most instances such property is placed in a class that is either assessed or taxed at a lower rate than other property. The types of assets most commonly taxed include equities, bonds, deposits, and mortgages. Although the general trend has been toward eliminat-

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ing the intangibles tax, Connecticut, Florida, and Tennessee recently moved to expand the base or raise the rate of taxation, and similar legislation has been proposed in Kansas and Louisiana.26 The property tax base consists of the assessed value (taxable value) of the various assets that are included. The assessed value, however, is often just a fraction (assessment ratio) of the true market value of the property. Assessment ratios differ across taxing jurisdictions, within jurisdictions across property classes (types), and even within classes of property across individual parcels. Some of the observed differences are due to legal mandate as set out in a state's constitution or local statutes. In other cases, variations arise because of the subjective nature of the assessor's task. Assessed value is supposed to reflect 100% of market value (the amount at which property changes hands between willing buyers and sellers in an open market) in 19 states. Other states define assessed value as a fixed percentage of market value. Examples range from 70% in Connecticut to 10% in Louisiana. In some states (New York, New Jersey, Delaware, and Maine), the ratio is determined and allowed to vary by local taxing unit. In still other states (14 states as of 1992) the assessment ratio varies by property class. Such tax systems are usually referred to as classified. In Colorado, residential properties are supposed to be assessed at 15% of market value, and all other properties at 29%. Similarly, in Arizona, residential properties are assessed at a lower rate (10%) than is agricultural property (16%) or commercial and industrial properties (25%). Tennessee assesses commercial and industrial properties at 40% of market value, all other real property at 25%, and personal property at 30% of market value.27 Under California's acquisition-value-based system, assessment ratios vary across like parcels, with the ratio being higher on those properties that most recently changed ownership. The assessor's primary task in market-value states is to provide estimates of the market value of all taxable properties. Such estimates can be based on the value of the property in its current use or in its highest and best use. For example, agricultural lands located on the urban fringe may fetch a higher price in the market if sold for development as residential lots versus continued agricultural production. The highest-and-best-use standard of assessment is used in 16 states and the District of Columbia, whereas 8 states base estimated values on current use only. The remaining 27 states use a combination of the two standards, usually highest and best use when valuing unimproved or vacant land, and current use on improved land.28 Three methods, endorsed by the American Institute of Real Estate Appraisers, are commonly used: the comparable-sales approach; the replacement-cost approach; and the income approach. The comparable-sales approach is currently used by assessors in 40 states for valuing primarily residential and small apartment or commercial proper-

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ties.29 It involves a comparison of the property being appraised to similar properties that have recently been sold. Statistical analysis of sales prices and property characteristics can identify hedonic prices or implicit values for each characteristic, including locational attributes. These prices can then be applied to the specific characteristics of the property in question. The success of this approach requires data on a substantial number of recent sales of similarly situated properties; thus the approach is not feasible for large commercial and industrial properties that sell infrequently and are relatively heterogeneous. The replacement-cost approach is used by assessors in 38 states to determine the value of structures, especially commercial and industrial buildings.30 The assessor first estimates the cost of replacing a building, and then adjusts for economic depreciation. Current cost data and depreciation factors are usually provided by state governments or appraisal firms. The value of the land included in the parcel is usually determined using the comparable-sales approach. The third method used to estimate the market value of real property is the income-capitalization approach. This approach requires information on income and operating expenses for the property that may be available from the property owner, or is determined from standardized tables available to assessors. The net income stream generated by the property is discounted (capitalized) at an appropriate rate to determine the property's value. For example, if a property yields an annual income net of expenses of $50,000 and if the discount rate is 10%, the income-based estimate of the property's value would be $50,000/0.10 or $500,000. Perhaps the most difficult aspect of this method is determining what discount rate to use. It should reflect the rate of return to capital over the life of the asset, but such rates vary over time and from industry to industry due to such factors as differences in risk. Even small changes in the discount rate can result in large differences in the market value of longlived assets. Because of such difficulties, assessors in only 18 states currently use the income approach, and it is typically used in conjunction with the cost approach when feasible.31 Tax rates Statutory tax rates, often referred to as millage rates, specify the amount of tax due per unit of value. Local governments have fiscal authority to set or change tax rates in 41 states.32 Of these, four states have set maximum rates that cannot be exceeded by local governments, such as the 1 % maximum rate in California and the 2.5% maximum in Massachusetts. Most taxing jurisdictions set rates based on budgetary needs and the available tax base as measured by the assessed valuation in the jurisdiction. In general the tax rate necessary to support a given budget is the budget divided by assessed valuations. Rates vary both within and across states. In 15 states statutory rates vary de-

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pending upon the classification of property, with generally lower rates applied to residential and agricultural - as opposed to commercial and industrial property.33 The rate expressed in dollars per $1,000 of assessed value was 2.00 in Blacksburg, Virginia in 1990 and 469.89 in Butte, Montana.34 This, however, does not mean that properties with identical market values would pay taxes more than 200 times higher if located in Montana as opposed to Virginia. The wide variation in statutory rates is misleading because assessment ratios also vary widely. For example, assessed value in Blacksburg, Virginia is defined as 100% of market value, whereas in Montana it is only 3.86% of market value.35 Thus the owner of a property whose market value is $100,000 would pay taxes of $200 per year in Blacksburg, Virginia, and $1,813.78 in Butte, Montana. The effective tax rate is the amount of tax paid expressed as a percentage of market value, and thus is determined as the product of the statutory rate and the assessment ratio. The effective tax rate in Blacksburg is 0.2%, whereas that in Butte is roughly 1.8%. Variations in effective tax rates occur because of variations in both statutory rates and assessment ratios, but tend to vary less than statutory rates. Statewide average effective tax rates for 1966, 1977, and 1987 are reported in Table 2.1. These rates are averages of the rates that applied to all existing single-family homes with FHA-insured mortgages, which represent varying percentages (by state) of total single-family homes. The U. S. average effective rate declined from 1.67% in 1977 to 1.15% in 1987, with the largest decline occurring in Massachusetts, from 3.50% to 0.84%. In five states the 1987 rate was actually higher than the 1977 rate (Iowa, Montana, North Dakota, Oregon, and South Dakota). Variations in the role of the property tax in local-government finance are reflected in variations across states in effective tax rates. In 1987, the effective tax rate varied from a low of 0.22% in Louisiana to 2.38% in New Jersey. The range in 1977 was from 0.61% in Louisiana to 3.5% in Massachusetts. Twenty-four states, mostly in the southeast and western parts of the country, had effective tax rates below 1% in 1987, whereas only six states had rates this low in 1977. For California, we replaced the ACIR estimate in Table 2.1 by our own estimate of the 1992 effective tax rate of 0.55%. The derivation of this estimate is discussed in detail in Chapter 4. Not surprisingly, the states that participated in the tax revolt in the late 1970s and early 1980s were among those with the highest effective tax rates in 1977, namely California with 2.21%, Massachusetts with 3.5%, and Michigan with 2.63%. New Jersey, with the second-highest rate in 1977, 3.31%, and the highest rate in 1987, 2.38%, has had property tax reform on the political agenda for many years. Relief programs The decade of the 1970s stands out in property tax history, along with the 1930s, as a period that brought widespread changes in the structure of the

Table 2.1. Average effective property tax rates, existing single-family homes with FHA-insured mortgages, by state and region State

1987

1987 Rank

U.S. Total Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware D. C. Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming

1.15% 0.39 0.81 0.66 0.64 0.55* 0.93 1.46 0.68 1.17 0.92 1.03 0.51 0.87 1.55 1.25 1.96 1.11 0.87 0.22 1.22 1.22 0.84 2.10 1.00 0.76 0.83 1.34 2.01 0.69 1.55 2.38 0.88 2.07 1.01 1.38 1.06 0.76 2.26 1.40 1.49 0.72 2.17 0.89 1.41 0.97 NA 0.98 1.10 0.69 2.03 0.57

48 37 44 45 NA 29 12 43 NA 30 24 47 34 10 17 8 20 33 49 19 18 35 4 26 39 36 16 7 42 9 1 32 5 25 15 22 38 2 14 11 40 3 31 13 28 NA 27 21 41 6 46

1977 1.67% 0.74 NA 1.72 1.49 2.21 1.80 2.17 0.88 NA 1.13 1.27 NA 1.46 1.90 1.66 1.76 1.37 1.25 0.61 1.65 1.69 3.50 2.63 1.39 1.10 1.59 1.31 2.48 1.71 NA 3.31 1.65 2.89 1.35 1.26 1.26 0.95 2.25 1.85 NA 0.82 1.79 1.40 1.84 1.03 NA 1.21 1.75 NA 2.22 0.87

1966 1.70% 0.66 1.42 2.41 1.09 2.03 2.20 2.01 1.14 1.37 1.09 1.30 0.81 1.23 1.96 1.64 2.12 1.96 1.03 0.43 2.17 2.05 2.76 1.81 2.14 0.93 1.64 1.70 2.67 1.47 2.38 2.57 1.30 2.40 1.31 1.81 1.44 1.11 1.98 1.88 1.96 0.60 2.64 1.37 1.62 1.52 2.27 1.13 1.14 0.71 2.31 1.34

NA-data not available. Rankings do not include D.C. California data for 1987 are based on 1992 estimates by the authors. Source: Advisory Commission on Intergovernmental Relations, Significant Features of Fiscal Federalism, Vol. 1,1989, Table 33, pp. 72-73.

Property taxes and tax revolts

26

property tax in the United States. Most of the changes that occurred can be described as property tax relief measures. Property tax relief refers to any measure that reduces property taxes below what they otherwise would be. Relief has taken many forms, including homestead exemptions or credits, classification, deferral programs, preferential assessment of farmland, and tax breaks for business; but the most widely publicized relief has been circuit-breaker and tax-limitation measures. Possible motives for the proliferation of relief programs include the desire to reduce reliance on the property tax in general, to encourage home ownership, to preserve farmland, to attract business, and to counteract the effects of inflation, particularly where assessment practices have improved. The rapid inflation in housing prices that began in the United States in 1973 produced a shift in many areas of property tax burdens from business property to residential property. Residential assessed valuations increased at a faster rate both because of inflation and because efforts to improve uniformity in assessment practices had a greater impact on traditionally underassessed residential properties. Thus many of the relief measures introduced during this period were directed toward residential property, and especially to homeowners. Property tax relief can be categorized as direct or indirect. Indirect property tax relief has occurred in the form of increased state aid to local governments, increased reliance on local nonproperty taxes, and limitations on local revenues, all of which allow for lower total property tax collections. These types of programs do not prevent the type of tax shifting already described; some form of direct relief is necessary to accomplish this. Direct-relief programs are either specific or general. Specific-relief programs are targeted to specific property owners, in that only those taxpayers with certain attributes such as age, income, disability, and military service are eligible. General relief is impersonal and thus applies to all properties regardless of the age, economic status, or other characteristics of the owner. Relief measures, whether specific or general, may be limited to certain classes of property, such as only owneroccupied housing or agricultural property. Homestead exemptions and credits: Homestead exemptions allow for the exemption from taxation of a specified amount of assessed value. The exemption amount is subtracted from the assessed value of the property before the tax is determined in the same way that individuals are allowed to subtract personal exemptions from their adjusted gross income before determining their tax liability. This is the most widely used form of relief for owner-occupied housing. Homestead credits differ from exemptions in that they are subtracted from the tax bill after the liability has been determined. Credits are often calculated as a specified percentage of the gross tax. Despite their apparent differences, credits can be designed to provide exactly the same relief as exemptions. How-

The diversity of property tax systems

27

ever, credits are almost always financed by the state, whereas exemptions are usually state mandated but locally financed, and thus may result in an increase in local tax rates. A homestead exemption or credit provides relief to homeowners in 44 states and the District of Columbia.36 The relief is available to all homeowners, regardless of income, age, or other status, in 19 states. According to available data, the average benefit in these states ranges from $70 in California to $268 in the District of Columbia. Some states provide larger exemptions or credits for seniors and/or the disabled, and in Montana only homeowners with adjusted gross incomes less than $11,921 for singles or $14,305 for couples are eligible for the exemption of $80,000 of assessed value. Other states are more restrictive in terms of eligibility criteria. Only senior citizens, and possibly veterans and disabled individuals, receive a credit or exemption in 14 states, and about half of these limit the relief to low-income households. Among these states, average benefits range from $124 in North Carolina to $1,037 in Alaska. Relief is limited to disabled and/or veterans in 12 states.37 Circuit breakers: Circuit-breaker programs, which currently exist in 34 states and the District of Columbia, are the second most widely used mechanism for providing property tax relief. These programs provide state-financed relief, usually in the form of a rebate or refundable credit against state income taxes. Relief is more narrowly targeted than is the case with exemptions, and is inversely related to income. When property taxes exceed what is determined to be an "acceptable" burden relative to income, the relief program "breaks" the load, hence the name circuit breaker. An "acceptable" tax burden is defined as a percentage of household income, and any tax above this qualifies for relief. The threshold percentage may vary with household income. These programs were devised primarily to prevent senior citizens with fixed retirement incomes and those in other low-income households from having to sell their homes because of increasing property tax burdens. Of the 35 states that provide circuit-breaker relief, 24 restrict the program to the elderly and/or disabled. Relief is sometimes restricted to homeowners generally, although 30 states extend the program to renters; Hawaii's program is limited only to renters. In 19 of the 30 states that provide a renter credit, only the elderly or disabled are eligible. All but two states (Maryland and Montana) impose an income ceiling on eligibility. However, Maryland imposes a $200,000 net-worth limit. Income ceilings vary widely, ranging from $5,000 in Arizona to $100,000 in New Jersey. The states with the largest programs include New Jersey, with 2 million beneficiaries, Michigan with 1.5 million, and New York with 0.5 million. Significantly smaller programs are found in Rhode Island, with 3,015 beneficiaries, and Oklahoma, with 3,625. Average benefits range from $81 in Arizona to $550 in Maryland.38

Property taxes and tax revolts

28

The rebate or credit is usually determined using one of two methods. Under the threshold approach (used in 16 states), the rebate is a percentage of the amount by which property tax liability exceeds the "acceptable" burden, which is specified as a percentage of income: Rebate = c(T - pY) where c is the proportion of "excess taxes" rebated and may decline with income, T is the property tax liability that may be subject to a maximum, p is the threshold percentage that may vary with income, and Y is household income, which in most cases is subject to a ceiling. Under the somewhat simpler sliding-scale approach (used in 13 states), a percentage of property taxes (c) are refunded where the percentage declines as income rises: Rebate = cT. Under either approach, the rebate may be subject to a maximum. Maximum rebates are in effect in 29 states. Both types of programs can result in a more progressive state tax structure by limiting eligibility to lower-income households, by allowing the income threshold (p) to increase with household income, and/or by allowing the percentage of taxes rebated (c) to decline with income. Classification: In addition to the above types of programs, some states provide additional relief to owners of certain types of property. Unlike circuit breakers and homestead exemption/credit programs, classification provides general relief that is independent of characteristics of the property owner. Under a classification system, different classes of property (e.g., residential, commercial, industrial, or agricultural) are legally taxed at different effective rates. This results in what is commonly referred to as a split-property roll, and is accomplished by either allowing the legal assessment ratio, the statutory tax rate, or both to vary across classes of property. By taxing certain types of property at lower effective rates, relief can be given to broad-based groups of property owners such as homeowners, farmers, or business owners. Homeowners and farmers are the most frequent beneficiaries. Classification is used in 23 states and the District of Columbia. Minnesota has the most elaborate system, involving 12 different classes of property; Montana runs a close second with 11 classes. The majority of the states (roughly two-thirds) that classify property do so by setting differential assessment ratios, whereas the remainder apply different statutory tax rates to supposedly uniform assessed values.39 The primary distinction between the two is that the differences in tax rates are somewhat more visible and assessment-level differences are more likely to affect other policies such as debt limits and state equalization funding.

The diversity of property tax systems

29

Deferral: Deferral programs are used in 18 states to allow certain property owners to postpone payment of all or a portion of their property tax.40 The deferred portion of the tax becomes a loan that creates a lien against the property, which comes due when the property owner dies or sells the property. The majority of states offering such an option restrict its use to the elderly and/or disabled. This form of relief is only temporary and does not involve any reduction in tax liability if the entire amount of deferred taxes plus interest must ultimately be paid. Use-value assessment: Agricultural land is given preferential treatment in 42 states.41 The most common method of limiting property taxes on this class of property is by basing its assessed value on its current use, as opposed to its highest-and-best-use. This prevents property tax increases on farmland due to its location and potential alternative uses, and should help to conserve agricultural land, particularly that on the fringe of expanding urban areas. Assessed values are determined as the capitalized value of the net income generated by farming the land. The majority of states using this method to assess agricultural land require repayment of the tax savings if the land is converted to a nonfarm use, and in fact several states require a contract specifying a 10-year period during which the owner cannot convert the land. Cancellation of the contract usually involves payment of back taxes at the full value of the property, plus a penalty. Other countries A wide array of different property tax systems is in use in other countries. Even cities within the same country differ in the specifics of the tax structure and applications. Local governments in most countries arrive at the type of system to be used, determine the tax base, set the tax rates, and handle all administrative aspects of the program. The three most common forms of property tax are the capital or market-value tax, the annual-value tax, and the sitevalue tax. The capital or market-value-based tax is fast becoming the most widely used system of property taxation, although there is a great deal of diversity in practice among local governments using it. Among the 12 OECD countries that levy recurrent property taxes, capital value is the basis of the majority of systems. Capital-value systems are also found in Brazil, Chile, Costa Rica, Indonesia, Portugal, the Philippines, and in urban areas in Zimbabwe.42 The capital value of a property is defined to be the price a buyer would be willing to pay and a seller would be willing to accept if the property were voluntarily sold in an open market. Generally the tax applies to both land and improvements, though they are often treated differently. In most cases of differ-

Property taxes and tax revolts

30

ential treatment, improvements are either assessed at a lower ratio to market value, or are taxed at a lower rate, so as not to discourage development. Classification systems are common where the assessed value of property is defined to be a varying fraction of market value. Assessment ratios may differ by the value as well as use class of the property. Generally, residential properties are assessed at lower rates than commercial and industrial properties. In fact, in some countries residential properties are excluded from the base entirely, whereas in others all properties except residential ones are excluded. It is also a common practice to apply lower assessment ratios in rural as opposed to urban areas. An annual-value-based system taxes the yearly rental income of properties, and hence is more of an income than a wealth tax. Most of such systems in use today are derived from the pre-1989 British property tax system known as "rates." India, Ireland, Italy, Malaysia, southern Nigeria, and Singapore are among the places in which annual-value systems are currently in use.43 The tax base is defined to be the annual rent that a property could be expected to earn in the market. Ideally the annual-value base and the capitalvalue base would be essentially equal, since capital value is equivalent to the discounted stream of net rental income. However, several factors tend to cause the two to differ. Deductions are often allowed from annual value to cover the costs of repairs, insurance, taxes, and other expenses. In some cases the legally allowed deduction is as high as 50% of the rent, and clearly exceeds actual costs. Also, rent controls can cause actual rental payments to differ from market rent. Market rent is the controlled rent plus a premium (often referred to as a "charge for furnishings" since rent premiums themselves are illegal). Under a capital-value system, taxes are based on market value, which is influenced by such premiums; but under an annual-value system, taxes are based only on the controlled rent. Finally, assessment is difficult, particularly in the case of vacant land and nonresidential properties where annual value is often defined to be a fixed proportion of capital value. The tax can be imposed on either the owner, the individual occupying the property, or both. The treatment of unoccupied properties varies from complete exclusion (Northern Ireland) to full taxation with liability falling on owners. In Malaysia, owners receive refunds of property taxes paid on unoccupied properties. Vacant land is excluded from the tax base in Southern Nigeria and in Indonesia based on the argument that no income is earned by such property. Owner-occupiers pay reduced taxes in Singapore and Northern Ireland.44 Site-value taxation is a form of capital-value taxation in which improvements are exempt. Site- or land-value systems differ as to whether improvements such as clearing, leveling, draining, and surrounding infrastructure are included in the property's value, or whether the value of such improvements is

The diversity of property tax systems

31

ignored. Differences also arise concerning the standard of valuation - highestand-best-use or current use. One of the principal advantages of this approach is that it places the tax on the immobile factor of production - land - and not on the value of improvements. It thus reduces economic distortions and encourages intensive use of land. Land-value taxes are currently used in Australia, New Zealand, Denmark, parts of South Africa, Barbados, Jamaica, Kenya, and Taiwan.45 Several countries use a combination of the three systems just described. The most common form of property tax in cities of former French colonies is a mixed system under which land is assessed on the basis of capital value, and improvements are assessed on an annual-value basis. Mexico levies both an annual- and a capital-value tax, and both Thailand and Turkey use a mixed system. Still other countries levy property taxes on the basis of area. In some Nigerian states, in order to reduce administrative costs, a flat fee is charged per building; the fee varies according to the type of building, or a fee is charged per room. This later method is used primarily for properties with low rental values and is referred to as "spot value."46 The most common feature of all these property tax systems is the list of properties that are exempt from taxation. In all countries exemptions are given to government properties including embassies, schools, hospitals, churches, charitable institutions, and cemeteries. Agricultural land is fully exempt in the Netherlands and Northern Ireland and given preferential treatment in most other countries. An exemption for low-valued properties is available in some countries. This tends to make the tax more progressive and, in most cases, lowers administrative costs by more than the revenue lost.47 Tax rates are usually set by local governments on the basis of budgetary needs and the level of services provided. Rates tend to vary even within individual cities on the basis of use, value, location, and owner/occupier characteristics. Where rates differ, as between land and improvements, the rates on land are higher, especially vacant land in urban areas. Cities in India apply a schedule of progressive rates that increase with property value. Commercial and industrial properties are taxed at higher rates than residential or agricultural properties in Korea, Taiwan, and Thailand. Property tax rates vary between 1.1% and 1.3% of capital value in urban areas of Portugal, whereas the rate is 0.8% in rural areas. The difference is based on differences in the level of services provided in urban versus rural areas. Columbia and Turkey also vary tax rates between urban and rural locations. Singapore is unique in that it applies a uniform rate of 23%.48 Another feature common to most property tax systems, especially those in developing countries, is infrequent reevaluations. This is largely the cause of the slow growth in property tax revenues. Revaluation occurs only every 20 to 30 years in Malaysia. The last revaluation in Northern Ireland occurred in

Property taxes and tax revolts

32

1976, and previous reevaluations took place in 1956 and 1939. Property tax administrators cite the shortage of qualified assessors as the principal cause.49 Tax limitations Most people would agree that the postwar tax-revolt movement began in California when voters endorsed Proposition 13 by a two-to-one margin in June 1978. Although it was the most widespread and fiscally constraining taxlimitation measure passed to date, it was not the first. The property tax had been undergoing extensive reforms in other states and countries in the early 1970s. Many of the early reforms were aimed at providing property tax relief to certain categories of property owners such as homeowners - especially the elderly and disabled - through homestead exemptions and circuit breakers. These were attempts on the part of local government to preserve autonomy and maintain control over their major source of revenue. In 1976 several states placed caps on property tax rates (Arizona, Indiana, Nevada, Ohio, Oklahoma, Washington, and West Virginia) or limited the growth in property tax revenues (Alaska, Arizona, Colorado, Indiana, Kansas, Minnesota, Oregon, Washington, and Wisconsin).50 Indeed, as already discussed, the decline in the property tax began well before 1978. If the term "tax revolt" refers to the popular movement that erupted across the United States as angry taxpayers, impatient and frustrated with the usual legislative processes, took matters into their own hands, then Proposition 13, the most dramatic and publicized of such efforts, deserves credit for having sparked the modern tax revolt. Within six months after its passage, taxlimitation measures were on the ballots in 17 states and all but five were approved. There were 58 ballot measures during the 1979-84 period concerning classification, exemptions, assessment reform, and rollbacks. Among the most successful were expenditure- and tax-control measures. Forty-three states adopted new property tax limitations or relief plans between 1978 and 1980.51 Idaho and Massachusetts followed California's lead and adopted measures that both cut and limited property taxes. Idaho passed a measure virtually identical to Proposition 13 in November 1978, limiting property taxes to 1 % of assessed value and restricting increases in assessments to 2% per year. Massachusetts^ Proposition 2Vi differed somewhat from the California and Idaho measures. Its major provisions required cities and towns to reduce their effective property tax rate (the ratio of their total property tax levy to their total assessed valuation) to 2.5% (or their 1978 ratio if that was lower), and limited the increase in total revenue raised by the property tax to 2.5% per year. Unlike California and Idaho, the Massachusetts limits apply to the aggregate taxes of a city or town, not to the taxes levied on individual parcels. New state spending limits were set in New Jersey and Colorado. Several states (Arizona, Michigan, Louisiana, Oregon, Utah, and Washington) tied

The diversity of property tax systems

33

growth in local government spending or revenue to growth in personal income or population. In November 1978 Michigan voted down the Tisch Amendment, a Proposition 13—like proposal that would have cut assessments in half and limited annual increases to 2.5%. They passed instead the more moderate Headlee Amendment, which placed restrictions on both state and local government. Growth in local property tax revenues could not exceed the rate of inflation as measured by the consumer price index, and state revenues were limited to the share of personal income they represented in 1978-79, 9.5%. In addition, reductions in the proportion of state spending going to local governments were prohibited. This meant that each additional state dollar had to be matched by 72 cents for local government.52 This feature was designed to be a deterrent to increased state spending. As of 1991 only six states were not constrained by some form of tax limitation. Among the most common are tax-rate limits that, according to the Advisory Commission on Intergovernmental Affairs, are in effect in 30 states.53 In some states such as Arizona the rate cap applies only to revenues used to fund the operating budget, whereas in others, the cap affects all budgetary spending. Alabama and West Virginia imposed different rate limits on different property classes. Colorado and Texas vary the limit according to the level of government levying the tax or using the revenue generated by the tax. In general, rate limits vary from 0.5% in West Virginia, Nebraska, and Colorado to 5.0% in Michigan.54 In the 1992 survey of states and provinces conducted by the International Association of Assessing Officers, 10 states reported limits on the annual increase in assessments. The limits range from a low of 2% in California to 25% in Wyoming. Some states have singled out specific classes of property to which such limits apply. Illinois limits the annual increase in farmland assessments to 10%, whereas Maryland applies the same limit, but only to owner-occupied housing. Several states, like California, exempt properties that change ownership from the assessment limit.55 Since property tax revenues depend on both the level of assessment and the nominal tax rate, limiting one or the other does not insure that total levies will be limited as well. For example, if assessment increases are limited but local authorities are free to adjust the tax rate, then the revenue capacity of the property tax is not really limited. For this reason, a majority of states have imposed both tax-rate and assessment-increase limits, or have simply imposed a property tax levy limit that restricts annual growth in property tax revenues without specifying specific limits on rates or assessments. Property tax revenue limits vary from allowing no growth in Kansas, Missouri, and Montana to an annual increase of 10% in Indiana. Massachusetts limits levy increases to 2.5% per year. Rather than selecting specific limits, some states restrict growth in property tax revenues to no more than the growth in population (Minnesota), the

Property taxes and tax revolts

34

rate of inflation (Michigan), or growth in assessed valuations (Wisconsin). Limitations apply only in years following reassessment in Arkansas (10%), Louisiana (0%), South Carolina (1%) and Virginia (1%).56 Even broader limitations have been placed on local governments in seven states where either own-source revenues or expenditures are restricted. Nevada has limited growth in both property and sales tax revenues. In California and New Jersey, limits apply to total own-source revenues with exemptions for user charges. Arizona limits total municipal expenditures.57 There has been much speculation as to the genesis of the tax revolt and why it was aimed at local government and the property tax. Historically, public attitudes toward the property tax have been adverse. The Advisory Commission on Intergovernmental Relations (ACIR) has sponsored an annual publicopinion poll on government and taxes since 1972. When asked, "Which do you think is the worst tax - that is the least fair?" 45% of respondents in 1972 chose the property tax, as compared to 19% for the federal income tax, 13% for the state income tax, and 13% for the state sales tax. Over the next five years, the property tax won a close battle with the federal income tax for the peoples' choice of worst tax. For the next 10 years, the federal income tax won the most "worst tax" votes. The following three years saw the property tax regain the lead. In 1991, 43% of the respondents in the North Central region thought the property tax was the worst tax, followed by those in the Northeast (32%), the West (25%), and the South (23%).58 These regional differences are probably due to the heavier reliance on the property tax in the North Central and Northeastern states. The tax revolt lost momentum in the latter half of the 1980s, but continued dislike of the property tax together with the fiscal pressures resulting from the recent recession served to maintain interest in property tax reform. In 1993, voters in Florida approved a 3% limit on assessed value increases until sale for homeowner property. In a historic move, the Michigan legislature recently voted to eliminate all property taxes for school operations, effective July 1994. This is expected to reduce property tax bills by roughly 65%.59 At the same time, Minnesota, in an attempt to reform its complex property tax system, had a 22-member task force preparing legislation for its 1994 session. Inequities According to the ACIR surveys of public attitudes toward governments and taxes, the property tax was judged to be the least-fair tax throughout most of the 1970s. Fairness is a subjective term; however, most would agree that in order for a tax to be fair, it must be applied equitably. There are two frequently used criteria for equity. A tax is considered vertically equitable if the tax bill rises with the value of the tax base. Since the property tax is a wealth tax whose base is the value of property, vertical equity requires that

The diversity of property tax systems

35

owners of more valuable properties pay higher taxes. Horizontal equity calls for the equal treatment of equals. In the context of the property tax this requires that owners of similar properties pay similar tax bills. The property tax has failed to satisfy either criterion. This failure is sometimes due to the difficulties in administering the tax; this has resulted in unintended inequities, but may also be due to structural features of various property tax systems that have resulted in legal inequities. Unintended inequities A unique feature of the property tax is that its base, usually the market value of property, must be estimated, as opposed to being determined by the outcome of a specific transaction. Valuation of the tax base is the critical stage of administration. Property value assessment is a subjective process: Value is in the eye of the beholder. Nevertheless, an equitable distribution of the tax burden can be achieved only if assessments of value are uniform. Methods for evaluating the quality of assessments involve comparing the assessor's estimated market value to the sales price of newly sold properties, assuming this price is the true market value of the property. The assessment/ sales ratio for such a property is simply the ratio of assessed value to sales price. A value of 1.0 would indicate a perfectly accurate assessment. Of course this is an ideal and a certain degree of error is expected. If errors are randomly distributed, they do not necessarily lead to systematic inequities. However, if assessment errors occur in patterns, then the distribution of the tax burden will be affected. Assessment biases occur not only across different taxing jurisdictions, but within jurisdictions across and within property classes. In some cities, higher income areas tend to be assessed at below-average ratios, whereas in others, low-income areas tend to be favored by assessors. Similarly, assessment errors may be greater for higher-valued properties because there are fewer sales of such properties on which to base assessments. Assessment/sales ratios are not necessarily a meaningful evaluative tool, particularly when comparing performance across different jurisdictions with different statutory assessment ratios. A better measure of the possibility of bias in assessment errors is provided by the coefficient of dispersion (COD), which measures the average percentage deviation of the assessment/sales ratios of a sample of properties from the median ratio for the sample. The higher the COD, the less uniform are assessments. Statewide assessment/sales ratios and CODs are reported in Table 2. 2. These data were self-reported by the states as part of the 1992 IAAO survey, and should thus be treated with extreme caution.60 Assessment/sales ratios expressed as percentages varied from a reported 11.43% in Oklahoma to 100% as reported by Montana, Wyoming, and Oregon. Eight states reported ratios

36

Property taxes and tax revolts Table 2.2. Assessment practices State Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware D. C. Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming

Statutory Assessment Cycle None None 1 year 1 year change of ownership 2 years 10 years none 1 year 1 year

NA 1 year 5 years 4 years 4 years 1 year 1 year 1 year 1 year 4 years 3 years 3 years 1 year 1 year 1 year 2 years 1 year 1 year 5 years 1 year 1 year 2 years 1 year 8 years 1 year 6 years 1 year 1 year 1 year 1 year none 1 year 1 year 1 year 1 year none 6 years 1 year 1 year 1 year 1 year

Assessment/ Sales Ratio 92.86 %

Statewide Coefficient of Dispersion 18.09

NA

NA

80.00 19.51

19.40 20.05

NA NA NA NA NA

NA

96.90 40.00

NA 99.20 33.33

NA NA 97.71 93.00

NA 78.00 97.60 98.00

NA

16-21

NA NA 9.0-16.6 20 or less

NA NA NA NA NA NA 18.04

25 NA NA 1.9 6.50

NA

92.60

13-21

NA NA

NA NA NA

95-105 92.13 33.95 75.00 71.50

NA 24.89 81.79 99.90

NA 11.43 100.0

NA 44.40 88.00 72.69

NA 99.00 97.00 76.00 81.20 95.70 32.00 92.30 100.0

18.68-35.37 7.60 18.66

NA NA 30.4

NA 36 NA 24.41

NA NA 24-52

14 NA NA 16.73

NA 21.29 14.00

NA 72.96

NA 17.24

NA~data not available. Source: International Association of Assessing Officers, Assessment Administration Practices in the U. S. and Canada, August 1992.

The diversity of property tax systems

37

below 50%. These low ratios are not necessarily an indication of poor assessment; rather, these states have established low assessment ratios by statute. For example, assessed value in Oklahoma is defined to be between 11% and 14% of market value, and the statutorily set ratios in Arkansas and Nevada are 20% and 35% respectively. Their reported ratios thus suggest a quite accurate assessment. However, assessments are likely to be less uniform if the legal assessment ratio is low because errors are harder for property owners to detect, and they are less likely to challenge assessments. The variability in assessments as measured by the COD provides a better measure of quality and is a better barometer of equity. Reported CODs range from 1.9% in Maryland and 6.5% in Massachusetts to 72.96% in West Virginia. It appears that assessments are more uniform in the Northeastern states, where local governments are more reliant on the property tax, and effective property tax rates tend to be higher. Infrequent reassessment is the principal cause of unintended inequities. Market values fluctuate from year to year, but assessments change only when reassessment is undertaken. If assessments are not kept current, the property tax burden shifts from properties whose values are rising rapidly to those properties appreciating more slowly. This means that the tax can be shifted from newer to older parts of a city, or from homeowners to businesses, depending on the relative changes in market value. Even though tax bills remain unchanged between reassessments, increases in market values tend to lower effective property tax rates. Annual reassessment is required by statute in 31 states. This may or may not involve value changes. It may simply require recopying last year's assessed values. Some local governments increase assessments only to reflect new construction, or they may apply a flat percentage increase to all properties to reflect inflation. Such increases bear no relation to actual changes in value, and in particular fail to reflect changes in relative property values. Statutory assessment cycles range from 1 year to 10 years (Table 2.2). Montana, however, with a one-year cycle has not undertaken a general reappraisal of property since 1986. Some states require that local taxing jurisdictions reassess only if average assessment/sales ratios fall below a specified level, such as 90%.61 Mass cyclical assessment refers to the practice of revaluing all properties at statutorily specified intervals. The assessed value of properties typically does not change between assessment years unless physical changes to the property have occurred. New construction is added to the assessment roll each year but is sometimes valued on the basis of standards and manuals developed during the last mass assessment. This helps to achieve horizontal equity by not discriminating against new construction. Due to the high costs of mass reappraisal, some states stagger their reassessments. For example, if the reassessment cycle is five years, then one-fifth of all parcels get revalued each year. This practice is more common in jurisdictions where electronic dataprocessing systems are not available.

Property taxes and tax revolts

38

Legal inequities Many of the inequities and corresponding shifts in tax burden that arise due to infrequent assessments are actually part of the property tax structure in some states. Classification systems and exemptions are ways of reducing the property tax burden on certain property owners, although some feel these means violate the vertical- and horizontal-equity criteria. California voters chose to sacrifice equity for lower taxes and increased certainty regarding future taxes by approving an acquisition-value-based property tax system. The inequities generated by assessing property on the basis of acquisition value rather than current market value are significant and continue to grow over time. The assessed value of a property is determined by the price at which it last sold. Assessed values can increase at most 2% per year until the property is again sold. As a consequence, effective tax rates differ among classes of property and within classes in different locations due to differences in turnover rates, rates of appreciation, and rates of new construction. Owners of otherwise identical properties will face differing tax liabilities based on when they acquired their property. Those who purchased their property more recently pay higher taxes. This violates the criteria of horizontal equity. In terms of vertical equity it is very possible that the owner of a highvalue property purchased several years earlier will pay lower taxes than the owner of a recently purchased lower-valued property. In the next three chapters we discuss the experience of California with the acquisition-value tax system in detail. Chapter 3 provides a stylized model of acquisition-value taxation highlighting the role of mobility and inflation. Chapter 4 presents the results of an extensive empirical investigation of actual effective tax rates. Chapter 5 examines the differential burden on individuals and explores the deeper economic forces operating in an acquisition-value tax system.

The simple analytics of an acquisition-value tax system

In an acquisition-value property tax system, property taxes are based on the purchase price plus a small, maximum yearly allowance for inflation. As long as actual inflation in property values exceeds this allowance, property taxes for newly purchased property will exceed taxes for identical property that has not been sold. These differences in taxation or disparities for identical properties will naturally depend on two key factors: the rate of property inflation and the turnover or sale of existing property. The rate of inflation in property in any region will depend on many diverse factors. These include, among others, the average inflation rate for the country, the supply of housing and commercial structures, the availability of land, the rate of population growth, the age structure of the population, national tax policies toward housing and real estate, and regional income. None of these factors is directly related to property taxes. In Chapter 5 we discuss how property taxes affect the level of property prices. However, the rate of inflation in property will generally be determined by factors other than property taxation. For this reason, in this book we treat the rate of inflation for property as exogenous, that is, as external to the property tax system; as a result, we will not study its determinants in detail. In the course of our work documenting the disparities that have arisen since the passage of Proposition 13, we will, in the next chapter, provide measures of the rate of increase in property values for different types and sizes of property in California since the passage of Proposition 13. This chapter concentrates on the process of turnover or sale of existing property, the other essential component in an acquisition-value tax system. We use our analysis of the turnover process of property in two ways. First, we present a simple analytical model of an acquisition-value system that emphasizes its dynamic character and its interactions with the rate of property inflation. This model will be used to provide examples illustrating how an acquisition-value 39

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40

system actually operates and its sensitivity to the turnover process and rate of property inflation. Second, we also will develop tools to provide forecasts for the turnover of property in California in the future. These forecasts underlie our discussion of revenue projections in Chapter 7 and the policy alternatives in Chapter 8. In developing our analysis of the turnover of property under an acquisitionvalue system, we will draw on a well-established branch of statistics known as renewal theory.l Statisticians originally developed this theory for industrial applications such as expected replacement times for light bulbs as they burn out. Another important use for renewal theory was to analyze labor turnover. Firms with a large labor force will face natural attrition as workers quit. When a worker quits, a new one must be hired in order to maintain the size of the labor force. Renewal theory can help to predict the quantity of new hires that a firm will need at any point in the future. A key assumption of renewal theory is that the turnover process is random. There are always unobservable differences that make objects or individuals behave differently. Not all light bulbs will burn out at precisely the same age, nor will all workers quit after the same length of service. This insight also applies to the turnover or sale of property. Even sociologically very similar property owners will hold onto their property for different lengths of time. For example, on average, homeowners may stay in their home for, say, five years. But five years will be just the average length of stay. Some will stay much longer, whereas others will stay less than five years. Under an acquisition-value property tax system, these differences will matter because those remaining longer in their homes will generally pay less in property taxes. We will use renewal theory to analyze a simplified model of an acquisitionvalue tax system such as the one in effect in California. Property taxes are based on the market price plus a maximum 2% a year increase for inflation. Assume that housing-price inflation exceeds 2% so that new purchasers of housing will pay higher taxes than existing owners. To fix ideas, consider the following housing market. Suppose that at time t = 0 the world begins, and a large number of new houses come onto the market and are purchased. For simplicity, assume that no new houses are constructed after t = 0. Initially assume that there is no turnover at all; all homeowners remain in their homes, the inflation rate is 5%, and the initial purchase price was $100,000. After 15 years, the assessed value of the homes would have gone up by a factor of (1 + .02)15 and would be assessed at $134,587. The market value of their homes, however, would have gone up by a factor of (1 + .05)15 and would be valued at $207,892. The disparity ratio, the ratio of market to assessed value, would be 1.54. Equivalently, they would be underassessed relative to market value by a factor of .65, which is the reciprocal of the disparity

The analytics of an acquisition-value tax system

41

ratio. These figures are identical for all homeowners because we assumed that their turnover patterns were identical; specifically, that there was no turnover at all. Now let's allow for turnover to occur by some random process. After 15 years, how will the situation differ from the prior case? Some homeowners will have remained in their homes for 15 years, and their disparity ratios will still be 1.54. However, there will be homeowners who, after 15 years, will have been in their homes for shorter periods. Some will have just purchased homes in the current year. For those households, assessed and market values will be equal, and the disparity ratio is 1.00. Because the turnover process is random, others will have been in their homes for other periods of time. Consider those who have been in their homes for five years. In the initial 10-year period, these households will have moved at least once and perhaps several times; but in the most recent five-year period they have remained in their homes. After 15 years, the market value of their home is the same as all others, namely, $207,892. Their assessed value will be equal to the market value at year 10 (when they purchased their homes) plus 2% annually until year 15 or $179,843. The disparity ratio for these households is 1.15. Similar calculations can be performed for households who, in year 15, have been in their homes for other periods of time. In general, with random turnover, there will be considerable differences in the length of time households have been in their current homes. Individuals who have been in their homes for the longest time will have the highest disparity ratios and will be underassessed relative to market value by the greatest degree. Those who have been in their homes for shorter periods will have lower disparity ratios and will be underassessed relative to market value by a smaller degree. Renewal theory allows us to calculate the distribution of households by length of stay in their current home for any given turnover process. Coupled with data on rates of inflation for property, we can then calculate individual as well as average disparity ratios and the average degree of underassessment. Renewal theory will also permit us to "work backward" or estimate the turnover process from actual data on the length of stay of households in their current homes. Once we have estimated the turnover process, renewal theory will enable us to make projections about the distribution of the length of stay in the current home for any time in the future. Before turning to a discussion of renewal theory, we should clear up one point of terminology. When Proposition 13 was passed in 1978, existing properties had their assessments rolled back to 1975 values. In 1993, therefore, there are properties that have not been reassessed at full market value for 18 years (since 1975), 17 years (since 1976) and so forth. The distribution of prop-

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erties according to the year since it was last reassessed at market value is called the "base-year distribution." At any point in time, say 1993, the base-year distribution translates directly into a distribution of property by time since the last reassessment at market value. Property that has not changed owners since 1975 has a 1975 base year, and, in 1993, will not have been reassessed at market value for 18 years. It will often be convenient to refer to the base-year distribution of property, particularly when we discuss the experience in California. It will also be convenient in analytical presentations to use the term "age distribution" to refer to the time since the last reassessment at market value. As we discuss in the next section, renewal theory assumes that turnover is given by an exogenous, fixed probability law. This is a convenient assumption if the environment in which individuals make decisions - for example, the inflation rate and tax laws that they face - does not change dramatically. On the other hand, if the inflation rate changes we may want to allow for the probability distribution for turnover to change as well. Later in this chapter, we demonstrate how to incorporate changes in the inflation rate that affect turnover probabilities into renewal theory. Renewal theory and acquisition-value taxation The basic building block of renewal theory as applied to an acquisition-value tax system is the probability-density function for a sale of a property, which we will denote f(t). In this notation, t refers to time and runs from t = 0 to t = infinity. Essentially, fit) is the probability that a property will sell for the first time at year t in the future. For example, if t = 3, this will be the probability of a property selling in year three.2 Closely related to the probability-density function of a sale of a property are two other functions, the cumulative-distribution function F(t) and the survivor function G(t). The cumulative-distribution function is the cumulative probability that a property will sell before year t. It starts at 0 for t = 0 and approaches the value of 1 as t approaches infinity. The survivor function G(t) is the mirror image of the cumulative-distribution function. It is the probability that a property has not been sold by year t. There is an additional useful concept to describe the probability distribution of a sale. This is the hazard function §(f) which is the probability of a sale in the next year given that the property has not sold until that time. The hazard function is the conditional distribution of a sale. All four of these functions that describe the probability of a single property selling are closely related. Their definitions are collected in Table 3.1 and their interrelationships are defined in Table 3.2. The cumulative-distribution function is defined (as usual) as the integral of the probability-density function. The survivor function is one minus the cumulative-distribution function. Finally, the hazard function is the probability of a sale, conditional upon the

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43

Table 3.1. Renewal theory functions f(t)

Probability-Density Function The probability that a house will sell for the first time at the time t in the future.

F(t)

Cumulative-Distribution Function The probability that a house will sell before the time t.

G(t)

Survivor Function The probability that a house will not sell before the time t.

<|>(t)

Hazard Function The probability that a house will sell in the next period, given survival until the time t.

Note: Assume that upon sale, the house has age zero, then we can define: h(t) A(t;x)

Renewal Density The probability that a house will sell at the time t, (this includes all intermediate resales). Age Distribution At time t, the distribution of time since last sale (x).

Table 3.2. Algebraic

relationships

t Cumulative-Distribution Function; F(t) = J f(x)dx. 0 Survivor Function; G(t) = 1 - F(t). Hazard Function; <j>(t) = f(t)/G(t) t Renewal Density; h(t) = f(t) + Jf(x)h(t-x)dx. 0 Age Distribution; A(t;x) = h(t-x) * G(x)

property not having sold up to that point. Thus, it equals the probability-density divided by the survivor function. Equipped with any one of these expressions, the others can be derived using the appropriate formulas in Table 3.2. To this point, we have simply described the probability of a single property selling. In an acquisition-value tax system, once a property has been sold, it is assessed at current market value. Assuming that it follows the same probability laws for a sale, it can be treated as a new property with a current base year. Now, let there be a large number of properties that each sell according to an identical probability-density function. Assume that each property is statisti-

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cally independent of the others; that is, that one property sells does not affect the probability that other properties may sell. Once a property has been sold, it is treated as a new property and follows the identical probability-density function for a sale. For example, if a property is sold in year eight, the probability of it selling again in year nine is /(I). Treating a property that has just been sold as a new property subject to the same probability density for future sales is the essential aspect of renewal theory. In industrial applications, its analogue is replacing burned-out light bulbs with new ones subject to an identical probability distribution of failure. The assumption that a property behaves as if it were new upon sale is a convenient simplification that enables us to understand an acquisition-value property tax system. We now have a large number of independent properties that are treated as new ones upon sale. This enables us to ask a new question: At any point in time, what fraction of the properties will sell, taking into account the possibility of sales in all prior years? The answer is given by the renewal density h(t), which describes the number of sales that are expected to occur in year t. The renewal density can also be derived directly from the probability density of a sale. Its description is given in Table 3.1 and its formula in Table 3.2. Essentially, this formula is derived by using the definition of the renewal density to take into account all possible intermediate sales of property. A property can sell in period t for the first time - this accounts for the leading term/(0- It also could have sold at time t — x and then sold again for the first time x periods later - this joint event occurs with probability h(t — x)f(x). Adding up over all intervening years x gives the expression for the renewal density.3 Finally, the last important concept from renewal theory is the age distribution A(t;x) or the distribution of property by time since last sale.4 The function A(t;x) tells us at time t the fraction of properties that have not been sold since time t - x, where x runs from 0 to t. For example, A(t;2) is the fraction or properties that have not sold for two years and A(t;i) is the fraction of properties that have not sold since t = 0. As we have noted, the age distribution is another way of describing the base-year distribution of property. The age distribution is also described in Table 3.1 and its formula given in Table 3.2. The age distribution is calculated as the renewal density times the survivor function. For example, for a property to have remained unsold for two years, it is necessary that it sold in year t - 2, which occurs with probability h(t — 2) and has survived for two years, which occurs with probability G(2). To illustrate the use of renewal theory to analyze an acquisition-value tax system, we need to specify a particular probability-density function for sale. A convenient density that has been used extensively in the statistical literature is the mixed-exponential function. Table 3.3 contains the expression for the density, cumulative-distribution, and hazard function for the mixed exponential.

The analytics of an acquisition-value tax system

45

Table 3.3. Functions for the mixed exponential f(t) = pXiexp{-Xit) +(1 -p)X2exp{-\2t} G(t) = pexp{-Xit) +(1 -p)exp{-X2t} h(t)=l/Y + aexp{-bt} Where... Y=

p/Xi+(l-p)/X2

a=

pXi+(l-p)X2-l/Y

b=

The mixed exponential has two important properties that are valuable for this application of renewal theory. First, the mixed exponential has a hazard function that declines over time. This means that the probability of a house selling in the next period, conditional on having not sold to that point, declines over time. In other words, the longer one holds a property, the less likely a sale is in the following year. Actual hazard rates for the sale of property do decline.5 There is a straightforward reason that hazard rates for the mixed exponential decline over time. An exponential density itself is characterized by a constant hazard rate. A mixed exponential takes a weighted average of two exponentials - one higher than the other. We can think of this as representing two types of property - one with a high turnover rate and one with a lower one. Naturally, the properties with the high turnover rates sell first, leaving a larger percentage of unsold properties with low turnover rates. Thus, the hazard rates will fall over time, reflecting the changing composition of those properties that have not sold. The other useful property of the mixed exponential is its analytical tractability. There are compact, explicit expressions for all the key functions. There are also only three parameters: two exponential rates and a parameter that takes a weighted average of the two exponentials. In our illustrative example, we will take p = .2 and the two decay rates (\x and X2) of .04 and .10. This can be thought of as a mixture of two types of property, with 20% selling at a rate of 4% per year and 80% selling at a higher rate of 10% per year. The numbers in this example fall within the range of experience we have found in California. In Figure 3.1 we plot the hazard function and the survivor function for this distribution. Note that the hazard function declines over time as expected. For these parameters, the survivor function indicates that after approximately eight years, half of the properties will have been sold. Figures 3.2 through 3.4 use renewal theory to plot the age distribution of properties at the beginning (t = 0), after 17 years, and in the very long run. Obviously, in the beginning all properties have the identical age of zero. After

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Hazard Function

10

15

25

Years

Survivor Function

5

Figure 3.1

10

15

20

25

Hazard and survivor functions for the baseline model

17 years, a more interesting distribution appears. There is still a large group of properties that have not sold at all and have a base year of zero. Even after 17 years this constitutes 24% of the properties. Notice that aside from this hump in the distribution at t = 0, the distribution slope upwards. Apart from this hump, later base years are associated with higher percentages of properties. The exact distribution of the base year for this case is given in the first column in Table 3.4. Figure 3.4 illustrates the long-term distribution of properties. In the long run, the base year distribution slopes upward throughout its range. This reflects that after a long time it is unlikely for properties to have older base years be-

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47

120% 100%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Figure 3.2

Age distribution for properties at t = 0

30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%

•niilllll

•Mill

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Figure 3.3

Age distribution for properties at t = 17

cause they eventually sell. In fact, there is an interesting analytical result in renewal theory that the long-term age distribution is proportional to the survival function.6 Table 3.4 presents the base-year distribution after 17 years for this case along with the disparity ratios for inflation rates of 2%, 5%, and 10%. Assuming that

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8%

-75 -70 -65 -60 -55 -50 -45 -40 -35 -30 - 2 5 - 2 0 - 1 5 - 1 0 - 5 Figure 3.4

0

Age distribution in the long run

Table 3.4. Base-year distributions and disparity ratios Base Year

Base Year Dist.

Disparity Ratios Infl. = 5%

Infl. = 10%

1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

1.64 1.59 1.54 1.50 1.46 1.42 1.38 1.34 1.30 1.26 1.22 1.19 1.16 1.12 1.09 1.06 1.03 1.00

3.61 3.35 3.10 2.88 2.67 2.47 2.29 2.18 1.97 1.83 1.70 1.57 1.46 1.35 1.25 1.16 1.08 1.00

1.00

1.27

1.75

Infl. = 2% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Revenue Ratios

24.02% 2.27% 2.43% 2.61% 2.81% 3.03% 3.26% 3.52% 3.80% 4.11% 4.45% 4.81% 5.22% 5.66% 6.15% 6.68% 7.27% 7.91%

.00 .00 .00 .00 .00 .00 .00

the acquisition-value tax system follows Proposition 13 and allows a 2% annual adjustment, then the disparity ratios for the 2% case are all equal to 1.00. That is, market value and assessed values are equal for all base years. For higher inflation rates, this is not the case. With a 10% inflation rate, the 24%

The analytics of an acquisition-value tax system

49

of the properties that have a base year of zero have a disparity ratio of 3.61. More recent base years, of course, have lower disparity ratios, because inflation will have had less time to create gaps between market and assessed values. At the bottom of Table 3.4 are revenue ratios for all three cases. The revenue ratio is the ratio of the total market value of all properties to their total assessed value. It is, so to speak, the average disparity ratio for the group of properties as a whole, averaged over all base years. To dispel confusion we will use the term "revenue ratio" for groups and reserve "disparity ratio" for individual properties or properties of the same base year. At a 5% inflation rate, the revenue ratio is 1.27, whereas at a 10% inflation rate the revenue ratio is 1.75. This means that if the inflation rate had been constant at 10%, revenues at a constant tax rate would have been 1.75 times higher under a market-value system than under an acquisition-value system. Equivalently, in year 17 a tax rate of 0.57% of market value would have produced the same amount of revenue as a 1 % tax rate on assessed value. Switching to this lower rate, however, would have important distributional effects across taxpayers. Taxpayers with earlier base years would be hurt, whereas those with more recent base years would gain. For example, taxpayers with a zero base year would see their tax bills increase by 112%, whereas those with the current base year would have a 43% decrease in their tax bills. In an acquisition-value tax system, reforms that are revenue neutral in the aggregate will not be neutral for individual taxpayers. This model can easily be extended to allow new property to enter the market at a constant rate. With an influx of new property, the distribution of base years would be weighted toward more recent years. In the long run, the base-year distribution would converge to a constant distribution. The higher the entry rate for new property, the steeper the long-term base-year distribution would become; that is, it would be weighted toward more recent base years. Inflation and the lock-in effect To this point, we have taken the turnover process as fixed and exogenous, and have analyzed disparity ratios and revenue ratios for different inflation rates. As already noted there may be important interactions between changes in inflation and changes in the turnover process. In an acquisition-value tax system, inflation increases mobility costs. For example, if a family moves from a home in which it had been living for some time and purchases another of identical market value, it will face higher property taxes, because it will now pay taxes on the market value rather than on the (lower) assessed value. This effect increases with the inflation rate because a higher inflation rate increases the gap between market and assessed values. Since the penalty of moving increases with inflation, we would expect there to be a decrease in mobility as inflation increases because of this tax penalty. An acquisition-value tax system creates a lock-in effect that increases with the

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inflation rate. It is precisely analogous to the lock-in effect in the taxation of capital gains. How significant is the decrease in mobility from the interaction of inflation and an acquisition-value tax system? A recent study by Quigley (1987) on household mobility and home mortgages can provide some important clues to address this question. Quigley looked at the lock-in effect that occurs when households hold mortgages with lower interest rates than current market interest rates. This occurred frequently in past decades as some homeowners obtained mortgages when inflation rates were low and than watched market mortgage rates rise sharply with inflation. For these households, there was a lockin effect associated with their mortgages. If they moved, they would lose the advantages of the lower interest rates. Quigley estimated empirical hazard-rate models for households and was able to obtain a quantitative measure for the effect of the lock-in from low mortgage rates on household mobility. In particular, he obtained estimates about the decrease in mobility that occurs for every $100 increase in the penalty associated with losing a low-interest mortgage. His coefficient estimates can be used to estimate the lock-in effect from the interaction of an acquisitionvalue tax system and inflation.7 To obtain a measure of the lock-in from these interactions, we first need to specify a base case. Our method and base case are described in Box 3.1. We first calculate the tax premium, which is the difference in taxes that would occur if a household moved. The tax premium is equal to the tax rate times the difference between market value and assessed value. We calculate the tax premium from year to year for 2%, 5%, and 10% inflation rates for property. Except for the 2% inflation-rate case, the tax premium increases from year to year along with the gap between market and assessed value. To illustrate the effects, we take a representative base case of a home with an initial market value of $198,000 and a 1% tax rate and use this to calculate the tax penalty for moving. We assume that the average rate of inflation in the economy is 2%. This implies that in our high inflation rate case, the real rate of property appreciation is 8%. This high rate of appreciation mirrors the experience in Southern California from 1975 to 1991. The tax penalty in an acquisition-value system decreases both the hazard and the survivor functions. To gauge the full magnitude of these effects, we assume the density function used above corresponds to a 5% property-inflation rate, and then use the tax penalty calculated for the 2% and 10% inflation rates to shift the hazard according to Quigley's estimate. Relative to the 5% base case, the hazard function for the 2% case will increase because the tax penalty is lower at the lower inflation rate. It will decrease for the 10% inflation case.

Box 3.1. The tax premium and mobility for an LA. homeowner In order to illustrate how changes in the inflation rate will affect the behavior of homeowners, it will be helpful to look at a typical home in the state of California. This example will be based on a single family residence that has a market value of $198,000. Under Proposition 13, the market value in future years will differ from the assessed value upon which the homeowner will pay taxes. The difference in the tax liability between an acquisition-value system and a market-value system is the tax premium. Tax premium = Tax rate (Market Value - Assessed Value) = 0.01 [Initial Price (1 + inflation rate)') - Initial Price (1.02)r] As the inflation rate changes, this will change the amount of the tax premium enjoyed by the homeowner. If the homeowner were to move into a new home with the same market value, property taxes would rise by the amount of the tax premium. Therefore, we can treat the tax premium as if it were a moving cost. In so doing, we can determine how differing inflation rates affect the mobility of homeowners. For this home, the tax premiums at different inflation rates are: Year

Tax Premium Inflation = 5%

Tax Premium Inflation = 2%

Tax Premium Inflation = 10%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

$0 58 118 180 243 309 376 445 517 590 666 744 824 906 991 1,078 1,168 1,261 1,356 1,454 1,555 1,659 1,767 1,877 1,990 >107

$0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

$0 155 323 503 698 908 1,135 1,379 1,642 1,927 2,233 2,563 2,920 3,304 3,718 4,165 4,647 5,167 5,728 6,332 6,984 7,687 8,446 9,263 10,145 11,096

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Box 3.1. (continued) These figures are real tax premiums. The general inflation rate is assumed to be 2%. This implies a 3% real inflation rate for housing in the 5% example. The 10% inflation example implies that housing costs rise 8% a year in real terms. This is similar to what happened in southern California between 1975 and 1991. After living in this home for only 10 years, the real tax premium would be $666 if the inflation rate were 5%. With an inflation rate of 10% the real tax premium is $2,233. We would expect that a higher inflation would make a homeowner less likely to move. This is borne out by empirical estimates of the effect of mortgage premiums on mobility rates. John Quigley (1987) used a proportional-hazard model to describe the mobility of homeowners and estimate the effects of mortgage premiums. Mortgage and tax premiums are simply monetary moving costs. Monetary costs are considered when deciding when to move, hence mortgage and tax premiums will have similar effects. In our example we will treat 5% as the baseline inflation rate from which the baseline survivor function is derived. Then for different inflation rates, the Quigley estimates can be used to shift the survivor function up or down to determine the effect on homeowner mobility. The resulting survivor functions (Figure 3.5) confirm the idea that higher inflation will lower the probability of moving in the future. Inflation Rate Time of 50% Survival Probability

2% 7% Years

5% V/e Years

10% 8!/3 Years

Higher inflation increases the lock-in effect of Proposition 13.

Figure 3.5 plots the survivor functions for these three cases. Between the 2% and 10% housing-inflation case, the shift of the survivor function increases the time until which there is a 50% probability of moving by about two-thirds of a year. In the baseline case, it takes eight years to reach this 50% probability point. Therefore, the increase in length of stay caused by the tax premium to reach this point is 8.3%. It is important to note that this is solely the effect from the tax premium itself. As described in Chapter 6, the response of some local governments to Proposition 13 has been to enact real-estate transfer taxes. These taxes, of course, would reduce mobility even further. This reduction in mobility naturally reduces household welfare as people remain in lesspreferred homes for a longer period of time. This issue is addressed more fully in Chapter 5. The lock-in effect also reduces sales of other types of property, including commercial, industrial, and rental. Because these properties are so diverse, it is difficult to develop a single example that captures the diversity of circumstances. Nevertheless, the same underlying forces reducing mobility are at work for these properties as well.

53

The analytics of an acquisition-value tax system

5

6

7

__ Infl. = 5% Figure 3.5

8

__ Infl. - 2 %

9

10

11

12

__ Infl. - 10%

Survivor functions for different inflation rates

Using renewal theory in empirical work We have relied on renewal theory extensively in the empirical work reported in this book. There are three areas in which we have used these tools: estimating the parameters of the turnover process from actual data; projecting historical base-year distributions into the future; and constructing base-year distributions for counties in which only limited information is available. Let us consider each in turn. As we discuss in detail in the next chapter, we have complete data for nine counties in California. In particular, we have the complete base-year distributions for different types of property. To estimate the turnover processes, we find the parameters of the mixed exponential density that predict an age distribution that most closely matches the actual age distributions. Specifically, we use the formulas for the age distribution for mixed exponential to predict the age distribution as a function of the unknown parameters of the density. We then search over all possible parameters of the function to minimize the sum of squared differences between the actual and predicted baseyear distributions. Two complications arise in this approach. First, we treat the properties that were in existence in 1975 as if they were new properties. We lack data on the age distribution of property before 1975; moreover, the entire tax system and thus the turnover process changed with the passage of Proposition 13. Second, our estimation process allows for new construction.8 If new

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homes were built in 1980, for example, we treated them as a separate renewal process starting in 1980 but subject to the same turnover process. Once we had estimated the parameters of the density function in this manner, we could calculate any of the other functions. We used the hazard function to project an existing base-year distribution into the future. Recall that the hazard function gives the probability of a sale in the next period conditional on a property's not having been sold. Equipped with the hazard function, we can estimate the fraction of properties from each base year that could sell in the following year. This process can be applied successively to project base-year distributions from this existing stock to any point in the future. Estimates for new construction are added to obtain a complete estimate of the base year distribution in the future. New construction is assumed to follow the same turnover process as existing units. Finally, we did not have historical base-year distributions for most of the 58 counties in California, and could not estimate the turnover process directly. For single-family residences, however, we had data on new construction and the stock of housing in a single year.9 For each of these counties, we matched the turnover process to a county for which we had estimates of the turnover process and then calculated their base-year distribution using the formulas for the age distribution. This procedure was used to construct the statewide model described in Chapter 6. Projections into future years used the appropriate hazard function along with assumptions about new construction activity. Finally, in all our projections we assumed that the inflation rate did not change the parameters of the renewal process, because the average effects were small.

Measuring the disparities

Introduction In a property tax system based on acquisition values, the life of the county assessor is comparatively easy. As long as property values are increasing at a rate in excess of the maximum allowable rate of increase, the assessor has only to automatically increase by this maximum rate assessments of properties that have not sold. There is no need for the assessor to visit the property and make a detailed appraisal of its market value; market value is irrelevant for properties that do not sell. Moreover, when properties sell there is a transaction price that can be used as the basis for the assessment. There are, of course, difficult problems that will remain, such as assessing the value of significant modifications to property or placing a value on transactions that may not have been conducted at market value. In addition, there may be complex rules determining when a property is actually "sold," particularly in sophisticated commercial transactions.1 The life of an assessor in much more complicated in a market-value system. In this type of system, the assessor is responsible for placing a market value on every property in every year. The advent of computers has made this endeavor somewhat easier with sophisticated programs to assist mass appraising. As described in Chapter 2, market-value assessment is an ideal that many jurisdictions fall far short of meeting. Although the life of the assessor is less complex under an acquisition-value tax system, it is much more complicated for researchers interested in measuring the differences between market and assessed values. At any point in time, most properties will not be assessed at market value. Moreover, the mere passage of time will not lead to a true measure of market value unless a property sells. How can researchers uncover the relationships between market and assessed value that prevail in a community under an acquisition-value tax system? 55

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56

One brute-force approach would be to hire a large staff of property appraisers and have them systematically appraise all the property in an area. Although this would provide market values for the properties, such a procedure is expensive and impractical. The alternative is to use the information on recent sales of existing properties to infer the relationship between market and assessed values for properties as a whole. The method we used to develop the data in this book is based on using sale prices to make estimates for the entire stock of housing. The procedure starts with the complete property tax roll for a county for the two most recent years. From this data, it is possible to determine which properties sold between the two years. For each sale, the property tax records will have the base year (year since last sale) prior to the sale; the prior assessed value; and the new assessed value, which will be the current market value of the property. For each property, therefore, it is possible to calculate the disparity ratio - the ratio of market to assessed value - by type of property and by prior base year. If there are sufficient sales, it would be possible to estimate average disparity ratios for all types of property by base year. These estimates can then be combined with the current distribution of assessed value by property type and base year (from the most recent property tax rolls) to provide overall estimates of market value. This is the method that we tried to follow in developing our detailed database. Property was classified into four types: single family homeowner, other single family, multifamily, and commercial and industrial. For each of these types, we followed the method just outlined. Properties that did not fall cleanly into these categories (for example, vacant land and golf courses) were classified as "other," and disparity ratios were not calculated for these properties. In practice, there were a number of complicating factors. First, under Proposition 13, if a property is significantly modified, for example by adding a new wing or by building another structure on the land, the new addition is assessed at market value and treated as a separate piece of property. Thus, properties that were substantially modified would have multiple base years - the original base year plus the base years of any substantial additions or modifications. This was common for many older homes, and especially so among larger commercial and industrial properties. To deal with this factor, we subdivided our four categories into nonmodified and modified properties and calculated separate disparity ratios for each type. A second complicating factor was that for some counties and some classes of properties there were often very few sales for some base years. This meant that estimates of the disparity ratios for those base years are subject to considerable error. To avoid using inaccurate disparity ratios, if the number of sales was small, we would "smooth" the disparity ratios by fitting an exponential function on the base years from 1975 to 1991 and use the "fitted" values from the regression as the disparity ratios.2

Measuring the disparities

57

A third factor is that the sales data may sometimes present a misleading picture of the actual situation. For example, suppose that there is land that is owned originally by a developer who builds a house and then sells it. The final market value will contain both the value of the land and the structure, but the prior assessed value will refer only to the land. Calculating a disparity ratio in this case by our usual method will produce a large and unreasonable estimate of the relationship between market and assessed value for other properties in the county. In general, since we are calculating ratios, any time the prior assessed value is for any reason unusually small, the estimated disparity ratios will be extremely large. To avoid biasing our estimates, we routinely used median disparity ratios in our estimates. By using the median, we avoid the problem of the mean or arithmetic average being distorted by unusually large disparity ratios. In some cases, either the sales information was not available from a county or it was felt that it did not reflect the true underlying economic activity, as in the example of the vacant land that was subsequently developed. In these situations, if we had one year of the property tax roll available, we used an alternative method to estimate disparity ratios. This method assumed that the average assessed value for the most recent year was equal to the average market value, and furthermore that the property in different base years also had the same average market value. Under these assumptions, the ratio of average assessed value for prior base years to the current average assessed value provides an estimate of the disparity ratio. We call this the "Santa Clara" method.3 Although the assumptions underlying this approach are quite stringent, we checked it for counties for which we had estimates of disparity ratios from sales and did not find any systematic biases. Determining disparity ratios through the use of sales data is a data-intensive project. For example, the property tax rolls for Los Angeles County contain more than two 2 million parcels. Our method requires examining a large number of items on two years of the property tax roll. In order to keep the project manageable, we selected key counties in the state to provide the basis for our data. In selecting the counties for our work, we chose those that were either significant in themselves or would be valuable proxies for other counties. There were three types of county that we needed to include in our sample in order to represent the diversity of California effectively. First, there were the large urban counties in the Los Angeles and San Francisco areas. Second, there were the fast-growing suburban counties throughout the state. Finally, there were California's rural counties. For a county to be included in our sample, it was necessary that it have the required data on file. The single biggest limitation we confronted was that many counties did not keep data on base years. In some counties, any time a

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modification is made to the property, the "base year" recorded in the record will just be the last date at which the property was modified. These counties could not be included in our sample. The nine counties that we analyzed intensively were: Urban counties: Fast-growing suburban counties: Rural and ex-urban:

Los Angeles, Alameda, San Mateo San Bernardino, Sacramento, Sonoma Butte, Kern, Placer

For all but two of the counties, we received computer tapes with the complete property tax rolls and sales. For Butte and Kern counties, we sent a team of researchers to the assessor's offices and drew a random sample of the property tax roll and sales. Because this was time-consuming work, the samples were small for those two counties. We also received extensive data in tabular form from Santa Clara and Riverside counties. In this chapter, we address important issues in property taxation using key statistics and in-depth information from the counties just listed. Chapter 6 builds on this information to make estimates of the relationship between market and assessed values for the entire state.

Disparities and base-year distributions for homeowners Two of the key statistics in our analysis are the disparity ratios - that is, the ratios of market values to assessed values - and the base-year distribution, the percentage of properties within each base year. Table 4.1 contains the disparity ratios and base-year distributions for Los Angeles and San Bernardino counties for homeowner property that has not been modified. Los Angeles, the largest county in California, contains approximately 30% of the market value of all properties. It also was largely developed before Proposition 13 was passed, and therefore has not had rapid new growth compared to other counties in California. Los Angeles has also been characterized by very rapid property appreciation. The relatively low growth and high appreciation rates are evident in the data in Table 4.1. More than 43% of the properties have 1975 base years; that is, they have not changed hands since 1975. The base-year distribution follows the basic pattern predicted by renewal theory in Chapter 3: a peak at 1975, rising levels toward most recent years, and the lowest levels in the intervening years. This pattern is also reinforced by the recession that occurred in the early 1980s, which reduced the pace of new construction. The disparity ratio for the 1975 base-year properties is 5.19. This translates into an average per-year

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59

Table 4.1. Base-year distribution and disparity ratios for two counties San Bernardino County Homeowners, Non-Modified

Los Angeles County Homeowners, Non-Modified Year 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

Base Year Distribution 43.2% 2.4% 2.6% 2.6% 2.7% 2.7% 1.9% 1.5% 1.5% 2.7% 3.2% 4.1% 5.5% 5.8% 6.9% 6.1% 4.8%

Disparity Ratio 5.19 4.18 3.55 2.90 2.49 2.04 L.71 L.68 L.70 L.68 L.66 L.62 1.55 L.43 L.27 1.12

LOO

Year

Base Year Distribution

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

20.3% 1.8% 2.5% 3.1% 3.7% 3.3% 1.8% 1.9% 1.7% 2.8% 3.8% 5.0% 7.3% 8.9% 10.9% 11.6% 9.4%

Disparity Ratio 3.91 3.26 3.01 2.55 1.95 1.63 1.46 1.43 1.40 1.43 1.43 1.43 1.42 1.38 1.34 1.25 1.00

Disparity ratios are the median ratio of market to assessed value. Base year distributions are the percentage of properties in a given year.

inflation rate of housing prices of approximately 12% a year.4 The estimated disparity ratios fall, as expected, from this level. After 1981 they are all below 2.0. To put these results in more concrete terms, a new purchaser of a home in Los Angeles County will pay $280,000 for the average home. The property taxes from the 1% assessment alone will be $2,800 a year. If a person had been living in the same home since 1975, their property tax bill would be $540 a year. It was precisely these inequities that brought the Nordlinger lawsuit. The evidence presented in this chapter demonstrates that the Nordlinger case was not accidental but is the common pattern in California. San Bernardino presents quite a different picture. Unlike Los Angeles, San Bernardino experienced very rapid growth after 1978. This is quite evident in the base-year distribution. Only 20.3% of properties have 1975 base years, and more than 48% of all the properties in the county were added between 1987 and 1991. Price appreciation was also less rapid in San Bernardino, although still quite high by most standards. The disparity ratio for 1975 base year properties is 3.91, which translates into an average annual appreciation rate of approximately 10%. The disparity ratio and percentage of base-year properties for 1975 convey considerable information about the nature of a county. Table 4.2 contains this

Table 4.2. Disparity ratios and base-year distributions

County 1975 Disparity Ratio Homeowners, Non-Modified 1975 Base Year Distribution Homeowners, Non-Modified Overall Effective Tax Rate (All Properties) a

Alameda 4.94

37.2%

.57%

Through 1990. ^Includes both modified and non-modified.

Los Angeles

5.19 43.2%

.51%

San Bernardino

3.91 20.3%

.74%

Butte

Kern

3.03

2.71

4.97

29.5%

24.8%

27.1%

a

.67%

.74%

Sonoma

.60%

San Mateo

Placer

3.92

4.58

4.00

30.3%

39.4%

20.6%b

Sacramento

.62%

.60%

.64%

Measuring the disparities

61

Table 4.3. Calculating average effective tax rates

Base Year

Disparity Ratios

Total Assessed Value

Total Market Value

1975

5.19

100

519

1991

1.00

300 Total:

Average Effective Tax Rate

32,000

53,333

Total Assessed Value Total Market Value

The disparity ratio and percentage of base-year properties for 1975 convey considerable information about the nature of a county. Table 4.2 contains this information about the nine counties for which we had detailed information. In addition to Los Angeles, three Bay Area counties - Sonoma, Alameda, and San Mateo - all have very high rates of appreciation, with 1975 disparity ratios well in excess of 4.0. San Bernardino, Sacramento, and Placer, which are all fast-growing suburban counties, have disparity ratios near 4.0. The rural counties, Butte and Kern, have disparity ratios for 1975 properties closer to 3.0. The percentage of the base year in 1975 is a good indicator of recent growth in the county. Los Angeles, Alameda, and San Mateo have had the slowest growth, with their percentages in the neighborhood of 40%. San Bernardino, Sonoma, and Placer exhibited the fastest growth, with 1975 base-year percentages lower than 25%. The disparity ratios and base-year distributions can be combined, along with data on assessed values by base year, to calculate average effective tax rates. The average effective tax rate is the statutory rate of 1% times the ratio of assessed to market value. Table 4.3 presents an illustrative calculation of the average effective tax rate. For each base year (only two are shown for illustration) the disparity ratio is multiplied by the total assessed value to obtain the

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total market value for that base year. Assessed and market values are then summed over all base years, and the ratio of their totals is multiplied by 1% to obtain the average effective tax rate. In our work, we modified this procedure slightly. First, we took into account that California allows a homeowner's exemption of $7,000 in assessed value. Second, we projected the data to 1992 before calculating the effective tax rates. Finally, in other chapters we often use the reciprocal of the effective tax rate the ratio of market to assessed value - which we call the revenue ratio. Table 4.2 contains estimates of the average effective tax rates for all property (not just homeowner property) in the nine counties. The discrepancy between market value and assessed value will be the greatest when there is high appreciation and relatively little turnover. Thus, counties such as Los Angeles, which exhibit this pattern, should have the lowest effective tax rates. Indeed, the effective tax rate in Los Angeles is the lowest, 0.51%. San Bernardino, on the other hand, has a higher effective tax rate on all property of 0.74% because it experienced more rapid growth and slower price appreciation. For the state of California as a whole, the effective tax rate is 0.55%. Chapter 6 contains a more detailed examination of revenue ratios (the reciprocal of the effective tax rate) for the nine counties by classes of property. The disparity ratios and base-year distributions presented in Tables 4.1 and 4.2 were for properties that had not been substantially modified, and therefore had only a single base year. Many property owners do, however, make modifications and additions to their property; indeed, Proposition 13 encourages modifications. Improvements or modifications do not trigger a full reassessment of the property, as would the sale of it. How should the disparity ratios and base-year distributions for modified and nonmodified properties compare? We would expect that, for any base year, modified properties would have lower disparity ratios than nonmodified properties. Modified properties have a portion of their property assessed at the older, original base year and the remainder of the property assessed at more recent times, when the modifications or additions were made. The overall disparity ratio would be an average of the older, original base year and the more recent base years with lower disparity ratios. The base-year distribution for modified properties, however, will typically be older, that is more weighted toward the past, than for nonmodified properties. Households and firms undertake additions and modifications as substitutes for buying or building new properties. By incorporating an addition or a substantial modification the taxpayer can remain in the same property and retain a portion of the property at the older base year. Proposition 13 has created an important incentive to renovate or remodel properties rather than purchase a new property. A homeowner or business will often chose to remodel an existing property rather than face higher property tax bills on a newly purchased property.

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63

Table 4.4. Modified and nonmodified properties Disparity Ratios Non-Modified Modified 1975 1976 1977 1978 1979 1980

5.19 4.18 3.55 2.90 2.49 2.04

Effective Tax Rate

4.35 3.66 3.17 2.76 2.41 2.07 .483% (non-modified)

Base Year Distribution Modified Non-Modified 43.2%

47.0%

2.4 2.6 2.6 2.7 2.7

4.7 5.5 5.9 5.7 4.6 .431% (modified)

Data for Los Angeles County, homeowners

These predictions about the disparity ratios for modified and nonmodified property are confirmed in the data. Table 4.4 compares the disparity ratios and base-year distributions for the period 1975-80 for modified and nonmodified homeowner property in Los Angeles County, which was chosen to illustrate this point because its large size ensures an adequate sample. Except for 1980, the disparity ratios for nonmodified properties exceed those for modified properties, as anticipated. Moreover, the base-year distributions for modified properties exceed those for nonmodified properties in this selection of older years. Because the disparity ratios are lower for modified properties, but the baseyear distributions are older, it is not clear a priori whether the effective tax rates are higher or lower for modified properties. In practice, however, the effective tax rates for modified properties are consistently lower. As Table 4.4 also shows, the effective tax rate for nonmodified homeowner properties in Los Angeles County is 0.483%, whereas it is 0.431% for modified properties. Among the homeowner property in Los Angeles County, modified properties constitute approximately 17% of the total assessed value and 19% of total market value. This same pattern was true for other counties, as well. For example, in Alameda County, the effective tax rate for this class of modified property was 0.403%, compared to 0.549% for nonmodified property. In Sonoma County, the effective tax rates were 0.422% and 0.552% respectively. All counties except Kern (where data was limited) exhibited this pattern. The discussion to this point has focused on the median disparity ratios. There is a wide distribution of disparity ratios for any base year. Figure 4.1 contains a plot of the disparity ratios for 1975 homeowner property in Los Angeles County. The distribution has a peak disparity ratio of 5.1 and is concentrated between 4 and 7. The distribution is slightly skewed to the right; however, less than 1% of all properties have disparity ratios greater than 8. For all years except 1975, there are too few sales to generate a meaningful distribu-

64

Property taxes and tax revolts

I? C

10%

0.0% 1

1.5

2

15

3

3.5

4

4.5

5

5.5

6

6.5

7

7.5

8

8.5

9

9.5

10

Disparity Ratios Figure 4.1 Disparity ratios for homeowner property in Los Angeles County tion for the disparity ratios. In the analysis of the winners and losers from Proposition 13 in Chapter 5, we use the entire 1975 disparity-ratio distribution. Other residential and commercial and industrial property For California as a whole, homeowner property constitutes about 34% of the assessed value of all property. Other residential property accounts for an additional 31%, of which 19% is single-family nonhomeowner property and 12% is multifamily dwellings. Commercial and industrial property accounts for 26%, whereas vacant land and agricultural holdings account for the remaining 9%. Thus, a comprehensive look at the property tax needs to account for these other categories, particularly nonhomeowner residential and commercial/industrial property. Other residential property Table 4.5 present key statistics for other residential property. It is quite evident that single-family nonhomeowner ("other single family") property exhibits rapid turnover. The percentage of the property accounted for by 1975 base years is considerably smaller than for homeowner property. In Los Angeles, for example, only 24% of other single-family property has a 1975 base year, compared to 43% for homeowners. Other single-family property

Table 4.5. Other residential property Multifamily

Other Single Family 1975 Disparity Ratio

1975 Base Year Percentage

Effective Tax Rate

1975 Disparity Ratio

1975 Base Year Percentage

37%

Effective Tax Rate

Alameda

4.77

19%

.66%

4.67

San Bernardino

3.91

12%

.77%

3.44

Butte3

2.42

27%

.71%

2.57

25%

.69%

Los Angeles

5.54

24%

.66%

6.10

35%

.49%

Sonoma

5.53

16%

.65%

5.65

21%

.63%

SanMateo

4.44

22%

.70%

3.80

34%

.64%

Placer

n.a.

14%

.73%

n.a.

10%

.68%

Non-Modified Properties Only a

Small samples.

8.5%

.51% .86%

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66

consists of rental and vacation property or second homes. These properties are often owned by small investors who apparently hold them for relatively short periods of time. This rapid turnover is also manifest in the comparatively low portion of modified properties in this category. In Los Angeles, for example, the other single-family modified properties compose only 10% of total assessed value compared to 17% for homeowner properties. Recall that a property can have multiple base years only until it is sold. Since turnover is rapid within this class of properties, the percentage of multiple-base-year properties will be low. Disparity ratios for 1975 base years for other single-family property is comparable to homeowner property. In some counties, the estimated median disparity ratios are higher than those for homeowner property, whereas in others, the estimates are lower. Unlike the base-year distributions, there is no distinct contrast between disparity ratios for homeowner and other single-family property. Effective tax rates for other single-family property are considerably higher than for homeowner property within each county. In Alameda County, for example, the effective tax rate for homeowners was 0.55%, whereas it is 0.66% for other single-family property. This pattern is uniform across all nine counties for which we had detailed information. The higher turnover rates for this class of properties is directly responsible for the higher effective tax rates. With higher turnover rates, the base-year distribution is less concentrated in early base years, unlike that for homeowner property. Multifamily properties generally have higher effective tax rates than homeowner properties, but lower effective tax rates than other single-family properties. Multifamily units are often owned by larger investors than other singlefamily property and turn over less rapidly. In Los Angeles and Alameda counties, for examples, the 1975 base-year distributions are nearly 35%. Again, no systematic pattern occurs with respect to appreciation rates compared to other types of property. Turnover rates for multifamily property are lower than for other single-family property but higher than for homeowner property. Effective tax rates are higher than for homeowner property but lower than for other single-family property. These findings indicate that effective tax rates on rental property as a whole (combining other single-family and multifamily properties) are somewhat higher on average than for homeowner property within each county. Differences in turnover rates, new construction, and price appreciation dampen these differences. For example, effective tax rates for other single-family property in Los Angeles County match those for homeowners in San Bernardino County, whereas effective tax rates on multifamily property in Sonoma are less than those for homeowners in Butte. Generalizations about effective tax rates and classes of property are best confined to within-county comparisons.

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67

Commercial and industrial property The market value for commercial and industrial property is the most difficult to estimate using methods based on recent sales. This category of property is the most heterogeneous - ranging from small retail outlets to major industrial complexes - and sales, particularly of large properties, are much less frequent than for residential properties. Some counties are dominated by a few extremely large properties. Nonetheless, our analysis using sales data provides reasonable results. Particularly for this category of property, it is important to examine the data from larger counties, where there were a sufficient number of sales, to make reliable inferences. Los Angeles contained the largest number of sales: In 1991-92 there were 4,384, of which 298 were of modified properties. Table 4.6 contains key data on commercial and industrial properties from Alameda and Los Angeles counties. One important fact clearly emerges from this table. For commercial and industrial property, the modified vs. nonmodified distinction is closely related to large versus small properties. In Alameda County, for example, the average assessed value for modified properties was more than $1.6 million, whereas the average assessed value for nonmodified properties was only about $563,000. This pattern, which held true in all counties, reflects the fact that the very large enterprises are the ones that will be constantly adding new buildings or wings. Modifications for these properties are frequent, whereas sales are relatively rare. Modified properties also account for a smaller fraction of total assessed value, although there is considerable variation across counties. In Alameda, modified properties account for 42% of the total assessed value of commercial and industrial properties; the corresponding figure in Los Angeles is 19%. Disparity ratios are, as expected, smaller for modified properties. In Los Angeles, the 1975 disparity ratios were 4.19 for modified properties and 5.66 for nonmodified properties, whereas in Alameda they were 3.17 and 3.70 respectively. The lower disparity ratios for modified properties reflect the mix of newer base years in the overall assessment. The effective tax rates for the larger, modified properties are smaller than for the smaller, nonmodified properties. In Los Angeles, for example, the effective tax rates are 0.43% for modified properties and 0.52% for nonmodified properties. Again, the level of effective tax rates varies substantially across counties. In Alameda County, the effective tax rates are 0.71% and 0.78% respectively. Thus, the average effective tax rate for large, modified properties in Alameda County exceeded the rate for smaller nonmodified properties in Los Angeles County. Comparisons across property types Soon after Proposition 13 was passed, critics charged that homeowners would bear the brunt of the tax burden because homeowner property would

Table 4.6. Commercial and industrial property Non-Modified Effective Tax Rate

Modified Average Assessed Value

Percent of Total Assessed Value

1975 Disparity Ratio

1975 Disparity Ratio

1975 Base Year Percentage

3.70

25.8%

.78%

$563,218

58%

3.17

27.3%

.71%

$1,624,569

42%

Los Angeles 5.66

35.8%

.52%

$564,946

81%

4.19

43.8%

.43%

$1,187,159

19%

Alameda

1975 Base Year Percentage

Effective Tax Rate

Average Assessed Value

Percent of Total Assessed Value

Measuring the disparities

69

Table 4.7. Tax rates across properties Nine-County Comparisons Homeowner vs. All others

.51% .58%

Commercial and Industrial vs. All others

.56% .53%

Statewide 8

a

Residential

.55%

Commercial and Industrial

.57%

All

.56%

Based on statewide model described in Chapter 6.

turn over more rapidly than other property. As the data in this chapter indicate, the picture is more complex. Homeowner property turns over less rapidly than other single-family property and multifamily property. For commercial property the picture is even more complicated. Large properties experience less turnover than smaller properties. Based on data similar to that presented in Tables 4.5 and 4.6, large (modified) commercial properties probably have turnover rates in aggregate similar to those of homeowner property, whereas smaller commercial properties turn over at a faster rate. The effective tax burden on different classes of property depends on the disparity ratios as well as the turnover rates. The best way to compare the tax burdens on different classes of property is to examine the effective tax rates directly. Table 4.7 presents some key comparisons. From our in-depth nine-county sample, we can compare the effective tax rates for several classes of property. First, averaged over these counties, homeowner property is taxed at an effective rate of 0.51% compared to 0.58% for all other property together. Commercial and industrial property is taxed at a 0.56% effective rate compared to 0.53% for all other property. Another comparison is possible using the statewide tax model developed in Chapter 6. In this model, limited data availability required that all residential property be treated together. The effective tax rate on all residential property in California is 0.55%, compared to 0.57% for commercial and industrial property statewide.5 Two points need to be emphasized about these results. First, there is no evidence whatsoever that commercial property is taxed more lightly than other classes of property. Indeed, all the evidence points in the opposite direction.6 As a group, homeowners have the lowest effective tax rates. Second, these differences across classes of property are very small. Recall that prior to Prop-

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osition 13, property tax rates in California reached as high as 2.5%. As Chapter 2 indicates, rates of this level are not uncommon across the country. The differences we are discussing are less than .05 percentage points. By itself, this differential in rates is not a significant public-policy issue, and lies well within the margin of error of any tax system. However, average tax rates across broad classes of property are only one measure by which to judge a property tax system. Another important dimension is horizontal equity - the extent to which taxpayers in similar situations are treated equally. It is clear from the differences in disparity ratios across base years that owners of nearly identical property may pay vastly different amounts of property tax. The next chapter studies the distributional effects in more detail.

Incidence, mobility, ownership, and capitalization

Introduction Economists have long stressed that the legal incidence of a tax is not the same as the economic incidence. In other words, the person or corporation that mails a check to the tax authorities may not actually be bearing the true economic burden of the tax. Corporations, for example, could in principle pass increased corporate taxes into higher prices for their goods or into reduced wages for their workers. In another important example, employers and employees each pay half of Social Security taxes, but most economists believe that employees pay the full burden of the tax and that the part that the employer pays actually leads to reduced wages. The same economic forces operate with respect to property taxes. Economists have traditionally studied the incidence of an ad valorem property tax based on market value. The standard analysis (dubbed the "new view") has been discussed extensively. Henry Aaron (1975) provides a classic treatment of the issue, and Wassmer (1993) provides a more recent view. According to the new view of property taxation, a uniform property tax levied on all land and capital would be borne only by the owners of land and capital. Since they would all be taxed at the same rate, they could not pass the tax on to consumers or other parties. This analysis applies to the average rate of property taxes levied in the country. It also suggests that uniform property taxation is a progressive tax because the ownership of land and capital is concentrated among upper-income individuals and families. If a jurisdiction has a higher rate of taxation, capital and land can escape the tax to the extent that they are mobile. Since capital improvements can take place in many locations, a jurisdiction that levies a higher property tax than average will find that there will be fewer improvements, and that the beforetax rate of return earned by the capital will rise to equalize the after-tax rate of return on improvements. This means consumers of the services of property 71

Property taxes and tax revolts

72

improvements (business and homeowners) will pay part of this tax in either higher explicit or implicit rents. To the extent that land is immobile, higher property tax rates will be borne directly by owners of land. Based on this analysis, it is possible to consider the effects of reductions in conventional ad valorem property taxes brought about by tax limitations. Suppose that the jurisdiction previously had a higher property tax rate than average. Then the reduction of property tax rates would benefit consumers of property improvements and lead to lower explicit or implicit rents. Owners of land would benefit directly from the reduced taxation. This type of analysis could be applied directly to tax limitations such as Massachusetts's Proposition 2lA, which lowered property tax rates in an ad valorem system from previously high levels. In California, however, property tax limitation took a very different form. Although the rate was capped at 1%, the major innovation was the institution of an acquisition-value tax system. Economists have never previously considered the economic burden and incidence of an acquisition-value tax. This chapter breaks new ground by providing an economic analysis of both the burdens and distortions of an acquisition-value tax system compared to a traditional ad valorem system. This chapter focuses on the effects of an acquisition-value tax system on different types of households. In the first section, we show that a switch from the present acquisition-value tax system to one based on current market value would increase the tax liabilities of low-income and senior-citizen homeowners. The second section explains that the acquisition-value tax system decreases household mobility, while the third section explores the efficiency implications of these mobility distortions. Section four shows that the acquisitionvalue tax system increases the likelihood of home ownership for infrequent movers and decreases the likelihood of home ownership for frequent movers. In the fifth section, we show how the tax cuts from Proposition 13 are capitalized into market values, and explore the implications of capitalization for different types of households. Effect of tax reform on homeowners: income and senior status Consider a revenue-neutral switch from the present acquisition-value tax system to one under which taxes are based on current market value. Suppose that property values appreciate at a rate exceeding 2% per year (the maximum reassessment rate under Proposition 13). For a fixed tax rate (1%), the market-value system would generate more revenue, because assessed values would increase more rapidly over time. For revenue neutrality, the marketvalue tax rate must be less than the 1 % tax rate in force under the acquisitionvalue tax system. Based on the analysis in Chapter 4, the revenue-neutral tax rate for California as a whole would be about 0.55% of current market value.

Incidence, mobility, ownership, and capitalization

73

Although a revenue-neutral switch to market-value taxation would not affect the tax liability of the "typical" homeowner, it would decrease the tax liabilities of frequent movers and increase the tax liabilities of infrequent movers. Consider a household that moves every year. This household never gets any benefit from the acquisition-value tax system: The household's effective tax rate is 1% per year. Under the market-value system with a lower tax rate, this household would pay lower taxes. Consider next a household that moves every 15 years. This household receives large benefits from the acquisition-value tax system: Its effective tax rate may be close to 0.20%. The market-value tax rate is less than the nominal acquisition-value tax rate (1%), but higher than the household's effective tax rate (0.20%). As a result, a switch to market-value taxation would increase the household's tax liability. We are interested in the effects of tax reform on homeowners with different incomes and senior-citizen status. Based on the preceding discussion of the relationship between household mobility and tax liabilities, we would predict that tax reform will harm low-income homeowners and households with senior citizens if such households move infrequently. Infrequent movers currently pay relatively low taxes because their properties have relatively low assessed values. A switch to market-value taxation would increase the assessed values of these households by a relatively large amount, causing a relatively large increase in property taxes. To predict the effects of a switch to market-value taxation, we relied on a match of property tax records with income tax returns (made available through cooperation with the California Franchise Tax Board) for homeowners in four counties (Alameda, Los Angeles, San Bernardino, and San Mateo). For each homeowner, we compiled a file that consisted of their adjusted gross income, senior-citizen status, the base year of their property, and their current assessed value. Using estimates of the disparity ratios for each base year, we then could estimate the market value of their property. For 1975 base years we took a random sample from the entire distribution of disparity ratios; for other years we used the median disparity ratio. We then calculated the total market value for homeowner property and the revenue-neutral property tax rate. Using this revenue-neutral property tax rate and the estimates of market value of property for each household, we can then analyze the consequences of switching from an acquisition-value to a marketvalue system of taxation in a revenue-neutral setting. Figure 5.1 shows the results of this procedure for Alameda County. The figure shows, for each income group, the average change in annual property taxes. On average, a switch to market-value taxation would increase the tax paid by low-income households and decrease the tax paid by high-income households. Middle-income households would experience relatively small changes in tax liabilities. Table 5.1 shows the numbers behind Figure 5.1, as

Property taxes and tax revolts

14

304

Income ($1,000)

Figure 5.1 Average change in tax liability for different income groups in Alameda County Table 5.1. Average change in tax liability for different income groups Average Change in Annual Tax San Bernardino

Alameda

Los Angeles

0 -> 10,000

268

179

65

San Mateo

Income Interval

335

10,000 -> 20,000

304

206

79

386

20,000 -> 30,000

213

138

38

294

30,000 -> 40,000

95

57

-3

164

40,000 -> 50,000

5

0

-25

62

50,000 -> 60,000

-47

-22

-35

6

60,000 -> 70,000

-105

-49

-41

-50

70,000 -> 80,000

-162

-69

-60

-105

80,000 -> 100,000

-233

-109

-56

-202

More than 100,000

-366

-335

-61

-530

well as the relevant numbers for the other three counties. In San Bernardino, there are relatively small changes in tax liabilities because a relatively small number of owner-occupied dwellings have a 1975 base year. In each income group, there is substantial variation across households in the changes in tax liabilities. Figure 5.2 and Table 5.2 show the results of the fol-

Incidence, mobility, ownership, and capitalization

75 3 25th percentile |

50th percentile

I

75th percentile

-740 Income: 80,000 to 90,000

Figure 5.2 Distribution of tax changes within different income groups in Alameda County Table 5.2. Variation in changes in taxes within selected income groups Change in Annual Tax Liability Alameda

Los Angeles

San Bernardino

SanMateo

149 373 566

-52 281 495

-106 31 238

-14 520 794

-418 69 465

413 126 417

-168 -80 136

-541 126 676

-740 -315 439

-659 31 517

-272 -121 178

-976 -356 654

Income = 15,000 to 20,000 25th Percentile 50th Percentile 75th Percentile Income = 40,000 to 45,000 25th Percentile 50th Percentile 75th Percentile Income = 80,000 to 90,000 25th Percentile 50th Percentile 75th Percentile

76

Property taxes and tax revolts

75

24 16

S

S

§

§

^

*>

S

5

Income ($1,000)

Non-Senior Households

Income ($1,000) Senior Households

Figure 5.3 Percentages of homeowners in Alameda County with 1975 base years, by income: seniors and nonseniors lowing exercise. For a given income group, rank the households with respect to the change in tax liability, with the household experiencing the largest decrease in taxes ranked first, and the household experiencing the largest increase in taxes ranked last. Figure 5.2 shows, for each of three different income groups in Alameda County, the change in taxes experienced by (1) the household in the 25th percentile (25% of households experience a larger decrease in taxes or a smaller increase in taxes), (2) the household in the 50th percentile (the median change in taxes), and (3) the household in the 75th percentile. The variation in the changes in tax liabilities is substantial: For example, the tax change for households in the 75th percentile exceeds the tax change for households in the 25th percentile by between $417 (for income between $15,000 and $20,000) and $1,179 (for income between $80,000 and $90,000). Why is the switch to market-value taxation so regressive? The principal reason for the regressivity of tax reform is that a disproportionate share of lowincome homeowners own properties with a 1975 base year. Figure 5.3 shows the percentages of homeowners with a given income that own properties with a 1975 base year. For nonsenior households in Alameda County (households in which no one claims a senior exemption), only 25% of homeowners owned

Incidence, mobility, ownership, and capitalization

11

Table 5.3. Percentages of homeowners with 1975 base years, by income and senior status Percent with 1975 Base Year Alameda

Los Angeles

San Bernardino

SanMateo

Non-Senior Homeowners

ALL

25

30

12

28

43 31 24 20 17 16

40 34 29 27 26 23

20 14 10 9 10 9

42 35 29 27 23 19

82

82

49

81

85 83 78 76 74 75

85 83 79 77 74 72

49 50 48 46 48 42

84 83 79 76 75 68

Income Interval 0 -> 20,000 20,000 -> 40,000 40,000 -> 60,000 60,000 -> 80,000 80,000 -> 100,000 Over 100,000 Senior Homeowners

ALL Income Interval 0 -> 20,000 20,000 -> 40,000 40,000 -> 60,000 60,000 -> 80,000 80,000 -> 100,000 Over 100,000

properties with a 1975 base year. The percentage of homeowners with 1975 base years decreases as income increases, from 43% for income between zero and $20,000 to 16% for income above $100,000. For senior households (households in which at least one person claims a senior exemption), 82% of homeowners have 1975 base years. The percentage of senior households with 1975 base years decreases with income. Table 5.3 shows the numbers behind Figure 5.3 as well as the numbers for the other three counties. In all four counties, a disproportionate share of low-income homeowners have 1975 base years. Consider next the effects of tax reform on senior and nonsenior households. A revenue-neutral switch to market-value taxation would increase the average tax liability of senior households and decrease the average tax liability of nonsenior households. Figure 5.4 and Table 5.4 show the average tax changes for senior and nonsenior households in the four counties. Taking a simple average across the four counties, the average senior household would experience a $474 increase in property taxes per year, whereas the average nonsenior household would experience an annual $138 decrease. There would be substantial variation between senior and nonsenior households in the changes in property taxes from a switch to market-value taxation. Table 5.4 shows, for each county, the changes in tax liabilities experienced by the household in the 25th percentile (25% of households experience a larger

Property taxes and tax revolts

78 | Senior j Non-Senior

700

6tX) 501 500 400 300 200 100 0 -100 -200 -300

Alameda

Figure 5.4

Los Angeles

San Bernardino

San Mateo

Average tax change: senior versus nonsenior households

Table 5.4. Tax change for senior and nonsenior households

Alameda

Los Angeles

San Bernardino

San Mateo

501 312 699

503 253 706

195 -29 349

697 394 1024

-131 -567 412

-152 -568 383

-38 -190 132

-232 -879 555

Senior Households Average Change 25th Percentile 75th Percentile Non-Senior Households Average Change 25th Percentile 75th Percentile

decrease in taxes or a smaller increase in taxes) and the household in the 75th percentile. In Alameda County, the taxes of the nonsenior homeowner in the 75th percentile would increase by $412, whereas the taxes of the homeowner in the 25th percentile would decrease by $567. For senior households in Alameda County, the tax increase for the household in the 75th percentile is more than twice the tax increase for the household in the 25th percentile. Senior households would, on average, pay more taxes under a market-value system. The principal reason is that a disproportionate share of senior households own properties with a 1975 base year. The evidence for this is shown in Table 5.3. The figure shows the percentages of senior and nonsenior house-

Incidence, mobility, ownership, and capitalization

79

holds with 1975 base years. In Alameda County, 25% of nonsenior households have 1975 base years, compared to 82% of senior households. On average, senior households in the four counties are about three times more likely to have 1975 base years. Moving penalties and household mobility This section explores the effects of the acquisition-value tax on the mobility of homeowners. We use a simple theoretical model to show the costs and benefits of moving from one dwelling to another, and derive expressions for the optimum time per dwelling under a conventional property tax and an acquisition-value tax. We also use a numerical version of the model to compute the optimum time per dwelling under the two taxes. There are several strands of literature on household mobility. The first explores the factors that precipitate a move, including changes in prices, income, housing preferences, and locational preferences (Quigley and Weinberg [1977], Weinberg [1979]; Weinberg, Friedman, & Mayo [1981]). The second explores the influence of socioeconomic characteristics such as income and education on household mobility (Henderson and Ioannides [1989]). A third strand explores the effects of adjustment costs on housing consumption (Hanushek and Quigley [1979]; Harmon and Potepan [1988]). The theoretical literature explores the effects of moving costs and other transaction costs on the optimum time per dwelling. Amundsen (1985) explores the effect of moving costs on the optimum number and timing of moves and the optimum consumption of housing. Englund (1985, 1986) shows that, like other transaction costs, capital-gains taxation for housing causes a lock-in effect: The higher the tax rate, the longer the household stays in each dwelling. The model in this chapter differs from the earlier theoretical literature in two ways. First, we incorporate property taxes into the household's optimization problem. Second, we simplify the household's optimization problem by assuming that housing consumption is fixed. This simplification allows us to derive, for each type of property tax, an expression for the optimum time per dwelling. Third, we develop a numerical version of the theoretical model and compute the efficiency and equity effects of the alternative taxes. Consider a household that consumes two goods, housing (//) and another good (X) over a lifetime of length N years. Over its lifetime, the household occupies a number of dwellings, and incurs a fixed moving cost (C) each time it moves. The household's problem is to decide how long to spend in each dwelling. We assume that the solution to the household's problem is repetitive: The household spends the same amount of time in each dwelling. The model has a number of simplifying assumptions. First, there is general inflation: All prices and incomes rise at the same exogenous rate, so the real prices (of housing and the nonhousing good), real income, and real moving

Property taxes and tax revolts

80

costs are constant over time. Second, the discount rate is zero, so lifetime utility is simply the sum of the utility levels generated in each period. Third, the real interest rate is zero. Fourth, all dwellings are identical and have the same constant real market value. To motivate the notion of household mobility, suppose that the quantity of housing services generated by a particular dwelling is a decreasing function of the length of time the household spends in the dwelling. There are two possible motivations for this assumption, both related to site characteristics rather than to the dwelling itself. The first is a change in relative accessibility: If the household's workplace or other destination changes over time, the quantity of housing services generated by a dwelling in a particular location decreases. The second is boredom: If the household becomes bored with living in the same location, the quantity of housing services decreases as the household's time in the dwelling increases. Consider first the housing and nonhousing consumption under a marketvalue tax system. The quantity of housing services generated by a particular dwelling depends on the rate at which housing services decay over time. To make the model analytically tractable, we assume that the quantity of housing services decays linearly at a rate equal to d (In the numerical exercises later in the chapter, we assume that decay is exponential). If the initial (first-year) quantity of housing services is 1.0, the quantity of housing services generated by a dwelling occupied for / years is h = I [1 - d- t]dt

(5.1)

0

The derivative of h with respect to / is (1 — d - i). Each household exists for N years, and lifetime housing consumption equals housing consumption per dwelling (h) times the number of dwellings occupied over the household's lifetime: H = h--i

(5.2)

The lifetime consumption of the nonhousing good (X) equals lifetime income less lifetime moving costs and taxes. Under a market-value tax system, lifetime consumption of the nonhousing good is: X=Y-N-

— ~ N-V-m (5.3) i where Y is the household's annual income, C is moving cost per move, V is the real market value of housing, and m is the annual tax rate. To make the model analytically tractable, we assume that the lifetime utility function is additive (an assumption to be relaxed in the numerical exercises): W=X +H (5.4)

Incidence, mobility, ownership, and capitalization

81

This simple model shows the tradeoffs associated with moving from one dwelling to another. An increase in the time spent per dwelling decreases lifetime moving costs and thus increases lifetime consumption of the nonhousing good. On the other hand, the longer the household spends in a dwelling, the greater the difference between the quantity of housing services generated by the old dwelling and a potential new dwelling. Therefore, the longer the time spent per dwelling, the lower the lifetime housing consumption. The household's problem is to pick an / that maximizes lifetime utility. Substituting (5.2) and (5.3) into (5.4) and differentiating with respect to i, (i )« dW=ON_^_ (1 - d'i)' N _ 2 di i2 i i2 Setting the derivative equal to zero and solving for /, 21/2 .£1/2 ;*

(5.6)

=

In other words, the optimum / is an increasing function of moving cost ( Q and a decreasing function of the decay rate (d). Consider next the household's choices under the acquisition-value tax system. Under an acquisition-value tax, the annual tax liability equals the tax rate (a) times the assessed value. If the nominal assessed value increases by more than 2% per year, the real assessed value decreases linearly over time, with the rate of decline equal to g, the gap between the inflation rate and the maximum reassessment rate (i.e., 2% per year in California). At the midpoint of the time in a particular dwelling, the real assessed value is

A = V-(l - \^-J)

(5.7)

If the acquisition tax rate is a, the lifetime consumption of the nonhousing good is x = YN - — - N-A-a (5.8) / The derivative of lifetime nonhousing consumption with respect to the time spent per dwelling is

dx_C-N dl

i

2

g-N-a-V 2

An increase in the time per dwelling increases the "leftover" income for the consumption of the nonhousing good for two reasons. First, as in the case with market-value taxation, an increase in the time per dwelling decreases lifetime moving costs. Second, an increase in / decreases lifetime property taxes be-

Property taxes and tax revolts

82

cause the longer the household stays in each dwelling, the lower its annual property taxes (in real terms). The household's problem is to pick an / that maximizes lifetime utility. Lifetime utility is U=x +H Substituting (2) and (8) into (10) and differentiating with respect to /,

(5.10)

0- - dA-N dU _ ON

(1 - d-i)-N _ I

2

-|-

—

2

g-N-a-V -|-

(J. 1 1 I

2

di i i i 2 Comparing (5.11) to (5.5), the derivative for the acquisition-value system exceeds the derivative for the market-value system by the last term in (11). A switch to an acquisition-value system increases the marginal benefit of remaining in a dwelling because nonhousing consumption increases more rapidly with /. Setting the derivative equal to zero and solving for /, 91/2. £1/2

i* =

(5.12) (d - g-a-V)m As in the case of the market-value tax system, the optimum / is an increasing function of moving cost (C) and a decreasing function of the decay rate (d). Under the acquisition-value system, the optimum / is also an increasing function of the gap between the inflation rate and the reassessment cap (g), the tax rate (a), and the real value of the dwelling. For a positive g, the optimum time per dwelling is larger under the acquisition-value system. We can illustrate the mobility distortions of the acquisition-value tax with a simple numerical example. We compute the optimum time per dwelling for different types of households (different decay rates for housing services) under the market-value tax and the acquisition-value tax. The features of the numerical model are as follows. The quantity of housing services decreases exponentially over time. For a dwelling occupied for / years,

-F

(5.13)

0

The utility function is Cobb-Douglas with coefficients equal to 0.33 for housing and 0.67 for the nonhousing good: W = X 0 6 7 H033 (5.14) Under the acquisition-value system, assessed value decreases exponentially. After t years of ownership, the real assessed value is A(t) = V-e'8'1 (5.15)

Incidence, mobility, ownership, and capitalization 10.47

I

83

I Market Value Tax I Acquisition-Value Tax

.s5

0.01

0.03

0.05

0.07

0.09

Household decay rate (d)

Figure 5.5 Time per dwelling under market-value and acquisition-value systems, appreciation rate equal to 6% We assume the following parameter values: 1. Y= annual real income = $50,000 2. N = lifetime of households = 60 years 3. C = real moving cost per move = $10,000 4. V = real value of housing = $150,000 5. m = annual market-value tax rate = 0.03 6. g = appreciation rate minus maximum reassessment rate (0.02) = 0.04 Figure 5.5 shows the mobility effects of the acquisition-value tax for five different decay rates, 0.01, 0.03, 0.05, 0.07, and 0.09. For each decay rate, we compute the optimum time per dwelling for the two taxes, with tax rates adjusted to ensure that the two systems generate the same total tax revenue. The largest mobility effects are experienced by infrequent movers. For example, for the least-mobile households (d = 0.01), the time per dwelling increases by about 12% (from 9.31 years to 10.47 years). In contrast, for the most-mobile households (d = 0.09), the time per dwelling increases by only 1.2% (from 3.23 to 3.27). The mobility effects are larger for relatively immobile households because the longer the household stays in a dwelling, the larger the gap between assessed and market value, and thus the larger the tax penalty from moving to a new dwelling. The mobility effects of the acquisition-value tax increase with the apprecia-

Property taxes and tax revolts

84

tion rate. The larger the appreciation rate, the larger the tax penalty from moving, so the greater the mobility changes from the acquisition-value tax. We performed similar calculations for an appreciation rate of 13%, the average appreciation rate for Los Angeles County between 1975 and 1992. For the least-mobile households (d = 0.01), the time per dwelling increases about 26% (compared to 12% with the lower appreciation rate); for the median household (decay rate = 0.05), the time per dwelling increases 6.4% (compared to 2.6% with the lower appreciation rate). Efficiency and excess burden In this section, we quantify the distortionary effects of the acquisition-value tax. The inefficiency or excess burden of the acquisition-value tax is computed by answering the following question: By how much would the typical household be better off if we made a revenue-neutral switch to marketvalue taxation? Even if the typical household faces the same tax liabilities under the two systems, the household will be better off because the change in tax policy eliminates the mobility distortions generated by the acquisition-value tax. The features of our computational model are as follows. First, households vary in their decay rates for housing services: We divide the households into five quintiles, with decay rates of 0.01, 0.03, 0.05, 0.07, and 0.09. The marketvalue tax rate is endogenous, being determined by the restriction that the market-value tax raises the same total revenue as the acquisition-value tax (with a tax rate of 0.01). The excess burden incurred by a particular household is the compensating variation associated with a switch to a market-value tax, that is, the lump-sum payment required to restore the utility level achieved under the acquisition-value system. Figure 5.6 shows the effects of a switch to a market-value tax under two different appreciation rates, 6% and 13%. For each appreciation rate, the figure shows the gain or loss for each type of household (each decay rate). The leastmobile households (d = 0.01) are worse off under the market-value system: The loss per household is $115 per year under the low appreciation rate and $255 under the high appreciation rate. The revenue-neutral switch to marketvalue taxation increases the tax liabilities of these households by a relatively large amount, making them worse off. In contrast, the most-mobile households (d = 0.09) are better off under the market-value system: The gain per household is $60 per year under the low appreciation rate and $152 under the high appreciation rate. The median household (d = 0.05) gains $30 per year under the low appreciation rate and $76 under the high appreciation rate. Although the median household pays about the same taxes under the two regimes, the elimination of the mobility distortion makes the household better off. It is worth noting the similarity between Figures 5.6, 5.1, and 5.4. In Figure

Incidence, mobility, ownership, and capitalization 200

-

150

-

100

-

50

-

-50

76

30

•

0

85

-4

-4

I

-

Appreciation Rate = 6% -100

Appreciation Rate = 13%

-115 -150

-

-200 -250

•

-300 o.oi

0.03

0.05

1 0.07

0.09

Household decay rate (d)

Figure 5.6 Gains and losses from switch to market-value tax system for different decay rates and appreciation rates

5.6, the switch to market-value taxation decreases the welfare of the leastmobile households and increases the welfare of the most-mobile ones. In Figure 5.1, the switch to market-value taxation increases the taxes of low-income households (the least-mobile households) and decreases the taxes of highincome households (the most-mobile households). Similarly, in Figure 5.4, the switch to market-value taxation increases the taxes of senior households (the least-mobile households) and decreases the taxes of nonsenior households (the most-mobile households). Table 5.5 summarizes the effects of the switch to market-value taxation. The revenue-neutral tax rate for the market-value tax is 0.897% under the low appreciation rate and 0.734% under the high appreciation rate. Under the low appreciation rate, the gains of the winners (households with d = 0.05, 0.07, and 0.09) exceed the losses of the losers by $19 per year. Therefore, the average gain per household (the excess burden of the acquisition-value tax system) is $3.80 per year, which is 0.238% of tax revenue per household, or 0.0076% of household income. Under the high appreciation rate, the gains of the winners exceed the losses of the losers by $91 per year. Therefore, the average gain per household is $18.20 per year, which is 1.65% of tax revenue per household, or 0.034% of household income. The gap between the largest gain (for the most-mobile household) and the largest loss (for the least-mobile

Property taxes and tax revolts

86

Table 5.5. Effects of switch to the market-value tax

Tax rate Average compensating variation Excess burden: percent of tax revenue Excess burden: percent of income Gap between largest gain and loss

Appreciation rate = 0.06

Appreciation rate = 0.13

0.00897 $3.80 0.233 0.0076 $175

0.00734 $18.20 1.65 0.034 $407

Table 5.6. Excess burden per household for different appreciation rates and decay rates

Appreciation rate = 0.06 Appreciation rate = 0.13

d = 0.01 $15 $66

d = 0.03 $3 $22

household) is $175 under the low appreciation rate and $407 under the high appreciation rate. The distortionary effects of the acquisition-value tax depend on the appreciation rate and the underlying mobility of households. Table 5.6 shows the excess burden for different values of the appreciation rate and the decay rate. To compute the numbers in the table, we assume that every household has the same decay rate (in contrast with the results in Table 5.5, which assume a distribution of decay rates). The excess burden increases as the decay rate decreases, reflecting the fact that the less mobile the typical household, the larger the tax-induced change in mobility. For example, under the high appreciation rate, the excess burden per household with the lower decay rate is $66 per year, compared to an excess burden of $22 per household per year with the higher decay rate. The excess burden increases with the appreciation rate because the larger the appreciation rate, the larger the moving penalty and the greater the distortion of household mobility. The excess burden of California's acquisition-value tax system is relatively low because the state's tax rate is relatively low. In the examples in this chapter, the effective tax rate is much less than 1% of market value, which by national standards is extremely low. A well-known proposition of public finance is that the excess burden of a tax increases with the square of the tax rate, and this proposition holds for the acquisition-value tax. In a separate paper (O'Sullivan, Sexton, & Sheffrin [forthcoming]), we compute the excess burden for higher tax rates (up to 3% of market value), with excess burdens more than 10 times higher than the burdens reported here for the California tax system. One alternative to the acquisition-value tax is a transfer tax, under which an ad valorem tax is imposed when a property is sold. The transfer tax is an ex-

Incidence, mobility, ownership, and capitalization

87

treme version of the acquisition-value tax. Under an acquisition-value system, a household's real tax liability drops each year the household owns a dwelling, and then returns to the original real value when the household moves. As the inflation rate increases, the tax liability drops more rapidly; for a sufficiently high inflation rate, the real tax liability is close to zero in the second year, and remains close to zero until the household moves. This is virtually the same as the transfer tax, under which the household pays the transfer tax in the first year of residence, then pays no tax until it moves again. Like an acquisitionvalue tax, an ad valorem transfer tax imposes a moving penalty, so it decreases household mobility. Because the transfer tax is an extreme version of the acquisition-value tax, the transfer tax has a larger negative effect on mobility. The transfer tax is equivalent to a large tax on moving costs. For revenue neutrality, a switch from a market-value tax to a transfer tax would require a tax rate equal to the marketvalue tax (e.g., 0.03) times the equilibrium time per dwelling. If the time per dwelling under the transfer tax is 10 years, the transfer tax on a $150,000 dwelling would be $45,000. If the moving cost is $10,000 per move, the transfer tax is equivalent to a 450% tax on moving costs. Although the acquisitionvalue tax also imposes a moving penalty (an additional move shortens the household's time in each dwelling, so the household pays higher taxes over its lifetime), the moving penalty is equivalent to a much smaller moving tax (about 30%), so the acquisition-value tax distorts mobility to a lesser extent. As a result, the welfare loss from a transfer tax is much higher: In our computations, the excess burden of the transfer tax is about ten times the excess burden of the acquisition-value tax. Another alternative to the acquisition-value tax is a deferred market-value tax. Under this tax, the property owner pays the acquisition-value tax as long as he or she owns the property, then upon sale pays a lump sum equal to the gap between the total taxes paid and the taxes that would have been paid under a market-value system. The lump-sum tax equals the accumulated tax savings, so the prospective tax increases every year that the household remains in its dwelling. In other words, the household cannot escape the tax, but only defer it. A switch from an acquisition-value system to a deferred tax system would reduce or eliminate the tax benefits from remaining in a dwelling and thus would increase household mobility. If the property owner pays interest on the deferred taxes, there is no tax benefit from remaining in a dwelling: The deferred tax system is identical to the market-value system except for the timing of the tax payments, and the present value of the tax payments is the same. As a result, the deferred tax would not distort household mobility and would generate no excess burden relative to a market-value tax. If interest is not paid on the deferred taxes, there would be a small benefit equal to the interest charges

Property taxes and tax revolts

o

d' Decay rate of housing services (d)

Figure 5.7 Household utility' for ownership and renting under the market and acquisition-value tax systems saved on the implicit loan from the government, so there would be a small mobility distortion and a small excess burden. The effects of the acquisition-value tax on home ownership Consider next the household's decision about whether to rent or own. Consider a state with a fixed number of households and the same number of identical dwellings. The households vary only in their decay rates for housing services (d). Figure 5.7 shows household utility for owning and renting (W = W) as a function of the decay rate under market-value taxation. Plugging (5.2) and (5.3) into (5.4) and differentiating with respect to d, lifetime utility is a decreasing function of the decay rate: dW

i-N (516)

The greater the household's decay rate, the lower the lifetime utility because the household (1) gets less utility out of a dwelling over a given time interval, and (2) moves more frequently, thus spending more of its income on moving costs. Plugging in the expression for the optimum time per dwelling: dW=

_ N-Cm

~M~ ~v^¥2

(5 17)

*

In a state with market-value taxation, households will be indifferent between renting and owning. Suppose that we ignore the other tax advantages of home ownership (e.g., deductibility of mortgage payments). In addition, suppose that

Incidence, mobility, ownership, and capitalization

89

renters and owner-occupiers incur the same moving cost per move (C) and the two types of property have the same market-value tax rate (m). Since there is no real difference between rental and owner-occupied housing, the owneroccupier utility function is identical to the renter utility function. In equilibrium, the two types of housing have the same real market value (V) and thus the same annual cost (m-V). For each type of household (each decay rate [d]) utility is the same in the two types of dwellings, so the decision about renting versus owning is determined by a flip of the coin. As a result, half the households will own their dwellings, and the other half will rent. Suppose that the city switches to an acquisition-value tax system with the same tax rate (a = m). In Figure 5.7, the tax change increases the homeowner utility level: U° > W for all d. Since the average assessed value (A) is less than the real market value (V), the switch to an acquisition-value tax increases nonhousing consumption for a given housing consumption, increasing utility. The slope of the utility function under the acquisition-value system is N ^ (5.18) ^ = m dd 2 - [d - g-a-VY12 which exceeds the slope under the market-value system (shown in 5.17): Utility falls more rapidly with the decay rate because the household's tax liability increases with its decay rate. Consider next the effects of the tax change on the utility from renting. The tax liability of a given rental dwelling depends on how long the current owner has held the property, not on how long the tenant has occupied the dwelling. If j is the common holding period for property owners, the average assessed value of a rental dwelling is

R = V-(l - ^ ) 2 ax li and the average annual tax liability is

8±

(5.19)

(5.20)

Assume that tenants are legally responsible for the tax on rental property. If the two tax rates are equal (a = m), the switch from a market-value tax to an acquisition-value tax decreases the average annual tax liability for each renter by 7* - P = a-V-(y)

(5.21)

Since the tax savings is independent of the household's decay rate and its time per dwelling, a switch to an acquisition-value tax increases renter utility by the same amount for each household. In Figure 5.7, the utility from renting under

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the acquisition-value system (Ur) exceeds the utility from renting under the market-value system (W = W), with the gap between Ur and W independent of the decay rate. The switch to the acquisition-value system introduces a bias toward home ownership for infrequent movers. Under a market-value tax system, all households are indifferent between owning and renting: W = W for all decay rates. In contrast, under an acquisition-value system, infrequent movers prefer ownership (U° > Ur for d < d'), and frequent movers prefer renting (Ur > U° for d > d'). To get the benefits of the acquisition-value tax system (lower taxes), a household must move infrequently and be an owner-occupier, so infrequent movers are biased toward ownership. To avoid paying relatively high taxes under the acquisition-value system, frequent movers switch to the rental sector. Capitalization of the provisions of Proposition 13 To what extent are the tax cuts from Proposition 13 capitalized into the market values of property? One of the basic tenets of economic analysis is that the imposition of a tax causes changes in behavior that affect the market prices of goods. In general, a decrease in the property tax rate increases the net benefits of owning property, increasing the amount that potential buyers are willing to pay for the property. This is the capitalization process: A tax cut is offset, at least in part, by an increase in the market price of housing, or an increase in the cost of acquiring the property. Proposition 13 in California decreased tax liabilities in two ways. First, the maximum tax rate (1%) was below the tax rates prevailing in most localities. Second, the use of acquisition-value rather than market-value decreased the effective tax rate below the 1% maximum. Both of these tax cuts affected the market values of dwellings in the state. Consider first the effects of decreasing the tax rate to 1%. In a world in which individuals have an option of either renting or owning and the only taxes are ad valorem property taxes, the rental rate is taken to be given. In equilibrium, individuals will be indifferent between renting and owning, meaning that the price of housing must be such that the sum of mortgage payments and property taxes equals the annual rental payment. For example, if the annual rental cost is $10,000, the interest rate is 10%, and the property tax rate is 2%, the price of housing will be $83,333. At this price, an individual is indifferent between purchasing the house and paying interest and taxes (annual cost = 12% of $83,333, or $10,000) or simply renting. If the market-value tax rate drops to 1%, the price of housing will increase to $90,909 (11% of this price equals the annual rental cost). To keep the household indifferent between renting and owning, a decrease in the tax rate increases the price of housing. Consider next the effects of the adoption of an acquisition-value tax system with a maximum reassessment rate of 2% per year. If the appreciation rate

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91

exceeds the maximum reassessment rate, the real value of the tax decreases over time; that is, the effective tax rate decreases over time, from 1% downward. To illustrate this phenomenon, suppose that all the features of the previous example still hold, but that real tax payments fall by 6% per year. Given the maximum reassessment rate of 2%, this corresponds to an appreciation rate of 8% per year. To calculate the housing price that would make an individual indifferent about owning a home versus renting, we need to make some assumptions about household mobility. As a first step, assume that the individual remains in the home forever. This individual would obtain the maximum benefit from Proposition 13, since the real level of taxes falls each year. To calculate the equilibrium housing price, we need to equate the present value of rental payments with the sum of the present value of mortgage plus taxes. The Appendix provides the formulas for this calculation. Using the same parameter values as in the previous example and assuming that property taxes fall 6% per year in real terms, the price of housing that would make this individual indifferent between renting and owning increases to $94,318. Since real property taxes fall over time in this example, an individual is willing to pay a higher price for a home. If the supply of houses is fixed and all individuals are identical, then the price of homes will rise to $94,318. The full benefits of Proposition 13 are capitalized into the housing price. In this case, the switch to the acquisition-value tax has the same effect as a cut in the tax rate under a market-value system. At the other extreme, suppose that each household moves every year, and so receives no benefits from the acquisition-value tax system. In this case, the acquisition-value system will have no effect on real tax liabilities and thus no effect on the willingness to pay for housing. The market value of housing will remain at $90,909. If individuals all change residences at fixed intervals, the price of housing will increase to some value between $90,909 and $94,318. The more rapid the turnover, the lower the benefits from the acquisition-value tax and the lower the market value. If the supply of housing is fixed, the price of housing still incorporates the full benefits of the tax breaks generated by the acquisitionvalue system. Individuals will continue to be indifferent between owning and renting. The story changes, however, once we allow for differential mobility patterns among households. Those households that move less frequently will be willing to pay more than frequent movers for owner-occupied housing, since infrequent movers enjoy larger tax benefits. With a fixed supply of housing, the price of housing will be determined by those who are prepared to pay the most, that is, those with the lowest turnover rates. Among those who actually purchase homes, the individual with the highest turnover rate (the marginal buyer)

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will be indifferent between owning and renting. For that individual, the tax benefits equal the increase in the price of housing. Individuals with lower turnover rates will enjoy net benefits from the acquisition-value system: The tax benefits are less than the increase in the price of housing. This simple, stylized model captures the essential inequities of an acquisition-value system in a dynamic setting. Compared to an ad valorem system, the winners will be those with the lowest turnover rates; the losers will be those with the highest turnover rates. If households differ in their turnover rates, only part of the benefits of the acquisition-value tax system are capitalized into the price of housing. Conclusions Under the acquisition-value tax system, a household's real tax liability decreases while the household remains in a particular dwelling. In other words, the acquisition-value tax system rewards a household for remaining in a dwelling and penalizes the household when it moves. This feature of the acquisitionvalue tax system has three consequences. First, as explained in the second section of the chapter, the acquisition-value tax system decreases household mobility. We show that the acquisition-value tax system increases the time spent per dwelling, with the largest percentage changes experienced by the least-mobile households. The second consequence of the acquisition-value tax system is that the system favors infrequent movers at the expense of frequent movers. Therefore, a switch to market-value taxation would cause frequent movers to gain at the expense of infrequent movers. A switch to market-value taxation would increase the tax liabilities of low-income homeowners because household mobility increases with income. For example, a disproportionate share of lowincome homeowners in California own dwellings with a 1975 base year. For the same reasons, a switch to market-value taxation would increase the tax liabilities of senior-citizen homeowners: A disproportionate share of senior households in California own dwellings with a 1975 base year. The third consequence of the acquisition-value tax system is that it increases the likelihood of home ownership among infrequent movers and decreases the likelihood of ownership among frequent movers. To get the benefits of the acquisition-value tax system (lower taxes), a household must move infrequently and be an owner-occupier, so infrequent movers are biased toward ownership. In contrast, frequent movers switch to the rental sector to avoid paying relatively high taxes under the acquisition-value system. How do young households fare under the acquisition-value tax system? First, when a young household buys a dwelling, it pays a relatively high tax rate to offset the low effective tax rates of established homeowners. In other words, young households lose because they are newcomers in the housing mar-

Incidence, mobility, ownership, and capitalization

93

ket. Second, young households are relatively mobile, so a young homeowner would pay relatively high property taxes. Third, given the greater mobility of young households and their relatively high homeowner taxes, young households are less likely to become homeowners. How does the acquisition-value tax system change the behavior of businesses? Break (1991) discusses the distortions generated by the acquisitionvalue system. Consider a business that moves from one building to another, selling the old property and buying the new one. Under the acquisition-value system, such a move increases the firm's property tax bill because the effective tax rate on the old property is lower than the effective rate on the new property (1%). This moving penalty causes two responses by firms. First, firms will delay their moves to new, more suitable properties. The distortion of mobility will cause inefficiencies as firms stay longer in old dwellings to maintain favorable tax treatment. Second, firms that move frequently are more likely to rent rather than own the properties they use. Appendix This appendix derives the formula for the price of housing that makes the individual indifferent between renting and owning, assuming that the household lives in the dwelling forever. To derive the formula, equate the present value of the payment streams under the two alternatives: y R y r-P px (1 + r)' =x (1 + r)'

y m-P =x (1 4- rj • (1 4- gj

where R = fixed yearly rental payment r = interest rate P = price of housing m = property tax rate g = rate at which real property tax decreases Solving for the price: P

R

r-h 4- r-m w h e r e h = r + g + r-g When g = 0 (the market-value case), the formula reduces to: r+ m

Tax limitation and local government

Introduction The principal advantage of a system of local governments is that it can better accommodate a wide array of tastes and demands for government services supplied or financed in accordance with local variations in cost conditions. This added flexibility allows citizens and businesses the option of choosing locations with some consideration of the availability and cost of government services offered at alternative locations. The ability of local governments to provide the array of services desired by its citizens depends on its ability to raise revenues to finance these services. Local governments must have access to a revenue source that they can adjust to meet varying demands. This is one justification for the local property tax. The property tax can be administered by local government with relatively little fear of its tax base migrating to other jurisdictions, thus providing local governments with the needed fiscal autonomy. The property tax has been the source of economic independence of local units of government. Property tax limitations have greatly diminished local government fiscal autonomy by restricting their power to raise revenue; but limiting revenue is why voters supported tax-limitation measures. Particularly in California, local governments exercised no restraint in failing to lower tax rates as property values soared. The immediate reductions in property tax revenues resulting from the passage of Proposition 13 were severe, and the 2% limit placed on increased assessments did not allow for growth in revenue to match the increasing demand for local public services or the increasing cost of providing those services. Alternative revenue sources were needed to avoid cutbacks in services. Local governments in California have few options apart from raising fees and charges, and thus had to turn to state government to bail them out. Reliance on 94

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state aid increased dramatically, and with it came significant changes in state and local fiscal relations. This result should not come as a surprise, for we saw a similar shift of the tax-collecting function from local to state government occur in states that passed property tax limitation measures during the Depression-era tax revolt. Jensen (1935) reports that all of the eight states (California, Indiana, Michigan, New Mexico, Ohio, Oklahoma, Washington, and West Virginia) that restricted property tax levies during the 1931-33 period subsequently adopted taxes on retail sales, gross receipts, or gross income. Tax-limitation states were much slower in adopting income taxes and much quicker in adopting sales taxes than states without property tax limitations. The shift from local to state revenue collection necessitated the assumption by the states of functions previously performed locally, especially school finance. In this chapter we examine and compare the impacts on local governments of two more recent tax-limitation measures, Massachusetts's Proposition 2Vi and California's Proposition 13. Although the two measures are similar in many respects, there are important differences in their impacts on state and local government, in government responses, and in the resulting state and local relationships. In the first section we describe the Massachusetts experience, then contrast this with the California case in the second. Finally, we develop a statewide model in the third section in order to consider the consequences of a return to market-value assessment in California. We use this model to identify the potential winners and losers of such a change. Massachusetts Proposition 2x/2 limits the property tax levy of Massachusetts^ cities and towns to 2.5% of their assessed valuations and restricts its growth to no more than 2.5% per year. A subsequent amendment exempted new construction from the growth limit. High-tax-rate cities and towns were required to reduce their levies by 15% per year until the 2.5% rate was reached. In 1980, property tax rates exceeded 2.5% in 192 of the state's 351 cities and towns, and 48 of those had rates in excess of 3.5%. By fiscal 1984 all but two had reached the limit of 2.5%.l In fiscal 1982, the first year following passage of Proposition 21/2, 170 cities and towns experienced cuts in their property tax revenues.2 Statewide, revenues fell by $311 million, or 9.3%.3 The first-year tax cuts were lower than would otherwise have been the case, because communities were allowed gradually rather than immediately to adjust their rates downward, and because many took the opportunity to reassess properties between the passage of Proposition 2x/2 in November of 1980 and its effective date, July 1, 1981. Although the 1974 Sudbury decision legally required assessments at "full

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and fair cash value," most cities and towns had resisted because higher assessments would result in reduced state grants such as aid for schools, lottery proceeds, and gas tax funds, that were inversely related to assessed valuations. In addition, since residential property was the most undervalued, revaluation would change the relative tax burdens, shifting a larger share to homeowners. Those communities required to cut tax rates in fiscal 1982 now had an incentive to reassess to reduce their loss of tax revenue. A classification law that became effective in January 1980 helped to moderate the shifts in burden from business to residential property by allowing the latter to be taxed at a lower rate. Fewer than 100 cities and towns had reassessed at full value in 1980, but by 1987 all 351 had done so, and 85 had exercised their option to classify.4 State government also helped to cushion the blow on local government by providing an additional $243 million in state aid in fiscal 1982.5 The allocation of aid was not based on property tax revenue losses, but instead on the same formula used to allocate state lottery revenues. Consequently, some cities and towns received only a fraction of their revenue losses, whereas others received aid in excess of their losses. Despite the fact that first-year revenue losses were moderated by revaluation and state aid, Citrin (1984) reports that local-government budgets were cut 1.5% in fiscal 1982. The deepest cuts occurred in libraries, recreation programs, schools, and capital expenditures on equipment, road construction, and maintenance. Public employment was cut 6.2% at the state level and 11.8% at the local level, with the majority of lost jobs in education.6 Property tax revenues continued their decline in fiscal 1983 by an additional $76.4 million, or 2.5%. In real terms property taxes fell more than 25% in the first three years following passage of Proposition 2!/2, from $947 per capita in 1981 to $712 in 1984. Property taxes fell from 59% of total local revenue in 1981 to 50% in 1984.7 During the period from 1985 to 1989, local revenues regained lost ground, increasing 18% in real terms so that by 1989 they were 9% above the 1981 level. Property tax revenues grew from $2,995 billion in 1984 to $4,122 billion in 1989, a nominal increase of 38%. In real terms this represented a 13% increase.8 This growth was the result of the Massachusetts real-estate boom, which brought expansion in the tax base. State government also contributed to the recovery in local revenues. It eased up on the rules and regulations governing local fee-setting authority, leading many local-government officials to restructure the financing of some services, namely water and sewer operations, switching from tax-based to fee-based funding. Fees and charges increased from $875 million in 1984 to $1,552 billion in 1989. This represents an increase of nearly $90 per capita (43%) measured in constant 1993 dollars. The state also increased aid to local governments over this period by 32% in real terms, or about $118 per capita.9

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Cities and towns were unable to sustain this revenue growth as the nationwide recession hit. State revenues began to decline and, in response, state aid to local governments was cut by more than 30% between 1990 and 1992. The cuts in state aid were roughly proportional, with all communities losing about 30%. However, this had a larger impact on revenue in large cities and propertypoor communities because they were more dependent on aid. For example, large urban centers such as Boston that obtain roughly 40% of their revenues from state aid lost 11.4% of revenue due to the cutbacks, whereas wealthy communities such as Cape Cod, where state aid accounts for only 10% of revenue, lost only 2.8% of revenue.10 The recession also translated into slower growth in fees and charges, and reduced construction activity, halting the expansion of the property tax base. Total local revenue measured in real terms fell roughly 3% statewide between 1990 and 1992.11 Cities and towns lost almost all that they had gained during the 1985-89 period so that by 1992, total local revenue per capita was only $23.80 higher in real terms than in 1981 (a less than 1.5% increase). By contrast, Massachusetts state revenues increased 46% ($768 per capita) between 1981 and 1992, and federal government revenues increased 11% ($422 per capita).12 The Massachusetts property tax burden fell from fourth-highest in the nation to 22d, and by 1992 real property taxes per capita were $75 (8%) less than in 1981. Property taxes were still, however, the dominant source of localgovernment revenue, representing 68% of local own-source income. Fees and charges increased 53.6% from 1981 to 1992, from 17% to 27% of own-source revenue, whereas state aid to local governments grew 11% above the 1981 level despite the 30% reduction during 1990-92.13 State and local government fiscal relations in Massachusetts continue to change. A recently passed education reform bill promises to increase state aid to local governments for schools. A 1990 proposal by a task force to replace the 2.5% annual property tax growth limit with an inflation-based index is still being debated. California Proposition 13 transformed California's property tax from a system of local taxes to a uniform statewide property tax. It transferred the power to raise revenue from local to state government, and with it the ability to set priorities and policies. Prior to Proposition 13 each local agency in the state - counties, cities, school districts, and special districts - had the authority to determine how much property tax revenue it would collect each year. Local agencies could annually adjust the tax rate levied against the assessed value of properties within their boundaries. Tax bills of individual property owners were determined by applying the tax rates of all the local agencies serving their property.

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Taxes generally varied between 1.5 and 3.5% of market value. Proceeds were returned to the local agencies in proportion to the tax rates levied. Total property tax levies in California fell from $10.3 billion in fiscal 197778 to $5.6 billion in 1978-79, a decline of more than 45%. Counties were hit hardest, experiencing a 57% reduction in property tax revenues. Although total property tax revenues were up to $14.7 billion by fiscal 1989-90, real property taxes per capita were still 46% below their 1977-78 level.14 Local governments, especially cities, scrambled to raise existing fees or enact new local levies in the wake of Proposition 13 in an effort to offset losses in property tax revenue. Most common among the new or increased levies were new building/developer fees, real-estate transfer fees, new or higher business license fees,"utility user fees, and increased park and recreation fees. For all California cities, service charges increased from 25% of city revenue in 1978 to 31% in 1991. Chief among these increases were increased sewer charges. Among nonenterprise special districts (e.g., parks, libraries, and police- and fire-protection districts), fees increased from 7% of revenue in 1978 to 38% in 1990.15 Clearly, some of these new or increased levies fell into the category of user fees. Residents were forced to pay more to gain access to parks, swimming pools, golf courses, museums, and zoos. Developers were forced to pay higher fees to cover needed capital improvements. To the extent that such fee increases better reflected the marginal cost of providing the services, their increase could have led to more efficient provision of the services. However, many of these fee increases were simply efforts to increase revenue. Property transfer fees, for example, are value-based taxes on the recording, registering, and transferring of documents levied at the time of conveyance of real property from one owner to another. These fees are an alternative form of property tax that, like an acquisition-based tax, tend to reduce mobility by discouraging moving. California counties levy such a tax at a rate of $0.55 per $500 of the full sales price, less any liens assumed by the purchaser. Any city within a county that levies the tax can claim half of the $0.55 collected by the county, in which case the amount collected on transfers within the city is split evenly between the city and the county. Charter cities may choose to set rates different from the statewide statutory rate of $0.55, but all revenues must go to the general fund, and the city forfeits its right to half of the county revenue. Property transferred within these cities is subject to both the city rate and the uniform county rate. In fiscal 1988-89, rates varied from $0.55 to $5.00 per $500 of value.16 City revenues from property-transfer taxes increased 237%, from $40.7 million in 1977-78 to $137.2 million in 1989-90.17 Legislative response In response to Proposition 13, the California legislature was busy trying to frame the necessary implementing legislation. The 1% ceiling placed on

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countywide property tax rates meant that property taxes collected by the counties could not exceed 1% of assessed valuations except to cover localgovernment indebtedness approved by voters prior to July 1, 1978. According to Section 1 of Article XIIIA, the official ballot measure for Proposition 13, the proceeds are to be collected by counties and "apportioned according to law" to the various districts and agencies within the county. The burden fell on the legislature to come up with such an apportionment law. How much of the reduced property tax pie should each city, school district, or special district within each county receive? SB 154: The emergency "bailout" legislation, SB 154, provided a temporary solution. SB 154 specified the rules for allocating the 1% property tax for the fiscal year immediately following the passage of Proposition 13, fiscal 1978— 79. In addition, it provided approximately $2 billion of state assistance in the form of block grants to local governments to replace lost property tax revenues, and provided for state assumption of the costs of several state-mandated health and welfare programs. County property tax revenues for 1978-79 were allocated to local agencies (cities, counties, special districts, and school districts) on the basis of their average share of countywide taxes (exclusive of taxes collected for debt retirement) over the previous three fiscal years. Block grants to compensate for property tax losses were made available to cities ($250 million), counties ($436 million), and special districts ($125 million). This assistance was intended to insure that no local government unit would experience more than a 10% loss in total revenue for fiscal 1978-79. The distribution of these "bailout" monies was based on each agency's property tax loss in relation to the property tax loss of all comparable agencies statewide. For example, each city's property tax loss was divided by the property tax loss of all cities statewide to determine its share of the $250 million. These allocations were reduced if the agency had reserve funds available. Bailout funds were to be used first to ensure continuation of the same level of police and fire protection that had been provided in 1977-78. County assistance also included state assumption of mandated health and welfare programs. The state relieved the counties of their previous obligations to share in the costs of Medi-Cal, Supplemental Security Income/State Supplemental Program (SSI/SSP), AFDC, Boarding Homes and Institutions (BHI), food-stamp administration, mental-health programs, and alcohol and drugabuse programs. Use of the state surplus to replace lost property taxes minimized the immediate impact on local governments; they suffered only a 10% decline in revenues in 1978-79. However, ignoring the "bailout," the allocation formula resulted in redistribution of property tax revenues among local governments. For example, consider two cities A and B located in the same county. Suppose both cities

100

Property taxes and tax revolts Table 6.1. Revenue transfers under SB 154: an example City A Tax Rate

CityB Amount Paid

Revenue Received

Tax Rate

Amount Paid

Revenue Received

Pre-Proposition 13 County City Special Districts Total Post-Proposition 13 County City Special Districts Total

1.5% .25 .75 2.5

1.0%

$15,000 2,500 7.500 25,000

$15,000 2,500 7.500 25,000

$10,000

$5,000 834 2,500 $8,334

1.5% 1.0 1.0 3.5

1.0%

$15,000 10,000 10,000 35,000

$15,000 10,000 10,000 35,000

$10,000

$5,000 3,334 3,334 11,667

have the same market value of taxable property equal to $1 million. Residents of each city are served by special districts that have coterminus boundaries with cities. Before Proposition 13, all residents of the county paid property taxes of 1.5% of market value to the county. However, property taxes paid to cities and special districts varied, with city A residents paying city taxes of 0.25% and special-district taxes of 0.75%. City B was a higher-tax city, with the city and special districts each collecting 1% of market value. Table 6.1 shows property tax collections in the two cities before and after Proposition 13. Ignoring any rollback in assessed valuations after Proposition 13, and assuming that the county tax base consists only of the property in these two cities, property taxes in the county were limited to 1% or $20,000 after Proposition 13. In city A taxes fell by $15,000, whereas in city B the reduction amounted to $25,000. SB 154 allocated the total $20,000 in taxes paid in the county to the various local governments on the basis of each local government's average share of total county revenues from the previous three years. Assuming that the preProposition 13 taxes shown in Table 6.1 also represent the average of the previous three fiscal years, the county share of the post-Proposition 13 revenues was 50%, since it previously received $30,000 of the total $60,000 in property tax revenue collected. Thus the county collected $5,000 in property tax revenues from property owners in each city. City A's proportion of the total $20,000 in revenues was 4.17%, which is determined by the ratio of their previous collections of $2,500 to the pre-Proposition 13 total taxes in the county of $60,000. Thus city A received $834 (0.0417 X $20,000). Similarly, the special districts in city A received $2,500 = 0.1250 X $20,000. City B and its special districts each received $3,334 under the SB 154 allocation rule. Tax revenues were redistributed from the previously lower-tax city A to the higher-tax city B. Resi-

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dents in city A pay a total of $10,000, yet their county, city, and special districts receive only $8,334; city B residents pay the same total, but their county, city, and special districts receive $11,667. An amount equal to $1,667 has been redistributed from city A to city B. Residents of low-tax areas subsidized residents of high-tax areas. Local services no longer related to current tax revenue, but to historical tax revenue. AB 8: It was obvious by early 1979 that the "bailout" was not a viable permanent solution. There was no guarantee that state budget surpluses would be available indefinitely for purposes of relieving local governments; indeed, such a system involved too much uncertainty in the budgetary planning process of local governments. In addition, the allocation formula did not recognize the needs of local governments experiencing rapid growth and development. Their share of property tax revenues under SB 154 was based on historical averages and thus was totally unresponsive to growth occurring within their boundaries. In 1979 the legislature passed AB 8, the "long-term solution" to local government financial problems. It was believed that AB 8 would solve the property tax apportionment problem by dividing the revenue losses equitably, and would prevent severe problems in growing counties. AB 8 eliminated the annual "bailout" of local governments and provided a more permanent and predictable source of revenue by shifting a portion of property tax revenues from school districts to local agencies. The state, in turn, increased assistance to school districts to make up the loss in property tax revenues. In addition, the growth in property tax revenues due to growth in assessed valuations was allocated to local governments on a situs basis; that is, it was given to the jurisdiction(s) in which the property was located. Each local agency receives, under AB 8, a "base" allocation equal to the property tax revenues it received in the prior year plus an "increment" equal to its share of any growth in property tax within its boundaries. The 1979-80 base allocation for each local agency was equal to its 1978-79 share of property taxes plus an amount determined by its 1978-79 SB 154 block grant (bailout). Each school district's property tax share was reduced to fund the permanent bailout, with state funds replacing lost property tax revenue. Cities received 82.9% of their 1978-79 block grant, whereas special districts received 95.2% of their grant. The base for counties was somewhat more complicated. They received their 1978-79 share of property taxes plus 100% of their 1978-79 block grant, less the state grant for county health services. An addition was made in the amount of reduced state funding of AFDC. Increment allocations were determined by the growth in assessed valuations within each jurisdiction's boundaries, regardless of whether the growth was due to the annual 2% increase in assessment, new construction, or reassessment triggered by changes in ownership. These incremental revenues were allocated

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first to geographic areas based on the location of the growth, and then among the local agencies that serve the area, based on their historical (three-year average prior to Proposition 13) share of property tax revenues. In subsequent years, 1980-81 and thereafter, each city, county, special district, and school district received a base allocation equal to the amount it received in the prior year plus its share of additional revenues generated by assessed-value growth within its boundaries. AB 8 did not solve the problem of revenue redistributions among local governments because each one's base allocation was determined by its previous year's allocation, which for 1979-80 was its 1978-79 allocation under SB 154. In addition, the incremental allocations were determined, as in SB 154, on the basis of historical shares of property tax revenues. Thus, as was true under SB 154, residents in jurisdictions that had low tax rates prior to Proposition 13 have subsidized residents in jurisdictions that had high tax rates. Fiscal effects Proposition 13 and its implementing legislation significantly changed the fiscal structure of local government in California. Property tax revenues have declined in importance for counties, cities, school districts, and special districts. The magnitude of decline and the extent to which state subventions (grants from state government) have replaced lost property taxes, however, has varied significantly among the levels of local government. Counties: Proposition 13 resulted in a decreased reliance on property tax revenues and increased reliance on state aid or subventions. In 1977-78, 33.2% of county revenues consisted of property tax collections. The property tax share fell to 15% in 1978-79, but has grown since to 21% as of 1990-91, due to increased assessments on new construction and property transfers (see Figure 6.1). The lost property tax revenues were replaced in part by state aid, which increased in importance from 23% of county revenues in 1977-78 to 32% in 1978-79 due to the bailout of SB 154. Although AB 8 eliminated the "bailout" funds, causing state subventions to fall to 29% of county revenues in 1979-80, they grew slowly until 1989-90, when they constituted 33% of county revenues.18 The state budget shortfalls resulting from the economic recession have led to reductions in state aid to counties since 1990. Estimates of the effect of Proposition 13 on revenue levels suggest that counties experienced a decline in property tax revenues of 57% between 197778 and 1978-79, but that a portion of the revenue loss was mitigated by increased state subventions, resulting in a net loss of 9% under SB 154. AB 8, which reduced state subventions but increased the county share of property taxes, resulted in revenues for 1979-80 that were 6.5% lower than in 197778.19

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1977-78

(25.4%) Federal Aid (22.9%) State Aid

(5.6%) Other (4.2%) Enterprise Rev. (31.8%) Property Taxes

(10.0%) Fees

1978-79

(32.0%) State Aid

(24.7%) Federal Aid

(7.5%) Other

(11.2%) Enterprise Rev.

(15.0%) Property Taxes

(9.7%) Fees

1990-91

(31.3%) State Aid (17.0%) Federal Aid

(8.1%) Other (20.9%) Property Taxes (12.3%) Enterprise Rev. (10.4%) Fees

Figure 6.1 Percentage of county revenue by source Cities: The experience of cities since Proposition 13 has been considerably different. Cities obtained 12.4% of their revenues from property taxes in 197778. This share was more than cut in half in 1978-79, falling to 5.6%. AB 8 restored a portion of this amount in 1979-80, when 7.7% of city revenues were

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property taxes, and this share has remained relatively stable since. Unlike the case for counties, however, state subventions have declined in importance since Proposition 13.20 Cities have sought alternative revenue sources such as increased service charges, which grew from $2.6 billion, or 25% of city revenues, in 1977-78, to more than $8 billion, or 31%, in 1989-90. While total city revenues increased 146% from $10.6 billion in 1977-78 to $26 billion in 1989-90, service charges grew 205%. Among the current service charges, charges for nonenterprise activities grew from $490 million in 1977-78 to $3.2 billion in 1989-90, an increase of 551%.21 Examples of such fees and charges are: zoning and subdivision fees, plan-checking fees, sewer service, solid-waste revenues, library fines and fees, and parks, recreation, and golf fees. School districts: Proposition 13 and its implementing legislation, AB 8, had a dramatic effect on school-district finances. Property tax revenues of school districts fell from $4.2 billion in 1977-78 to $2.0 billion in 1978-79, and to $1.6 billion in 1979-80. This represented a 61% decrease over the two-year period. To compensate for the loss, the state increased funding to school districts from $3.1 billion in 1977-78 to $5.2 billion and $6.4 billion respectively in 1978-79 and 1979-80, for a total increase of 104%. Prior to Proposition 13, school districts obtained more than half (52.3% in 1977-78) of their revenues from property taxes. This share fell sharply to 24.8% in 1978-79, and declined even further to 18.5% in 1979-80, when AB 8 shifted a portion of the property tax from school districts to other local governments. In the meantime, state subventions increased from 38.7% of school revenues in 1977-78 to 64.9% in 1978-79, and to 71.4% in 1980.22 A portion of this shift in reliance from property taxes to state subventions may be attributable to legislative response to Serrano v. Priest, the famous 1974 decision that revolutionized school finance. John Serrano sued the state of California, claiming that school-district reliance on the property tax violated the equal-protection clause of the state constitution because it resulted in variations in per-pupil spending across school districts. The California Supreme Court ruled in his favor and ordered the state legislature to develop a financing system that would eliminate per-pupil spending inequalities. Thus a shift in reliance from local property taxes to state subventions was occurring already and would have continued in the absence of Proposition 13. Special districts: Enterprise special districts provide services that are generally supported by user fees. Examples of such districts include utilities (electric, gas, and water), transportation (airports, harbors, parking, and transit), sewers, and waste disposal. These districts experienced a 27% reduction in property tax revenues from 1977-78 to 1978-79. The property tax share decreased from

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17.5% of total revenues to 11.7% over the one-year period. They subsequently declined further in importance, constituting only 9% of revenues in 1989-90. In the same period, the share of revenue from state subventions declined from 7.5% in 1977-78 to 3.6% in 1978-79, and to 0.5% in 1989-90. These districts turned to increased service charges to make up their revenue losses. Operating revenue obtained from service charges increased from 44% of revenues in 1977-78 to 51% in 1978-79, and to 55% in 1989-90.23 Hardest hit were the nonenterprise special districts such as parks, libraries, and police- and fire-protection districts, which experienced a 52% reduction in property tax revenues from 1977-78 to 1978-79. Since the services provided by these districts are difficult to support by user fees, they were more reliant on property tax revenues, which constituted the largest share (40.6%) of their revenues in 1977-78. This share fell to 20% in 1978-79.24 Alternative financing tools California's continued growth has led to new infrastructure demands. Local governments have been forced to be creative in developing financing arrangements in a climate of tax-and-expenditure limitations. Legislation passed since Proposition 13 has accommodated local governments in their efforts to provide a variety of needed facilities and services. Benefit-assessment districts: Local governments have been able to establish special assessment districts since the Park and Playground Act of 1909. Since Proposition 13, their use has been expanded greatly and facilitated by a series of laws governing them. The Benefit Assessment Act of 1982 allowed benefit assessments for a variety of services including flood control, drainage, and street lighting. The courts have held that special assessments do not require the two-thirds approval mandated under Proposition 13 because they are not ad valorem assessments but rather per-parcel ones. Revenues from bond issues are not subject to the "Gann limit" (Proposition 4), enacted in November 1979, which limits appropriations by all government agencies in California out of taxes and state subventions to the agency's prior-year appropriations adjusted by the change in the national Consumer Price Index or state per-capita personal income, whichever is smaller. Any revenues collected in excess of this limit are to be returned to taxpayers within two years. Appropriations for statemandated new programs, higher levels of service, and servicing voterapproved bonded indebtedness are exempt from the limit. Figure 6.2 illustrates the growth in outstanding benefit-assessment bonds since 1977-78. Mello-Roos: The Mello-Roos Community Facilities Act of 1982 gave counties, cities and special districts the authority to establish community facilities districts (CFDs) within their jurisdictions. With a two-thirds approval of the

106

Property taxes and tax revolts o -

4

-

lousands

5

-

•"2

-

1

—i

—issm

0 p ^ Cities ^ Counties | | | Special Dist.

Figure 6.2

1977-78 363 111 125

1981-82 580 93 140

1985-86 2420 99 204

1989-90 4907 573 310

Outstanding benefit assessment bonds in millions of dollars

district's voters, tax-exempt bonds can be issued and special taxes levied. If there are fewer than 12 registered voters residing in the CFD when it is established, approval of two-thirds of the landowners in the district is sufficient. There are virtually no limitations on the uses of the revenues raised. They can be used to finance public services such as police and fire protection, library services, park and recreation services, and flood and storm services as well as facilities including streets, water, sewer and drainage construction, parks, schools, libraries, jails, and administrative facilities. Mello-Roos financing grew considerably in the 1980s, as can be seen in Figure 6.3, and is expected to continue to grow in importance. School construction: School districts have historically relied on state loans to finance new construction. The loans are repaid with a property tax override that, since 1978, has required a two-thirds vote. Due to the high failure rate of such issues, districts have relied on cities or counties to impose fees on developers or to set up Mello-Roos community facilities districts. Legislation passed in 1986 now allows school districts to levy fees directly on developers. Although the proceeds of the fees are not subject to Gann limits, there is a cap on the fee per square foot, originally set at $1.50 for residential and $0.25 for commercial and industrial property.

Tax limitation and local government

1983

1984

1985

1986

1987

107

1988

1989

1990

Figure 6.3 Mello-Roos financing Tax-increment financing: Tax-increment financing refers to issuing bonds to finance redevelopment in blighted areas under the premise that the redevelopment will generate enough additional property tax revenues to service the bonds. The use of tax-increment financing by cities and counties has grown substantially despite the fear that Proposition 13's 1% rate cap would severely limit property tax revenues. The situs provision of AB 8 that insures that property tax revenues generated by new development in a jurisdiction stay within that jurisdiction has helped to mitigate that fear. Tax-increment revenue was about $179 million in 1977-7825 and had increased to $582 million by 1985-86.26 Local finance and recent fiscal crises An $8 billion revenue shortfall resulting from the persistent economic recession in the early 1990s led to delays in the adoption of a state budget for fiscal 1992-93. A budget compromise was eventually signed by Governor Pete Wilson on September 2, 1992, a record 63 days into the fiscal year. The $57 billion budget cut into virtually all areas of government and included major changes in state- and local-government relations. Facing a budgetary crisis of its own, the state could no longer afford the local government bailout that had occurred since 1978. The 1992-93 budget shifted $1.3 billion of county, city, redevelopment, and special-district property tax revenues to schools, reversing the shift under AB 8.27

Property taxes and tax revolts

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Legislation implementing the local-government portion of the 1992-93 state budget shifted $525 million of county property tax revenues to school districts. This amounted to a reduction of 8.4% statewide and became a permanent adjustment to counties' shares of local property tax revenue. To ease the burden of the lost revenues, the state eliminated certain county health-and-welfare mandates. Each city lost 9% of its 1991-92 property tax revenues as the budget shifted a total of $200 million from cities to school districts. Cities experienced an additional loss of $25 million as their share of cigarette tax revenues was shifted to the state General Fund. The budget transferred $200 million from redevelopment agencies and $375 million from special districts to schools. Each special district lost 35% of its property tax revenues, but not more than 10% of its total revenue. Thus a district that received nearly 100% of its funding from property taxes (e.g., a park, fire, or library district), experienced a 10%, not a 35% loss in funding. With the ongoing recession in California, budget troubles continued into the next fiscal year. The 1993-94 state budget doubled the property tax shift of the previous year to $2.6 billion, thus continuing the reversal of AB 8. The increased school-district revenue reduced the amount of funds that the state is required to provide for education. County governments experienced the largest funding reductions - more than $2 billion. Cities lost $288 million, special districts $244 million, and redevelopment agencies $65 million.28 Cities and counties were offered replacement revenues through the sixmonth extension of a temporary half-cent sales tax that had been imposed in 1991 and was scheduled to expire in June 1993. Voters were given the option of extending the sales tax permanently. This shift in emphasis from property taxes to sales taxes has many local officials concerned that cities and counties will encourage development of shopping centers and auto malls instead of housing and manufacturing, in an effort to boost sales tax revenues. Housing development, particularly low- and moderate-income housing, would not provide enough tax revenue to pay for the local services that would have to be provided. Angered that the state is balancing its budget on the backs of local government, many counties are fighting back. At least 22 counties have adopted ordinances that order their county auditors to withhold property taxes from the state. Several counties took legal action by filing lawsuits against the state alleging that the tax shift violates the state constitution. The supervisors in Sacramento County, which stands to lose an estimated $80 million in 1993-94, recently agreed to pursue a multifaceted attack, not only claiming that the state's property tax shift is illegal, but also challenging the legality of state mandates and the constitutionality of Proposition 13. At the same time, there is a growing movement to completely overhaul Cali-

Tax limitation and local government

109

fornia government. Proposals before the legislature have forced debate on major revision of state and local government. One proposal that was not adopted would have halted government spending by withholding property taxes, sales taxes, and vehicle license fees until changes in local financing were made. Consequences of returning to market-value assessment in California A return to a full-market-value assessment system with no change in either the tax-rate ceiling of 1% or the revenue-allocation formulas (AB 8) would lead to windfall gains to local governments. In order to avoid the significant increases in property tax burdens and windfall gains to local government, changes in the tax rate and apportionment formula would likely accompany a return to a market-value assessment system. A reduction in the tax rate that would leave total state revenues unchanged (revenue-neutral statewide) is one possible reform. Before considering changes in legislation that would redistribute these gains or provide relief to taxpayers, it is useful to examine the distribution pattern of these gains themselves. Clearly all counties would experience revenue increases; however, certain counties would experience far greater increases than others. Furthermore, if the tax rate were reduced to compensate for the higher assessments so as to generate the same revenues statewide as under the current system, some counties would experience increases in revenues, whereas others would face losses. Older, more established urban counties would be the winners under revenue-neutral reform because the assessed value of properties has fallen further behind market value under the acquisition-value system. Counties that have higher turnover rates (more property sales) and more new construction would be the losers under such a system because the gain in tax base would not compensate for the lower tax rate. Chapter 4 describes the methodology used to obtain disparity ratios for various classes of property in the nine counties from which sales data were available. These disparity ratios can be used to obtain estimates of county property tax revenues based on market-value assessments. Average market values for each base year are obtained by multiplying the average assessed values by the appropriate disparity ratio. As discussed in Chapter 3, renewal theory can be used to estimate the number of properties with each base year in 1992; the market value of each class of property is simply the sum over all base years of the average market value times the number of units. See Appendix A for an illustration of the computations for nonmodified single-family residential properties with homeowners' exemptions in San Bernardino County. The "revenue ratio" of market-value taxes to Proposition 13 taxes indicates the magnitude by which tax revenues would have increased in 1992 if marketvalue assessment had replaced the acquisition-value assessment system. San

Property taxes and tax revolts

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Bernardino's revenue ratio of 1.51 for nonmodified, single-family residential properties with homeowners' exemptions indicates that revenues would be approximately 51 % higher for this class of property with market-value assessment. Similar estimates of revenue ratios for each class of property in the nine counties are reported in Table 6.2. Statewide model The remaining 49 California counties were unable to provide either the base-year distribution of their assessment roll or the sales data necessary for computing disparity ratios, or both. In order to estimate revenue ratios for these counties, they were matched to similar counties for purposes of obtaining the missing data. Matches were made primarily on the basis of geographic location and similarities in economic base, growth rates, and the extent of urbanization. For example, Los Angeles County's disparity ratios, single-family residential-renewal parameters, and commercial/industrial base-year distribution, were used in the estimation of Orange County's revenue ratio. Similarly, Alameda County data were used for San Francisco County estimates. Table 6.3 contains a listing of the remaining 49 counties and indicates which counties provided disparity ratios and base-year distribution data for single-family residential and commercial/industrial properties. Revenue ratios were estimated for all such counties for single-family residential and commercial/industrial properties. The methodology employed was similar to that used in the nine fully reporting counties, but varied somewhat from county to county depending on the information provided. Appendix B illustrates the computations for Colusa County, which supplied no data. Table 6.4 contains estimated revenue ratios for all 58 California counties by type of property (single-family residential, commercial/industrial, Williamson Act, and other, which includes multifamily residential). Since agricultural land under Williamson Act contract is assessed according to its use value (the capitalized value of income generated from its current agricultural use), it has been assigned a revenue ratio of 1.0. Its assessed value would be unaffected by changes in general-assessment practices. The California State Board of Equalization provided 1991 assessed values by property use for each county. Census data from 1986 were used to allocate these totals to the different classes of property. The breakdown of assessed value by property use was available from the 1986 census of governments for most counties. For counties about which this data was not available, we matched to similar counties. The product of these assessed values and the appropriate revenue ratio results in the estimated market values in Table 6. 4. Total revenue ratios for each county were then computed by summing the market values of each type of property and dividing by the sum of assessed values. Finally, by adding the estimated market values for all counties and dividing by

Table 6.2. 1992 revenue ratios by class of property

County

Alameda Butte Kern

Single-Family Residential Non-Modified Modified With HomeWithout With HomeWithout Homeowner's owner's owner's Homeowner's Exemption Exemption Exemption Exemption 1.52 1.82 2.48 1.88

1VIulti-Family Residential Non-Modified Modified

1.96

1.48

1.41

1.71

1.50

1.46

1.47 b 2.07

1.41 b 1.51

1.45a 2.32

1.20 s

Los Angeles

1.81

1.48 b 2.04

Placer Sacramento San Bernardino

1.54 1.74 1.51

1.37 1.47 1.30

1.91 1.96 1.57

L.61 1.12 1.51

1.46 1.50 1.16

SanMateo

1.79

2.01

1.51

Sonoma

1.81

1.43 1.52

2.37

1.87

1.56 b 1.60

a

(Commercial/ Industrial Non-Modified Modified

2.31 a 1.56

1.29

1.46 a

1.36 b 1.92

2.81 b 1.56 1.45 1.61 a 1.56 a 2.09 a

the disparity ratios were smoothed using the exponential rate, starting and ending values from the non-modified properties, the disparity ratios were smoothed using the exponential rate from the non-modified properties.

1.34

1.37 1.76 1.31 1.40 b 1.37

1.40 b 1.77 1.24 a 2.30 b 1.54 1.37 1.81 a 1.55 a 1.71 a

Property taxes and tax revolts

112

Table 6.3. County data matches County

Single-Family Residential Renewal Disparity Ratios Parameters

Commercial/Industrial Base Year Disparity Ratios Distribution

Counties Supplying Contra Costa Del Norte Marin Modoc Riverside Santa Barbara Santa Clara Stanislaus Ventura

Partial Data Contra Costa Del Norte Marin Butte Riverside Los Angeles Santa Clara Stanislaus Ventura

Alameda Butte Marin Modoc/Butte Riverside Ventura Santa Clara Stanislaus Ventura

Contra Costa Del Norte Marin Del Norte Riverside Ventura Santa Clara Stanislaus Ventura

Alameda Butte Marin Butte Riverside Ventura Santa Clara Sacramento Ventura

Counties Supplying Alpine Amador Calaveras Colusa El Dorado Fresno Glenn Humboldt Imperial Inyo Kings Lake Lassen Madera Mariposa Mendocino Merced Mono Monterey Napa Nevada Orange Plumas San Benito San Diego San Francisco San Joaquin San Luis Obispo Santa Cruz Shasta Sierra Siskiyou Solano Sutter Tehama Trinity Tulare Tuolumne Yolo Yuba

No Data Butte Butte Stanislaus Butte Butte Stanislaus Butte Butte San Bernardino Stanislaus Stanislaus Sonoma Butte Stanislaus Stanislaus Sonoma Stanislaus Stanislaus Sonoma Sonoma Butte Los Angeles Butte Stanislaus San Mateo Alameda Stanislaus Sonoma Sonoma Butte Butte Butte Sonoma Butte Butte Butte Stanislaus Stanislaus Stanislaus Butte

Butte Butte Stanislaus Butte Butte Kern Butte Butte Riverside Kern Kern Butte Modoc/Butte Stanislaus Stanislaus Butte Stanislaus Stanislaus Santa Clara Sonoma Butte Los Angeles Butte Butte San Mateo Alameda Stanislaus Santa Clara Santa Clara Butte Butte Butte Marin Butte Butte Butte Kern Stanislaus Stanislaus Butte

Butte Butte Stanislaus Butte Butte Sacramento Butte Del Norte Riverside Sacramento Kern Sonoma Butte Stanislaus Stanislaus Sonoma Stanislaus Stanislaus Sonoma Sonoma Butte Los Angeles Butte Stanislaus Santa Clara Alameda Stanislaus Sonoma Sonoma Sonoma Butte Del Norte Marin Butte Butte Del Norte Stanislaus Stanislaus Stanislaus Butte

Butte Butte Placer Butte Butte Kern Butte Butte Riverside Kern Kern Butte Butte Kern Kern Butte Kern Kern Santa Clara Sonoma Butte Los Angeles Butte Kern San Mateo Alameda Kern Santa Clara Santa Clara Butte Butte Butte Marin Butte Butte Butte Kern Kern Butte Butte

Table 6.4. Statewide revenue ratios County

Revenue Ratio by Property

Assessed Value by Property Use (Bill. $)

Total Revenue Ratio

Market Value by Property Use (Bill. $)

Use Alameda Alpine Amador Butte Calaveras Colusa Contra Costa Del Norte El Dorado Fresno Glenn

Humboldt Imperial Inyo Kern Kings Lake Lassen Los Angeles Madera Marin Mariposa

Mendocino Merced Modoc Mono Monterey Napa Nevada Orange

Placer Plumas Riverside Sacramento San Benito San Bernardino San Diego San Francisco SanJoaquin San Luis Obispo San Mateo Santa Barbara Santa Clara Santa Cruz Shasta Sierra Siskiyou Solano Sonoma Stanislaus Sutler Tehama Trinity Tulare Tuolumne Ventura Yolo Yuba TOTAL

5FR .81 .42 .41 .52 .64 .43

COM 1.33 1.41 1.41 1.42 1.46 1.41 1.93 1.39 1.41 1.37 1.41 1.55 1.55 1.37 1.32 1.28 1.46 1.41 2.00 1.46 1.73 1.46 1.46 1.46 1.55 1.46 1.67 1.66 1.41 2.24 1.50 1.41 1.49 1.54 1.46

\MLL

.00 .00

SFR

$35.5

COM $15.5

0.1

0.0

0.8

0.2 0.9

WILL

$0.1 0.0 0.0

OTHER $16.4

TOTAL

SFR

COM

$67.5

0.1 0.6

$64.1 0.1

$20.6 0.0

2.4 0.6 0.4

0.2 1.6 6.8 2.0 1.2

1.1 5.1 1.5

0.3 1.3 0.7 0.2

7.8 0.0

54.1 0.5

1 .43

1.38

1 .00

1.50 1.50 1.50 1.50 1.99 1.50 1.50 1.49 1.50 1.50 1.17 1.50 1.48 1.48 1.50 1.50 2.07 1.48 1.99 1.50 1.50 1.49 1.50 1.50 1.56 1.64 1.50 2.07 1.52 1.50 1.17 1.49 1.50 1.17

36.4

14.8 0.2 1.0 4.7 0.3 1.0 1.2 1.2 19.5 0.6 0.7 0.3 88.8 0.9 3.1 0.2 0.8 0.9 0.0 0.2 3.9 1.5 0.7 46.5 1.4 0.2 11.3 11.2 0.3 10.8

1.92 2.30

1.66 1.58

1 .00 1 .00

1.56 1.99

75.8 15.7

27.1 21.2

0.1 0.0

28.7

1.72 1 .93

1.46 1.67

1 .00 1 .00

1.48 1.56

8.2

4.7

2.9

0.7 0.7

5.4

6.9

1 .73 2 .06

1.48 1.44

1 .00 1 .00

1.56 2.07

34.8 11.8

3.9

1 .83 2 .16 1 .40 1 .43 1 .43 2 .00 1 .77 1 .69 1 .42 1 .43 1 .42 1 .38 1 .70 1 .74 1.77 1 .44 1 .83

1.85 1.67 1.46 1.41 1.55 1.90 1.44 1.77 1.46 1.41 1.55 1.46 1.46 1.49 1.64 1.41 1.76

1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00

1.56

56.5

1.56 1.50

8.0 2.9 0.1 0.8 9.4 11.3 6.8 1.5 0.8 0.3 4.5 1.6 26.1 2.5 0.8

.80 .41 .39 .38

.45 .45 2.03 .43

1 .43 1 .63 1 .63 1 .35 1 88 1 .69 < .02 .70 1 .67 1 .76 1 .35 1 .72 1 .14 2 .28 1 .38 2 .14 1 .62 1 .41 1 .37 1 .68 1 .73

.00 .00

OTHER 1.99 1.50

.00

.00 .00 .00 .00 .00 .00 .00 .00 .00 .00 .00 1 .00 1 .00 1 .00 1 .00 .00

.00 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00 1 .00

1.50 1.50 1.49 1.64 1.49 1.49

1.50 1.50 1.48 1.50 2,07 1.49 1.50 1.80

3.4 0.9 0.6

31.4 0.3 5.2

10.2 0.2 1.6 1.4 0.4 6.6 1.3 1.4 0.5

227.3 1.6

13.0 0.3 1.3 2.3 0.1 0.6 8.7 2.8 2.4

92.2 7.8 0.6 39.1 25.5 0.7

852

SFR is Single Family Residential COM is Commercial/Industrial WILL is Agricultural Land Under Williamson Act Contract OTHER includes multifamily units and land

0.1

0.5 0.2

0.0 0.0 0.1 0.0 0.0 1.5 0.1 0.0 0.0 0.0 1.7 0.8 0.0 0.0 0.0

0.0 0.1 0.0 0.2 0.2 0.2 0.1

7.5

30.2 1.9 1.6

0.0 0.4 3.1 2.4 3.8 0.4

0.2 0.1 1.5 0.4

7.7 1.8 0.2 368

0.5 0.1 0.0

0.0 0.0 0.0 0.0 0.2 0.0

0.0

1.9 7.4 0.5 1.8 2.1 0.4 4.9 0.3 0.7 0.2 144.4 0.6 2.8 0.2 1.5 3.0 0.3 0.6 4.5 3.2 1.8 26.6 3.6 0.4 14.6 9.0 0.8 16.2

0.8 56.4

28.7

8.1

0.4 7.2

0.2 1.5

23.8

14.0

6.5

1.1 4.4 4.7 2.0

0.4 1.5 1.8 1.7

3.0 2.8 1.0

0.3 2.3 2.9 0.6 9.4 2.1 2.2 0.7

460.5

426.4

177.1 1.4 5.3 0.3 1.1 1.3 0.0 0.3 6.4 2.5 0.9

32.7

25.6 0.8

1,1 0.4

3.6

2.8

19.0

26.2

0.7 3.6 6.2 0.4 1.4

0.6 2.1 4.1 0.1 1.1

17.3

18.7

7.5 4.9

6.4 3.4

165.3 12.9

104.0

65.2 45.9

197.4 12.7 0.8 53.7 42.7

2.0

1.3

0.4

1.2

2.1 0.2

16.8 17.2

WILL $0.1 0.0

0.0 0.1 0.0

0.0 0.1 0.0 0.0 1.5 0.1 0.0 0.0 0.0 1.7 0.8 0.0 0.0 0.0 0.5 0.1 0.0 0.0 0.0 0.0 0.0 0.2 0.0 0.0 0.0 0.1 0.0 0.2 0.2 0.2

OTHER $32.7 0.1 0.8 3.6

0.9 0.6 15.6

0.0 2.9 11.1 0.8 2.7 2.5 0.6 7.2 0.4 1.0 0.3 299.1 0.8

5.5 0.3 2.2 4.5 0.5 0.9 7.0 5.2 2.7

55.0 5.4 0.6

TOTAL $117.5

0.2 2.2 10.1 3.1 1.6 100.8 0.6 11.6 33.1 1.6 6.5 7.2 2.9 43.9 4.1 4.3 1.4 902.6 7.0 37.1 1.2 5.4 9.9

0.6 2.3 32.3 14.1

7.0 356.4 20.3 1.6 87.8 73.6 3.1

1.74 1.45 1.44 1.49 1.55 1.44 1.86 1.41 1.42 1.39 1.43 1.49 1.53 1.41 1.35 1.37 1.55 1.38 1.96 1.50 1.97 1.57 1.55 1.59 1.47 1.59 1.87 1.88 1.43 2.16 1.57 1.44 1.35 1.60 1.54 1.35

63.5

52.0

14.9

0.1

17.1 13.5 1.2 19.0

131.7 51.0

145.7 36.0

45.1 33.6

0.1 0.0

44.9 28.2

235.8 97.8

1.79 1.91

2,0

19.0 12.5

14.2 13.4

6.9 4.8

0.7 0.7

7.9 3.2

29.7 22.1

1.56 1.76

0.0 0.5

7.0 5,6

49.3 21.8

60.3 24.4

11.0 5.7

0.0

0.5

10.9 11.5

82.2 42.1

1.67 1.93

0.2

13.7 2.5 1.5 0.1 0.4 2.6 8.9 3.8 1.1 0.5 0.2 2.8 0.5 6.0 1.8 0.6 392

100.6 12.4

103.5 17.4

55.8

4.1 0.2 1.2

0.2 0.0 0.0

21.5 3.9 2.2

181.0

6.0 0.2 1.7

0.1 0.5

15.4 22.8 15.1 3.0

18.8 20.0 11.5

0.4 25 28.8 38.2 24.6

1.80 1.97 1.44 1.44 1.46 1.88 1.67 1.63 1.45 1.41 1.46 1.37 1.61 1.74 1.62 1.46 1.80

0.0 0.0 0.0 0.1 0.3 0.2 0.7 0.0 0.1

0.0 1.2 0.0 0.2

0.3 0.0 12

14.1

2.5

2.1 1.2 0.4 6.2 2.7

40.0

45.4

6.4 1.6

4.5 1.2

1,624

1,558

1.6

0.6 10.0

3.2 2.3 0.1

0.7 5.8

0.0 0.1

86.0

245 8.6

3.4 6.8 0.6

0.3 0.2 0.7 0.0

3.9 14.6

0.3

0.1

0.7 0.2

4.4 2.3 0.7

4.1

13.7

0.1 2.2 0.6 11.4 3.0

0.3 649

0.0 1.2 0.0 0.2 0.3 0.0 12

5.6 1.7

0.8

4.1

12.3 2.6 0.9 707

69.3 10.4 2,4

2,926

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the sum of actual assessed values across all counties, the statewide revenue ratio of 1.80 was obtained. A return to market-value assessment would result in an 80% or $13 billion, increase in property tax revenues statewide, assuming a tax rate of 1%. Winners and losers The total revenue ratios for counties exhibit considerable variation, ranging from a low 1.35 in Riverside, Kern, and San Bernardino counties to a high of 2.16 in Orange County. The mean revenue ratio is 1.59 and the standard deviation is 0.20. Counties with above-average revenue ratios would be the big winners if current assessment practices were abandoned in favor of marketvalue assessments. These counties would experience the largest increases in revenues, whereas counties with lower ratios would be smaller winners. Among the big winners, Orange (2.16), Marin (1.97), Los Angeles (1.96), Santa Barbara (1.93), and San Francisco (1.91) counties stand out. These are all older, established counties that have been experiencing relatively little growth in terms of new construction, but rapid appreciation of existing property values. Under an acquisition-value system, unless properties change ownership regularly, the appreciation in values is not reflected in assessed valuations and hence property tax revenues. A return to market-value assessment would result in huge increases in revenue as older properties were taxed on the basis of their current, as opposed to base-year, values. In contrast, in counties where the tax base consists of more-recently constructed or sold properties, smaller increases in revenues will occur. If the properties have sold recently or are newly constructed, their base-year value will be closer to their true market value; hence market-value assessment will generate lower additional revenues. This describes the situation in Riverside, Kern, and San Bernardino counties, where revenue ratios are 1.35. These counties have been experiencing rapid growth in new construction and higher-thanaverage turnover rates. A larger percentage of properties in these counties have recent base years and therefore assessed values that deviate relatively little from market values. The revenue ratios developed in this chapter suggest that a reduced but uniform statewide tax rate with no change in apportionment would benefit some counties at the expense of others. The winners would be those counties with above-average revenue ratios because the increase in their assessed valuations would more than compensate for the reduced tax rate. In turn, the losers counties with below-average revenue ratios - would experience reduced revenues due to below-average increases in assessed valuations. Conclusions Local governments have undergone significant changes in both California and Massachusetts since the passage of their property tax limitation

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measures. The property tax, once the principal source of local government revenue, has been reduced and limited. A centralization of power at the state level has occurred. In both states, the tax-collecting function has been shifted from local to state government. Initially it was relatively easy to replace lost property tax revenues in California because the state had a surplus to draw on. In Massachusetts, while cities and towns waited for the state to bail them out (there was no state surplus to fall back on), they were able to cushion the initial blow through reassessment. However, the recession of the early 1990s has resulted in state budget deficits and therefore cutbacks in state aid to local government. Local governments used to be relatively "recessionproof" because their principal source of revenue, the property tax, was less sensitive to economic downturns (property values tend to decline more slowly than other tax bases such as income). However, the increased reliance on state aid has harmed the fiscal health of local governments because they are now more vulnerable to state fiscal problems. They are finally, 12 to 15 years later, beginning to feel the full impact of the property tax limitations. Although local governments in both California and Massachusetts have been forced to relinquish control to their respective states, there are important differences that have allowed Massachusetts to maintain more local autonomy. Proposition 2V2 does not limit the tax rate or the rate of increase in taxes on individual properties. This difference, together with local governments' ability to classify property, allowing tax rates to vary, has preserved the property tax as a local planning tool. The property tax system in Massachusetts is market-value based so that cities and towns still have an interest in up-to-date, accurate assessments. Differences in tax levies on similarly situated properties are less likely to occur in Massachusetts as compared to California, with its acquisition-value based property tax. Local governments in Massachusetts are also better off than those in California regarding state mandates. Proposition 2V2 explicitly says that the state may not require cities and towns to establish programs or enforce regulations without reimbursement. In California there has occurred some mandate relief in recent years, but the majority of local revenues are still earmarked for stateand federally mandated health and welfare programs. It is difficult to identify who, among local governments in California, have been the biggest losers because of the complicated formula that apportions the smaller property tax pie among them. It could be argued that counties and nonenterprise special districts were the biggest losers because they were more reliant on property tax revenues prior to Proposition 13 and have fewer alternative sources of revenue relative to cities and enterprise special districts. A return to market-value assessment would, under the current apportionment formula (AB 8) and the uniform statewide tax rate, result in increased

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revenues for all counties and other local governments, but the gains would not be uniformly distributed across the state. The older, more established urban counties would experience the largest increases in revenues because the assessed value of property in these counties has fallen farther behind market value under the acquisition-value system. Revenue-neutral reform would benefit these counties at the expense of the rest of the state. Appendix A: An example of revenue-ratio computation for San Bernardino County The median disparity ratios by base year are displayed in column 2 of Table 6. A. They were obtained by taking the median value of the ratio of preand post-sale assessed values of all properties that sold in 1991 by base year prior to the sale. The number of nonmodified single-family residential properties with homeowners' exemptions by base year (column 3) was determined from the county's 1991 roll file, as was the average assessed values of such properties (column 5). Some of the properties were sold between April 1991 and April 1992, and thus experienced a change in base year, so the number of properties with each base year in 1992 (column 4) had to be estimated using renewal theory. The average assessed values for 1992 (column 6) were obtained by inflating the 1991 values (column 5) by 2%, the maximum increase allowed under Proposition 13. The net average assessed values for 1992 (column 7) are the average assessed values less the $7,000 homeowner's exemption (column 6 - $7,000). Average market value for 1992 (column 8) is the average assessed value for 1991 times the disparity ratio (column 5 X column 2). The homeowner's exemption of $7,000 is then subtracted to yield the net average market value (column 9). Property tax revenues under the current acquisitionvalue system (column 10) are estimated as the net average assessed value in 1992 times the number of properties to yield net assessed values to which the 1% tax rate is applied (column 7 X column 4 X .01). Market values are estimated as the product of net average market value and number of properties in 1992 (column 9 X column 4). Applying the 1% tax rate results in estimated revenues under a market-value-based tax as indicated in column 11. Total revenues from this class of property under each system are then the sum across all base years (i.e., the totals that appear in columns 10 and 11). Appendix B: Revenue-ratio estimation for Colusa County The assessment rolls in Colusa County did not contain base-year information, and thus the county was unable to provide its base-year distribution and the data required to compute revenue ratios. Whenever such data were available from counties, even if it included only disparity ratios for 1975 baseyear properties, that information was used. For Colusa County, disparity ratios for all classes of property were borrowed from Butte County under the assumption that they have experienced similar growth and turnover rates (columns 12

Table 6. A. San Bernardino County revenue-ratio computation, nonmodified single-family residential property with homeowner's exemptions 1 Base Year

2 Disparity Ratio

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990* 1991 1992 TOTAL

3.91 3.26 3.01 2.55 1.95 1.63 1.46 1.43 1.40 1.43 1.43 1.43 1.42 1.38 1.34 1.25

3 Number of Units 1991 36,109 3,276 4,412 5,545 6,541 5,912 3,212 3,304 2,967 4,931 6,661 8,927 12,963 15,868 19,297 20,685 16,778 177,388

4 Number of Units 1992 34,623 3,140 4,226 5,308 6,256 5,648 3,064 3,146 2,818 4,670 6,283 8,380 12,094 14,693 17,705 18,769 15,026 15,120 180,971

5 Average Assessed Value 1991 $30,361 37,994 44,142 52,025 65,145 72,057 86,616 85,523 86,600 88,881 90,790 93,699 99,404 106,542 118,161 133,363 142,400 142,400

estimate for 1990, disparity ratios not available for 1991, 1992

6 Average Assessed Value 1992 $30,974 38,762 45,034 53,076 66,461 73,513 88,366 87,251 88,349 90,677 92,624 95,592 101,412 108,694 120,548 136,057 145,277 145,277

7 Net Avg. Assessed Value 1992 $23,974 31,762 38,034 46,076 59,461 66,513 81,366 80,251 81,349 83,677 85,624 88,592 94,412 101,694 113,548 129,057 138,277 138,277

8 Average Market Value 1992 $118,712 123,860 132,867 132,664 127,033 117,453 126,459 122,298 121,240 127,100 129,830 133,990 141,154 147,028 158,336 166,704 142,400 142,400

9 Net Avg. Market Value 1992 $111,712 116,860 125,867 125,664 120,033 110,453 119,459 115,298 114,240 120,100 122,830 126,990 134,154 140,028 151,336 159,704 135,400 135,400

10 Revenue: Prop. 13 1992 $8,300,705 997,287 1,607,491 2,445,808 3,719,962 3,756,691 2,493,143 2,524,654 2,292,665 3,907,297 5,380,060 7,423,834 11,418,557 14,942,384 20,103,428 24,223,045 20,777,956 20,907,529 157,222,497

11 Revenue: Market Value 1992 $38,678,212 3,669,324 5,319,772 6,670,493 7,509,412 6,238,475 3,660,377 3,627,225 3,219,617 5,608,094 7,717,819 10,641,492 16,225,055 20,574,917 26,793,663 29,975,187 20,345,697 20,472,575 236,947,405

REVENUE RATIO: 1.51

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and 13 of Table 6.B). In particular, the 1975 and 1990 disparity ratios for single-family residential property in Colusa County are assumed to be the weighted average of the disparity ratios of the four classes (modified/nonmodified, with/without homeowner's exemption) of single-family residential properties in Butte County (weighted by the number of properties in each category). The remaining disparity ratios are constructed as a decreasing exponential curve from the initial 1975 figures to the 1990 values using the estimated rate of decay from Butte County. In essence then, Colusa's disparity ratios are assumed to be a "smoothed" version of Butte's. The distribution of single-family residential properties by base year was estimated by first computing the number of such properties in 1975 from the 1980 stock of single-family residences (data from California Department of Finance) and construction data (Construction Industry Research Board). The percentage of these properties having a particular base year in 1991 (column 2) was estimated using renewal theory with parameters borrowed from Butte County. The base-year distribution of commercial/industrial properties (column 3) was also assumed to mirror the distribution in Butte County in terms of the percentage of such properties with a particular base year. The average market value of all properties, both single-family residential and commercial/industrial, was assumed to be $100 (columns 8 and 9), meaning that the actual value of a property is assumed to be independent of its base year, that the average size and quality of homes remains the same across time. The specific value that is assumed is irrelevant; any value would lead to the same revenue-ratio estimates. Average assessed values (columns 4 and 5) were obtained by dividing the average market values of $100 by the disparity ratios (column 8 + column 12 and column 9 -r- column 13). Then, multiplying the average assessed and market values by the number of units yields gross assessed (columns 6 and 7) and market (columns 10 and 11) values. Finally, the ratio of the gross market value summed across base years to the sum of gross assessed values yields the respective revenue ratios of 1.43 for single-family residential and 1.41 for commercial/industrial properties. For the "other" category, the revenue ratios were taken directly from the matched county for single-family residential properties.

Table 6.B. Colusa County revenue-ratio computation, single-family residential and commercial/industrial property 1 Base Year 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 TOTAL

2 3 Number of Units 1991 SFR COM 760 28 87 1 2 97 117 9 14 133 163 8 178 13 204 4 8 245 250 5 290 10 326 13 11 352 377 10 433 11 12 510 576 29 188 5098

4 5 Average Assessed Value COM SFR $39 $39 44 44 50 49 54 55 59 58 62 63 67 65 70 68 72 71 74 73 74 76 77 75 76 78 77 79 78 80 78 80 100 100

SFR is Single Family Residential Property COM is Commercial/Industrial Property

7 6 Gross Assessed Value SFR COM $1,092 $29,640 44 3,828 4,753 100 6,318 495 7,714 826 504 10,106 871 11,570 13,872 280 17,395 576 18,250 370 760 21,460 1,001 24,450 26,752 858 790 29,029 33,774 880 960 39,780 2,900 57,600 13,307 356,291

8 9 Average Market Value SFR COM $100 $100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100

11 Gross Market Value SFR COM $2,800 $76,000 100 8,700 200 9,700 11,700 900 1,400 13,300 16,300 800 1,300 17,800 400 20,400 800 24,500 25,000 500 1,000 29,000 32,600 1,300 1,100 35,200 1,000 37,700 1,100 43,300 51,000 1,200 2,900 57,600 18,800 509,800 10

13 12 Disparity Ratios COM SFR 2.56 2.59 2.28 2.25 2.02 2.05 1.86 1.83 1.72 1.69 1.62 1.59 1.53 1.50 1.44 1.47 L42 1.39 L.38 1.35 1.32 1.35 L33 1.30 1.28 1.31 1.30 1.27 1.29 1.26 1.28 1.25 1 .00 1.00 1.41 1 .43

Revenue projections and policy alternatives

An effective tax-limitation movement decreases the revenue raised from the property tax. Under most tax-limitation measures, it is not particularly difficult to estimate tax revenue. For example, if the property tax rate is fixed at 1%, the growth of property tax revenue is determined solely by the growth in assessed value. Alternatively, tax revenue could be controlled directly with a maximum growth rate for property tax revenue. Under an acquisition-value tax system, however, the projection of tax revenue is more complex. As discussed in Chapter 3 in the context of renewal theory, the revenue generated by an acquisition-value tax system will depend on both the turnover and appreciation rates of property. Unlike a market-value system, the pattern of turnover affects the growth of assessed value, and hence property tax revenue. Faced with continuing budget crises, citizens and policymakers in California are interested in revenue projections for the current acquisition-value tax system and potential alternative systems. In this chapter, we present two sets of revenue projections for alternative property tax systems in California. The first is a set of statewide revenue projections for several variations on the conventional property tax. Specifically, we project statewide property tax revenue for the period 1992-2008 under the following systems: (1) the current acquisition-value tax system, (2) a market-value system (all property is assessed at current market value), (3) a split-roll system under which all property except single-family residential property is assessed at market value, and (4) a splitroll system under which all property except owner-occupied single-family residential property is assessed at market value. The second set of projections explores the revenue implications of two unconventional tax instruments: (1) a transfer tax, which is an ad valorem tax levied at the time a property is sold, and (2) a deferred market-value tax, under which the difference between the market-value tax and the acquisition-value tax is deferred until the property is 121

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sold. For the second set of projections, we project tax revenue for two counties, Los Angeles and San Bernardino. It is important to explain the rationale for considering these alternative tax systems. The market-value system is the most common property tax system in the world and provides a natural benchmark and an obvious alternative to California's acquisition-value tax system. However, as we examined in detail in Chapter 5, a large number of individuals would be harmed by the transition to a market-value system, even if the change in tax policy is revenue-neutral. The alternative split-roll systems try to accommodate the political difficulties inherent in a complete switch to market-value taxation. One split-roll tax includes all residential property - including renters - whereas the other tax is restricted to homeowners. Our split-roll systems are unlike the conventional split-roll tax systems in other states, under which tax rates are lower for some types of property, and all property is subject to market-value taxation. Under our split-roll systems, the tax rates for different types of property are the same, but part of the roll remains under the acquisition-value tax system and the rest is switched to a market-value system. The two other reform options deserve serious political consideration. As discussed in Chapter 6, transfer taxes are currently used in California, and could be used to augment existing revenue from the property tax. A deferred market-value tax is another logical alternative that postpones the shock of higher market-value taxes. Deferred taxes are currently in use in California and other states for elderly, low-income property owners. Our statewide revenue projections answer two questions about the effects of a change in the property tax system. First, what are the revenue implications of a complete or a partial switch to market-value taxation? Specifically, if the tax rate remains at 1% of assessed value, by how much would a switch to a market-value system increase tax revenue in the next several years? The second question deals with revenue neutrality: If an alternative system is designed to generate the same total revenue as the current system, what is the appropriate tax rate under the alternative system? The California Department of Finance has projected a large and growing gap between the state's tax revenues and its spending responsibilities. The projected fiscal gap is believed to be "structural" in the sense that it will occur even if the state's economy recovers from the current recession and grows at historical rates. On the spending side, the Department of Finance projects rapid growth in the number of citizens who benefit from state programs, such as students, welfare recipients, prisoners, and people covered by Medi-Cal. On the tax side, the Department of Finance projects somewhat slow growth in the number of taxpayers, especially those with relatively high earnings and taxes. The combination of rapid growth in the number of "tax receivers," and slow growth in the number of taxpayers, is expected to generate a fiscal deficit of

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about $20 billion per year by the year 2000. In projecting tax revenues and spending, the Department of Finance assumes an annual inflation rate of 4%, and the projected deficit is expressed in nominal - not real - terms. We use our statewide revenue projections to answer the following question: How much of the projected deficit could be eliminated by a partial or a complete switch to market-value taxation? Projection methodology This chapter reports statewide revenue projections under four alternative tax systems. The starting point for the projections is the 1991 tax year: Based on data from counties for 1991, we project revenue changes for the period 1992-2008. Most of the procedures used in this chapter are described in Chapters 3 and 6. We use renewal theory (explained in Chapter 3) to estimate turnover rates of property, allowing us to project the distribution of properties across base years. We use the statewide model (explained in Chapter 6) to match "base" counties (counties that provided a complete set of data) with "nonbase" counties, and then use data from the base counties to fill in the data gaps for the nonbase counties. The first set of revenue projections is for the current (acquisition-value) tax system. These revenue projections require four steps. 1. Project the distribution of properties across base years (the number of properties with each base year). For existing properties, we use the current base-year distribution (the number of properties with each base year) and the estimated renewal function (which shows turnover rates) to project the base-year distribution of "old" properties (properties that existed in 1991). The future base-year distribution of the tax roll also depends on new construction over the intervening period. We assume that the construction rate is 2% per year, and then use the estimated renewal function to project the base-year distribution of "new" properties. By summing the "old" and "new" properties of each base year, we project the base-year distribution of the tax roll. 2. Project average assessed values for properties with each base year. Using the 1991 average assessed value as a starting point, we assume that assessed values grow at 2% per year (the maximum rate of increase under Proposition 13). In other words, we assume that the nominal appreciation rate for housing is at least 2% per year. 3. Compute the tax revenue for each base year. The tax contribution of a particular base year is the product of the tax rate (1%), the average assessed value, and the number of properties with that base year. 4. Add the contributions of properties with different base years to compute the total tax revenue for some projection year.

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The second set of revenue projections is for a tax system based on market value. These revenue projections require five steps. 1. Use the disparity ratios and the current average assessed value to estimate the average market value for each base year: The market value is the product of the assessed value and the disparity ratio. Under a market-value system, base years are irrelevant once properties are reassessed at market value, so the base-year distribution is replaced by a distribution of properties across initial market values (market value in 1991). 2. Use one of three assumed nominal appreciation rates to project future market values for each initial market value. 3. Use an assumed construction rate (2% per year) to project additions to the tax roll between the current year and the projection year. 4. Compute the tax contribution for each initial market value. The tax contribution of a particular initial market value is the product of the tax rate, the average future market value, and the number of properties with that initial market value. The number of properties with a particular market value is the sum of "old" properties (in existence in 1991) and "new" properties (built since 1991). 5. Add the tax contributions of different initial market values to compute the total tax revenue for some projection year. The third and fourth sets of revenue projections are for a hybrid or a splitroll tax system. Under a split-roll system, some types of property (e.g., singlefamily residential) are taxed according to acquisition value, and other types of property are taxed according to market value. To project tax revenue under a split roll, we divide the tax roll into two components, use the two projection methodologies already described to project the tax revenue from each component, and then sum the revenue contributions to get total tax revenue. There are two key assumptions underlying our revenue projections. All the projections in this chapter are based on a construction rate of 2% per year. In the body of the chapter, we report revenue projections for a medium nominal appreciation rate (5% per year). The Appendix to the chapter reports the revenue projections for a low appreciation rate (2%) and a high appreciation rate (10%). Our projections are in nominal - not real - terms. Like the California Department of Finance, we assume a general inflation rate of 4% per year. The real appreciation rate of property equals the nominal appreciation rate minus 4%: A 5% nominal appreciation rate implies a real appreciation rate of 1%. Because we have complete data on only 9 of California's 58 counties, we must match "base" counties (counties that provided a complete set of data) with nonbase counties, and then use data from the base counties to fill in the data gaps for the non-base counties. In general, we used the matching and filling methods described in Chapter 6.

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Table 7.1. Projected tax revenue from current tax system and a market-value system: medium appreciation rate Tax Revenue in Year ($ millions)

Average Annual Growth Rate

1992

2000

2008

9,053 3,670 3,394 16,117

18,374 6,922 6,579 31,875

33,858 12,390 11,950 58,198

8.24 7.60 7.87 8.02

16,569 6,363 6,442 29,374

28,670 10,840 10,940 50,450

49,612 18,607 18,639 86,858

6.85 6.71 6.64 6.78

Current Tax System

SFR COM Other Total Market-Value System

SFR COM Other Total Appreciation rate = 5 percent

Current system and market-value system Consider first the time path of tax revenue under the current tax system. In 1992, about 61% of property-tax revenue came from single-family residential property, and about 25% came from commercial/industrial property, leaving about 14% for other property (primarily multifamily residential). Table 7.1 presents the revenue projections by property type for a medium appreciation rate (a nominal rate of 5% per year). Total revenue in 2008 is about 3.61 times the total revenue in 1992, and the average annual growth is 8.02%. The revenue from single-family residential (SFR) property grows at a relatively rapid rate because the base-year distribution of SFR is relatively old: A relatively large fraction of the SFR tax base has earlier base years. Because SFR property has a lower turnover rate (which tends to decrease revenue growth rates), the SFR base-year distribution is old enough to offset the effects of relatively slow turnover in this sector. In the Appendix, Table 7.A presents revenue projections by property type for two other appreciation rates, low (2%) and high (10%). Consider next the revenue implications of a complete switch to market-value taxation. Under this tax regime, all property in California (except agricultural property covered by the Williamson Act) is assessed at its full market value, and the tax rate is 1% of market value. Table 7.1 shows the revenue projections for the medium appreciation rate by type of property. In the Appendix, Table 7.B presents revenue projections for a low appreciation rate (2%) and a high rate (10%). Table 7.2 presents the projections of total tax revenue for both the current system and the market-value tax system with a medium appreciation rate. In 1992, the difference in revenue generated by the two systems is $13.26 billion, or about 82% of the revenue under the current system. Over time, the revenue

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Table 7.2. Projected tax revenue from alternative tax systems: medium appreciation rate Tax Revenue in Year ($ millions) 1992

2000

2008

Current System

16,117

31,876

58,197

Market Value

29,375

50,450

86,858

Increase in Revenue: Market Value

13,258

18,574

28,661

Split Roll SFR

21,858

40,154

71,104

5,741

8,278

12,907

24,827

44,221

77,327

8,710

12,345

19,130

Increase in Revenue: SFR Split Roll OSFR Increase in Revenue: OSFR Appreciation rate = 5 percent

difference grows in absolute terms but shrinks in relative terms: In 2008, the difference is $28.67 billion, which is 49% of the revenue that would be generated by the current system. The revenue gap shrinks over time in relative terms because the revenue from the acquisition-value system increases at a faster rate. The annual growth rate from the acquisition-value system is about 8%, the sum of the 2% construction rate, the 2% growth from reassessment of unsold properties, and an additional 4 percentage points from turnover (the reassessment of sold properties at full market value). In contrast, the revenue from the market-value system increases about 7% per year, the sum of the 2% construction rate and the 5% nominal appreciation rate. In this case, the appreciation rate, which has a larger positive revenue effect on the market-value system, is not high enough to offset the effects of turnover and reassessment on the acquisition-value system. As shown in Table 7.C in the Appendix, if the appreciation rate is 10%, the revenue gap increases in both absolute and relative terms over time. What are the implications of a switch to market-value taxation for the state's projected structural deficits? If the appreciation rate is 5%, we project that a switch to the market-value system would increase revenue by about $19 billion, meaning that the change in tax policy would cover about 93% of the projected deficit. If the appreciation rate is 2%, the change in tax policy would cover about 51% of the projected deficit; if the appreciation rate is 10%, the change in tax policy would cover about 182% of the projected deficit. Another option for tax reform is a revenue-neutral switch to market-value

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Table 7.3. Revenue-neutral tax rates for different tax systems: medium appreciation rate Revenue-Neutral Tax Rate in Percent 1992

2000

2008

Market Value

0.55

0.63

0.67

Split Roll SFR

0.74

0.79

0.82

Split Roll OSFR

0.65

0.72

0.75

Appreciation rate = 5 percent

taxation. The revenue-neutral tax rate is that at which the projected revenue from the market-value system equals that from the current system. Table 7.3 shows the revenue-neutral tax rates for a market-value tax system with a medium appreciation rate. In 1992, the revenue-neutral tax rate for the marketvalue system is 0.55%. The tax rate increases over time, reflecting a narrowing of the gap between the revenue from the current system and that from a marketvalue system. As shown in Table 7.D in the Appendix, if the appreciation rate is 10%, the revenue-neutral tax rate decreases over time, reflecting the relatively rapid growth in the tax base of the market-value system. A split roll for all single-family residential properties Consider next the revenue implications of a switch to market-value taxation for all property except single-family residential property (SFR). Under the SFR split-roll tax system, about 39% of the tax base would be assessed at its full market value, and the remaining 61% (single-family residential, including both owner-occupied and rental property) would continue to be taxed under the current acquisition-value system. Table 7.2 presents the revenue implications of a switch from the current system to the SFR split-roll system, assuming a 5% appreciation rate. In 1992, the projected revenue difference between the current system and the SFR split roll is about $6 billion; by 2008, the projected revenue difference grows to about $13 billion. Since the revenue difference is about $8 billion in the year 2000, a switch to the SFR split roll would cover about 41% of the state's projected structural budget deficit. Table 7.3 shows the revenue-neutral tax rates for the SFR split-roll system. The revenue-neutral tax rate applies to all types of property (commercial, industrial, single-family residential, and other). In the first year, the revenueneutral tax rate is 0.74%: At this tax rate, the SFR split-roll system generates the same revenue as the current system. The revenue-neutral tax rate increases over time because the tax base of the SFR split-roll system increases less rap-

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idly than the tax base of the current system. Under the assumption of a high appreciation rate (10%), the revenue-neutral tax rate decreases over time, reflecting the relatively rapid increase in the tax base of the SFR split-roll system. A split roll for owner-occupied single-family residential properties Consider next the revenue implications of a switch to market-value taxation for all property except owner-occupied single-family residential property (OSFR). Under the OSFR split-roll tax system, about 66% of the tax base would be assessed at its full market value, and the remaining 34% (owneroccupied single-family residential property) would continue to be taxed under the current acquisition-value system. Our projections are based on the assumption that owner-occupied single-family residential property is responsible for a constant 34% of total assessed value. Table 7.2 presents the revenue implications of a switch from the current system to the OSFR split-roll system, assuming a 5% appreciation rate. In 1992, the projected revenue difference between the current system and the OSFR split roll is about $9 billion; by 2008, the projected revenue difference grows to about $19 billion. Since the revenue difference is about $12 billion in the year 2000, a switch to the OSFR split roll would cover about 73% of the state's projected structural budget deficit. Table 7.3 shows the revenue-neutral tax rates for the OSFR split-roll system. The revenue-neutral tax rate applies to all types of property (commercial, industrial, single-family residential, and other). In the first year, the revenueneutral tax rate is 0.65%: At this tax rate, the OSFR split-roll system generates the same revenue as the current system. The revenue-neutral tax rate increases over time because the tax base of the OSFR split-roll system increases less rapidly than the tax base of the current system. Under the assumption of a high appreciation rate (10%), the revenue-neutral tax rate decreases over time, reflecting the relatively rapid increase in the tax base of the OSFR split-roll system. Transfer tax and deferred market-value tax This section explores the revenue implications of two alternative reform options, a transfer tax and a deferred market-value tax. The transfer tax is 1% of the market value of the property, imposed at the time of sale. The deferred tax is also imposed at the time of sale, and is equal to the difference between the property owner's total tax payments under the acquisition-value system and the total payments that would have occurred under a market-value system with a 1% tax rate. We present revenue projections for two counties, Los Angeles and San Bernardino. The projections for the transfer tax require two steps. First, we use renewal

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Table 7.4. Revenue from transfer tax as percentage of revenue from current tax system: medium appreciation rate Transfer Tax Revenue as Percentage of Total Revenue Under Current System 1992

2000

2008

Single-Family Residential Los Angeles San Bernardino

10.6 15.2

8.7 14.2

8.0 17.1

Commercial/Industrial Los Angeles San Bernardino

10.6 6.3

8.6 4.3

7.7 3.9

Appreciation rate = 5 percent

theory (explained in Chapter 3) to estimate turnover rates, allowing us to predict the number of properties sold for each year from 1992 to 2008. Second, based on an assumed appreciation rate, we project market values over the same period. The revenue from the transfer tax in a particular year equals the product of (1) the number of properties sold, (2) the average market value, and (3) the tax rate (1%). It is important to note that we are assuming that the transfer tax does not affect turnover rates. To the extent that the transfer tax decreases the turnover rate, our projections overstate the revenue from the tax. Table 7.4 shows the projected revenue from the transfer tax as a percentage of tax revenue generated by the current system. The assumed appreciation rate is 5%. (Table 7.E in the Appendix gives the raw numbers behind the percentages shown in Table 7.4.) In Los Angeles in the year 2000, the transfer tax would increase property tax revenue by about 8.7% for single-family residential property and about 8.6% for commercial/industrial property. In San Bernardino, the corresponding numbers are 14.2% for single-family residential property and 4.3% for commercial/industrial property. For single-family residential properties, the revenue from the transfer tax is smaller, in relative terms, in Los Angeles because the number of properties sold (including new properties) is relatively low. For both counties, the revenue from commercial/industrial properties is relatively low because turnover rates are lower for commercial/industrial property than for single-family residential property. Consider next the deferred market-value tax. Under this tax system, the property owner pays the acquisition-value tax as long as he or she owns the property, and then pays a lump sum equal to the gap between the total taxes paid and the taxes that would have been paid under a market-value system from the time of tax reform (e.g., 1991) to the time of sale. Table 7.5 illustrates the mechanics of a deferred tax for a dwelling purchased in 1980 for $100,000 and then sold at the end of 1994 for $300,258. When tax reform is implemented in

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Table 7.5. Mechanics of deferred tax for property purchased before tax reform Year

Assessed Value

Market Value

AVTax

1980

100,000

100,000

1,000

1991 1992 1993 1994

121,899 127,994 134,394 141,114

259,374 272,343 285,960 300,258

1,219 1,243 1,268 1,294

MVTax

Tax Defeired

Tax Paid

2,594 2,723 2,860 3,003

1,375 1,480 1,591 1,709

1,219 1,243 1,268 7,449

Table 7.6. Revenue from simple deferred market-value tax as percentage of revenue from current tax system: medium appreciation rate Deferred Tax Revenue as Percentage of Total Revenue Under Current System 1992

2000

2008

Single-Family Residential Los Angeles San Bernardino

5.3 3.8

19.9 11.9

20.0 13.7

Commercial/Industrial Los Angeles San Bernardino

5.8 1.4

24.6 4.7

25.1 5.8

Appreciation rate = 5 percent

1991, the market value of the property is $259,374 (assuming an appreciation rate of 10% per year between 1980 and 1991), and the assessed value is $121,899 (the purchase price plus 2% growth per year for 10 years), so the disparity ratio is 2.13. The gap between the actual taxes paid ($1,219) and the taxes that would be paid under a market-value tax ($2,594) is $1,375. The difference between the taxes under the two systems increases to $1,709 in 1994, reflecting the fact that the appreciation rate (5%) exceeds the reassessment rate (2%). In 1994 (the year the property is sold), the household's actual tax bill equals the acquisition-value tax for that year ($1,294) plus the cumulative taxes deferred ($6,155), or $7,449. Table 7.6 shows the projected revenue from the deferred tax as a percentage of tax revenue generated by the current system. The assumed appreciation rate starting in 1991 is 5%. (Table 7.E in the Appendix gives the raw numbers behind Table 7.6.) In Los Angeles in the year 2000, the deferred tax would increase property tax revenue by about 20% for single-family residential property and about 25% for commercial/industrial property. In San Bernardino, the corresponding numbers are 12% for single-family residential property and 5% for commercial/industrial property.

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The deferred tax generates a large amount of revenue in Los Angeles County because disparity ratios are much higher there. As a result, the gap between market value and assessed value is relatively large, as is the amount of taxes deferred per year. The differences in disparity ratios are offset, in part, by differences in turnover rates: Los Angeles has a lower turnover rate, which tends to decrease the tax revenue from the deferred tax. Because the difference in disparity ratios is large relative to the differences in turnover rates, the deferred tax generates more revenue, in relative terms, in Los Angeles. An alternative to this simple version of the deferred tax is to charge taxpayers interest on the taxes deferred until the property is sold. The idea behind this proposal is that deferred taxes are like a loan to the property owner, and the borrower should pay interest on the implicit loan. Suppose that the interest rate on deferred taxes is the same as the appreciation rate (5%). In Los Angeles in the year 2000, the deferred tax would increase property-tax revenue by about 24% for single-family residential property and about 29% for commercial/industrial property. In San Bernardino, the corresponding numbers are 14% for single-family residential property and 6% for commercial/industrial property. Summary and conclusions The various reform options explored in this chapter differ dramatically in their effects on total property tax revenue. One way to summarize the revenue effects of the alternatives is to compute the percentage of the state's projected structural deficit ($20 billion in the year 2000) that would be covered by each tax scheme, assuming a 5% appreciation rate. A complete switch to market-value taxation would cover about 93% of the deficit, compared to 73% under the split-roll plan with all properties except owner-occupied properties taxed at market value, and 41% under the split-roll plan with all properties except single-family properties taxed at market value. In general, the closer the tax system is to a pure market-value taxation, the larger the revenue generated. Since the revenue projection for the two other reform options (the transfer tax and the deferred tax) are for individual counties, we did not compute the effects of these other reform options on the state's projected budget deficit. Based on our county projections, the revenue generated by these taxes is smaller than the revenue from market-value taxation. A switch to a marketvalue system would increase tax revenue in the year 2000 by about 60%. In contrast, the 1% transfer tax would increase tax revenue by less than 10% in the two counties studied, and the deferred tax would increase tax revenue by less than 30%. The reform options also differ in their effects on efficiency and economic welfare. As explained in Chapter 5, the acquisition-value system distorts household and firm mobility because it imposes a moving penalty on property owners. The general rule for evaluating alternative taxes with respect to their

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efficiency effects is that systems closest to market value are the best. Because the split roll is a hybrid system, imposing a market-value system on some types of property, it is less efficient than a pure market-value system but more efficient than a pure acquisition-value system. The OSFR system (acquisitionvalue system only for homeowners) is more efficient than the SFR system (acquisition-value system for all single-family properties) because the OSFR applies the acquisition-value system to a smaller part of the tax base. As explained in Chapter 5, the transfer tax is an extreme version of the acquisitionvalue system, so it distorts mobility to a larger extent and is therefore less efficient. Under the simple deferred tax, property owners may delay a move to a different property to delay paying the accumulated taxes. Because taxes are merely delayed (not avoided), however, the mobility distortions are much smaller than the distortions generated by the acquisition-value tax and the transfer tax. Finally, the deferred tax with interest charges for deferred taxes is identical to a market-value tax, so it does not distort mobility relative to a market-value tax. Appendix Table 7.A. Projected tax revenue from current tax system, 1992, 2000, 2008 Tax Revenue in Year ($ millions)

Average Annual Growth Rate

1992

2000

2008

9,018 3,658 3,420 16,096

16,509 6,280 5,999 28,788

25,849 9,625 9,290 44,764

6.58 6.05 6.25 6.39

9,053 3,670 3,394 16,117

18,374 6,922 6,579 31,875

33,858 12,390 11,950 58,198

8.24 7.60 7.87 8.02

9,111 3,690 3,324 16,125

22,264 8,209 5,967 36,440

55,316 19,490 12,684 87,490

11.27 10.40 8.37 10.57

Low Appreciation (2%)

SFR COM Other Total Medium Appreciation (5%)

SFR COM Other Total High Appreciation (10%)

SFR COM Other Total

Table 7.B. Projected tax revenue from market-value tax system, 1992, 2000, 2008 Average Annual Growth Rate

Tax Revenue in Year ($ millions) 1992

2000

2008

Low Appreciation (2%) SFR COM Other Total

16,067 6,174 6,305 28,546

22,071 8,345 8,508 38,924

30,301 11,364 11,493 53,158

3.97 3.81 3.75 3.89

Medium Appreciation (5%) SFR COM Other Total

16,569 6,363 6,442 29,374

28,670 10,840 10,940 50,450

49,612 18,607 18,639 86,858

6.85 6.71 6.64 6.78

High Appreciation (10%) SFR COM Other Total

17,328 6,658 6,669 30,655

43,535 16,463 12,914 72,912

109,337 41,011 27,764 178,112

11.51 11.36 8.91 11.00

Table 7.C. Projected tax revenue from alternative tax systems, 1992, 2000, 2008 Tax Revenue in Year ($ millions) 1992

2000

2008

16,906

28,788

44,763

Market Value Increase in Revenue: Market Value

28,546 11,640

38,924 10,136

53,158 8,395

Split Roll SFR Increase in Revenue: SFR

21,496 4,590

33,363 4,575

48,706 3,943

Split Roll OSFR Increase in Revenue: OSFR

24,267 7,361

35,548 6,760

50,456 5,693

16,117

31,876

58,197

Market Value Increase in Revenue: Market Value

29,375 13,258

50,450 18,574

86,858 28,661

Split Roll SFR Increase in Revenue: SFR

21,858 5,741

40,154 8,278

71,104 12,907

Split Roll OSFR Increase in Revenue: OSFR

24,827 8,710

44,221 12,345

77,327 19,130

16,125

36,441

87,491

30,655 14,530

72,912 36,471

178,112 90,621

Low Appreciation (2%) Acquisition Value

Medium Appreciation (5%) Acquisition Value

High Appreciation (10%) Acquisition Value Market Value Increase in Revenue: Market Value

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Table 7.C. Projected tax revenue from alternative tax systems, 1992, 2000, 2008 (cont.) Split Roll SFR Increase in Revenue: SFR

22,438 6,313

51,641 15,200

124,019 36,528

Split Roll OSFR Increase in Revenue: OSFR

25,709 9,584

60,107 23,666

145,592 58,101

Table 7.D. Revenue-neutral tax rates for different tax systems, 1992, 2000, 2008 Revenue-Neutral Tax Rate in Percent 1992

2000

2008

Low Appreciation (2%) Market Value Split Roll SFR Split Roll OSFR

0.56 0.75 0.66

0.74 0.86 0.81

0.84 0.92 0.89

Medium Appreciation (5%) Market Value Split Roll SFR Split Roll OSFR

0.55 0.74 0.65

0.63 0.79 0.72

0.67 0.82 0.75

High Appreciation (10%) Market Value Split Roll SFR Split Roll OSFR

0.53 0.72 0.63

0.50 0.71 0.61

0.49 0.71 0.60

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alternatives

Table 7.E. Revenue from acquisition-value tax, transfer tax, and deferred market-value taxes: medium appreciation value Tax Revenue in Year ($ millions) 1992 Single-Family Residential Los Angeles Acquisition-Value Tax Transfer Tax Simple Deferred Tax Deferred Tax with Interest (5%) San Bernardino Acquisition-Value Tax Transfer Tax Simple Deferred Tax Deferred Tax with Interest (5%) Commercial/Industrial Los Angeles Acquisition-Value Tax Transfer Tax Simple Deferred Tax Deferred Tax with Interest (5%) San Bernardino Acquisition-Value Tax Transfer Tax Simple Deferred Tax Deferred Tax with Interest (5%) Appreciation rate = 5 percent

2000

2008

2352 250 124 124

5045 437 1004 1195

9448 760 1888 2573

382 58 15 15

710 101 85 99

1259 216 173 230

890 94 52 52

1744 149 430 513

3176 245 798 1100

109 7 1 1

194 8 9 11

334 13 20 26

8 The future of the property tax

The property tax is one of the least popular taxes. The public's hostility is bred by a number of factors, including difficulties in determining the true market value of property, general antipathy to taxes based on wealth, and sudden changes in the relative burden of property taxes. Voters have translated their feelings toward the property tax into a variety of property tax limitations across the country. Some limitations just affect the rates that can be levied. These constrain revenue but do not fundamentally alter the nature of the tax. Other limitations affect the base of the tax. These can take two forms. First, as in Massachusetts, there can be overall limits to the growth in the tax base. Second, many jurisdictions classify property, that is, assess different types of property at different percentages of market value with the result that property within the state is taxed at differential rates. The most radical change in the nature of the tax occurred in California (and recently in Florida) where property taxes based on market value were replaced with taxes based on acquisition value. Why do property tax revolts occur? From the review of four key property tax revolts in Chapter 1, it is clear that taxpayer revolts can occur in different contexts. One of the major precipitating factors is a sudden change in the relative burden of property taxation. During the Great Depression this occurred as incomes fell dramatically and property taxes failed to decline, so that the relative burden increased. In California during the late 1970s, rapid inflation and a deadlocked political system were the culprits that increased the burden of taxation relative to income, especially for homeowners. In Massachusetts, the story was quite different. For years, Massachusetts residents had experienced one of the highest property tax rates in the country, and the politicians, although perceiving this problem, had failed to find a workable solution. Proposition 13 energized opponents of the property tax, and this process led eventually to Proposition 2l/i. In the United Kingdom, the revolt against the poll tax had a different dimension. In part, the rebellion was fueled 136

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by perceptions of unfairness and regressivity as well as by sudden increases in taxation for many individuals. All successful revolts change the face of the property tax. In the United Kingdom, the poll tax was replaced. The Depression experiences led to limitations on rates. But perhaps the most radical and least understood transformation of the property tax occurred in California. As the previous chapters have demonstrated, Proposition 13 has dramatically changed the nature of the property tax in California. The changes have been so profound that there naturally have been many suggestions for reform of the entire system of property taxation. But any discussions of reform must be sensitive to the changes that have occurred in the fifteen-year period since the measure's passage. After such a long time, individuals and businesses have become accustomed to operating under new rules and a new regime. Any changes must be sensitive to prior decisions and commitments that have been made in the post-Proposition 13 era. Key empirical findings Before discussing alternatives for reform, it will be useful to review some of the key empirical findings of our study for California. At the risk of oversimplification, there are six basic elements to our findings: 1. Proposition 13 left California with a very low effective property tax rate by national standards. The overall effective tax rate on locally assessed real property is approximately 0.55%. Prior to Proposition 13, the average effective tax rate on property was between 2% and 3%. By another standard, local property tax revenue per $100 of personal income, California moved from a rank of 7 among the states in 1978 to 35 in 1990.1 However, there has been recent growth in property-related taxes. Residential growth in California has depended largely upon hefty fees for new construction. In a sense, property-related taxes have been increased on new construction and reduced on existing property. New construction pays initially a 1% effective rate and is saddled with substantial fees. Older property has a much lower effective tax rate. In addition, cities and municipalities have cleverly expanded the scope of property-related taxes, including benefit-assessment districts and transfer taxes. 2. There are dramatically large disparities in property taxation among virtually identical properties. In the large urban counties in California in the Los Angeles and San Francisco regions, more than 40% of the households have remained in their homes since 1975. For those households, their effective tax rate is approximately 0.2% compared to 1% for recent purchasers of property. To put it another way, if an individual who has owned his house since 1975 suddenly purchased an identical property next door, property tax payments would increase by a factor of five.

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3. Among the class of homeowners, Proposition 13 has actually led to a more progressive property tax than a traditional ad valorem property tax that raised the same amount of revenue. This is one of our most surprising findings. Both lower-income and elderly homeowners benefit from Proposition 13 because they are more concentrated in earlier base years. In California's highpriced real estate market, lower-income individuals, on average, are able to own a home today only if they bought it in the distant past. The elderly, as well, bought their homes in the past and have remained in them. In the large urban counties, more than 80% of the elderly over 65 years of age have been in their homes since 1975. This finding has two important implications. First, it demonstrates that a switch to a revenue-neutral property tax system based on market values would hurt elderly and lower income homeowners. For example, for the 80% of the elderly with 1975 base years living in large urban counties, a switch to a revenue-neutral market-value property tax would mean an increase in their property tax payments of more than 120%. Second, it demonstrates that there is a profound conflict between vertical and horizontal equity among homeowners. With its disparate assessments for identical property, Proposition 13 clearly violates the basic principle of horizontal equity that equally situated individuals should be treated equally. On the other hand, Proposition 13 fares better under the principle of vertical equity, which dictates progressive taxation. A reform in the direction of horizontal equity would violate vertical equity. 4. Although Proposition 13 does create a "lock-in" effect, the effects on mobility and loss of economic welfare from this lock-in effect are small. As long as inflation exceeds 2%, an individual faces a tax on mobility, because property taxes on newly purchased property will be based on market value that will exceed the assessed value in the current residence. However, we estimate that for the average household a 13% inflation rate will lengthen the average time between moves by only approximately two months. Similarly, the distortion created for the average homeowner from living under an acquisition-value system as compared to a market-value system that raised identical revenue (the excess burden) is only $18 per year. However, individuals are not all homogenous, and those that tend to remain in their homes longer would face greater disincentives to move as well as larger welfare costs. For individuals who would normally stay in their homes for 9.3 years under a market-value property tax system, their length of stay would increase by more than 2.4 years, and the excess burden from the acquisitionvalue system would exceed $65 per year. Nonetheless, the reason that these numbers are still comparatively small is that the property tax rate of 1% is itself relatively low. With a higher tax rate, acquisition-value taxation would create substantially more distortions. Relatively large excess burdens are created by transfer taxes. Transfer taxes

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can be viewed as extreme examples of acquisition-value taxation: No tax is paid during the ownership period, but a large tax is due upon sale. The growth of transfer taxes in California as substitutes for ad valorem property taxes has decreased taxpayer mobility. 5. There are substantial revenue gains possible from taxing nonhomeowner property at market value with a 1% rate. We estimate that raising assessments on all nonhomeowner property to market value would raise $8.6 billion per year. This increase would be an important contribution to closing the structural budget deficit in California. If assessments on only commercial and industrial property are increased (and not single and multifamily residential property), we estimate that revenues would increase by $3.3 billion per year. Over time, the revenue gains from switching to a market-value system depend on the inflation rate. Turnover and new construction reduce the gap between market and assessed value, whereas inflation in excess of 2% increases the gap. If the inflation rate for property is in the neighborhood of 5%, the gap between market and assessed value will remain relatively constant over the next decade. If inflation exceeds 5% the gap will widen and the revenue increase in real terms from switching to market value will grow, whereas if inflation is less than 5%, the revenue gains will decrease. We also used our models to estimate for several counties the revenue increases from a supplemental 1% transfer tax and a deferred market-value tax. The transfer tax would raise approximately 10% of existing property tax revenues, or in the neighborhood of $1.6 billion per year. A deferred market-value tax would raise an additional 15% for a total of approximately $2.4 billion per year. 6. Finally, Proposition 13 has effectively converted the property tax from a local to a statewide tax. This process actually began with a series of court decisions concerning equalization of school finance across districts, and indeed some commentators have suggested that the loss of control of local school financing was the ultimate cause of Proposition 13. In any case, Proposition 13 fixed the property tax rate at 1%, thereby removing any local discretion from the decision on rates, and also dictated that the state would design a mechanism to allocate property tax revenues to districts within each county. Shortly after Proposition 13 passed, the state used its budget surplus to finance the schools, and transferred the property tax revenues from the schools to the cities and counties. With a series of state budget crises in the early 1990s, this process was essentially reversed. The state removed funds from the schools and replaced these funds with property tax revenues from the cities and counties. The result of this entire process has been a reduction in local autonomy and a pervasive sense of uncertainty among local governments. Cities have found it easier than counties to discover new sources of revenues. Taxes on new development have been important sources of revenue, and competition between

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localities has been exacerbated. All local government is more dependent upon decisions made at the statewide level, with priorities increasingly determined outside of local jurisdictions. The dramatic changes in the property tax and local government brought about by Proposition 13 cannot simply be undone; they have permeated the fiscal landscape, and a generation of homeowners and businesses have become accustomed to a new style of property taxation. There is a saying that an "old tax is a good tax," which reflects the basic principle that there is value in stability. Proposition 13 has become an "old tax." Nonetheless, despite its age, certain elements need to be changed. Different considerations, however, apply to homeowner and nonhomeowner property. Reform options Wholesale reform of the property tax for individuals will be impossible. As our work has revealed, there are tremendous disparities between owners of identical property. Yet, the years of rapid price inflation have created such large disparities that switching to market-value taxation - even with a revenue-neutral system - would create undue burdens. The fact that the elderly and lower-income homeowners have been primary beneficiaries of the assessment system just compounds the problem with reform. With 80% of the elderly in large urban areas having owned their homes at least since 1975, wholesale reform is not remotely feasible. There have been suggestions for the increased use of transfer taxes or "recapture" taxes upon the sale of property by homeowners. As we have seen, a 1% transfer tax would raise only a modest amount of revenue, but would have adverse effects on household mobility and welfare. Revenues from a deferred market-value tax are potentially greater, and this would not have an adverse effect on household mobility. However, these taxes have been used only in limited contexts in the past, mostly as a means of assisting low-income elderly homeowners. For many individuals, especially the elderly in urban areas, the cumulative gap between market-value and acquisition-value taxation would quickly become very large. Many homeowners would be adversely affected by this change and would view it as simply a return to the old system of taxation that they have rejected. Moreover, the state would be in the position of becoming, along with the banks, the major lien holders for the property. As long as inflation in housing prices continued at a high and steady rate, capital gains from owning a home would rise with the cumulative tax liability. But what happens when housing prices start to fall, as they have done in the early 1990s, especially in the large urban areas? In this case, a household's mortgage and cumulative liability to the state in deferred taxes would remain constant while the capital gains fell. The result would be a decrease in household net worth, and in some cases the

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liens (private and public) against the house could exceed its value. This is a recipe for wholesale defaults on mortgages, tax difficulties, and a taxpayer revolt. A deferred market-value tax may look fine in an idealized world of smooth inflation, but in a world of real taxpayers and uncertain inflation it is probably inferior, in both a political and economic sense, to a traditional ad valorem tax. As we discovered, the welfare or efficiency costs associated with the tax on mobility under Proposition 13 were not large. The main problem is the dramatic horizontal inequities. There are, however, some forces at work that will reduce these inequities among homeowners. Turnover and new construction will reduce the percentage of properties with older base years. For example, we estimated that with a 2% growth rate in new construction and turnover rates comparable to those in the past, the percentage of homeowners with 1975 base years in Los Angeles County will fall from 43% to 25% by the year 2000. Low projected inflation will also work toward reducing inequities. As long as housing price inflation falls short of 2%, the disparities will not increase. Because the real-estate market has been soft in California in the 1990s and the outlook is currently for very low inflation in housing, the existing inequities are not likely to grow rapidly in the near future. Nonetheless, two reforms would raise some revenue and reduce inequities among homeowners. One step would be to raise the maximum allowable increase in assessed value from 2% to 4%. Moreover, the increase could be mandated at 4% as long as current assessed value falls short of market value. This measure would begin to reduce some of the discrepancies between market and assessed values, particularly at a time when housing-price inflation is expected to be low. This measure would also raise a modest amount of revenue, in the neighborhood of $100 million per year. A second step would have a much less significant effect on revenues but would be of symbolic importance. The provision allowing property to be passed through the generations within the family without reassessment should be repealed. There is little public-policy rationale for this provision; it is not desirable to create a dynastic class within the state, and it serves to dramatize the inequities built into the existing system. It is best to tackle this particular problem now before intergenerational transmission of property without reassessment becomes a common practice in California. For business property, the considerations are quite different. Proposition 13 was a creature of angry protests by homeowners and was actually opposed by big business, which feared its effects on the overall fiscal environment. Although inequities across different types of property are not desirable, we judge a tax system for business on its overall economic burden and the incentives or disincentives it creates for economic growth. On these grounds, Proposition 13 in its current form has important defects.

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The main problem with the property tax system for business property is that it places the burden on new activity while subsidizing older, existing property. A new firm pays a 1% tax rate on property. If it actually builds a new facility it will also face substantial additional fees related to new construction. Existing firms pay taxes at a substantially reduced rate, as low as 0.2% in many cases. They also are not saddled with the fees levied by cities for new construction. In effect, new business is taxed at a substantially higher rate than existing business. This is precisely the opposite of the incentive system that we would like to create. Taxing new activity at a higher rate than existing activity is not sound tax policy and has no policy rationale. Even for new business, the 1% effective tax rate is not a burden by national standards. The substantially lower rate for older, existing business property is below national norms. Assessing nonhomeowner property at market value would level the playing field between new and existing business and raise a considerable amount of revenue as well. As noted, assessing business property at market value and maintaining the 1% rate would raise $8.6 billion a year. This is nearly twice the sum collected from the state corporation tax. An important component of business property is single and multifamily rentals. Raising taxes on rental property would cause some anxiety that this would lead to higher rents. In the short run, rents would not be likely to increase for several reasons. First, neither the supply nor demand for rental property would change in the short run and therefore rents will not change. Just as the passage of Proposition 13 did not lower rents, raising property taxes will not increase them in the short run. Second, rent controls in many cities would mitigate any rent increases. In the long run, however, there would be some upward pressure on rents. Higher taxes will reduce the supply to some degree and, even with rent control, property owners will successfully pass on some of the rent increases in the long run. For these reasons as well as political appeal, it would be advisable to combine market- value assessment of business property with an expansion of income tax credits for renters. These credits, however, should be means-tested, with the benefits primarily flowing to lower-income renters. However, middleincome homeowners would still have advantage that middle-income renters would lack. Two other changes could make the different assessment practices more palatable to business, and would have beneficial economic effects. First, the assessment of business property at market value could be combined with limitations on fees for new construction. Since cities and counties would have additional revenues from the property tax, they would still be net winners. Moreover, it would be another measure that would reduce the additional burden placed today on new business. The second possible change would be to exempt some fraction of improvements or new construction from property taxation for a period of time. In ef-

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feet, this would move in the direction of taxing land at a higher rate than improvements. As economic theorists have long recognized, tax distortions are minimized when relatively immobile factors of production are taxed. Land is not mobile, so the burden of a tax on land falls on the landowner.2 The landowner cannot escape the tax. In contrast, a tax on new construction discourages economic activity. Shifting the burden to land would reduce economic distortions. It is, of course, difficult to separate the value of land from the value of structures and improvements; but if some fraction of the value of new construction were exempted for a period of time, these assessment problems would be avoided. Data on the value of new construction is readily available, and there would be no need to make an overall separation between the value of land and the value of structures. The economic effect, however, would be essentially the same. Land would have a higher effective tax rate than structures. There are apparently successful precedents for this approach. Differential taxation of land and structures is common in Australia, and the policy is generally regarded as promoting better land use. In the United States, a recent study of Pittsburgh, Pennsylvania, which taxes land at higher rates, found that its rate of economic growth exceeded that of comparable cities.3 A similar system has been recommended for the state of New Jersey.4 How important is land as a component of total market value for commercial and industrial property? This is difficult to estimate in California because the assessors under Proposition 13 do not really care about the breakdown between land and improvements. Nonetheless, using our data for newly constructed and recently sold property, we estimated this percentage for three counties. In Los Angeles County, land constituted 65% of assessed value. This was somewhat lower in Sonoma and San Bernardino counties, where the figures were 43% and 48% respectively. These numbers may be too high if assessors value improvements at construction costs and thereby attribute to the land alone the value added by the combination of structures and land. A conservative estimate for the state as a whole would be that land constitutes 40% of assessed value for commercial and industrial property. Land is clearly a significant part of the tax base.5 How expensive would a policy of partial abatement on new construction be? As a benchmark, we estimate that the cost of exempting 20% of improvements to commercial and industrial property from property taxation for two years would be approximately $36 million per year.6 This is a relatively small loss in revenue compared to an increase of $3.3 billion from assessing commercial and industrial property at market value, or to the $8.6 billion gained from assessing all nonresidential property at market value. Nevertheless, this two-year abatement program for improvements would be viewed as a significant tax incentive. Our preferred reform package includes all the elements outlined above: in-

Property taxes and tax revolts

144

creasing the maximum yearly assessment to 4% for homeowners; ending the provision allowing property to be passed down through generations within a family without reassessment; assessing business property at market value; expanded renter credits; limits on fees on new construction; and some limited abatement of property taxation on new construction. These changes would require a constitutional amendment. Although all tax increases are painful for the electorate, these changes are likely to cause fewer distortions than increases in income or sales taxes. This entire package of reforms would dramatically improve the tax system and fiscal situation in California. It would reduce inequities among homeowners, level the playing field between new and existing businesses, reduce the penalty on new construction, and raise needed revenue for the state. It would be more difficult to restore autonomy to counties and cities. The combined effects of the Serrano equalization ruling for educational finance plus 15 years of effective state control of local finance makes it difficult to turn back the clock. Maintaining an overall limit of a 1% tax rate on property, while it limits local autonomy, does provide safeguards for the public. If these safeguards had been in place, Proposition 13 would probably not have been drafted. Local autonomy could be restored by lifting the 1% property tax rate. However, voters would need to be reassured that rising market values would not lead to a situation similar to the one that existed prior to the passage of Proposition 13. One possibility would be to enact revenue limits for local jurisdictions as a safeguard. Now that the Supreme Court has ruled that an acquisition-value tax system does not violate the Equal Protection clause of the U.S. Constitution, other states, particularly those with regions of high price appreciation, will be tempted to enact systems similar to that of California. In 1992, Florida put in place an acquisition-value system with a 3% maximum rate of increase for homeowner property. But as other states contemplate such a change, they should examine the experience of California that we have documented. Although Proposition 13 did successfully limit property taxation, it did so at the cost of generating new inequities, economic distortions, and a loss of localgovernment autonomy. Property tax revolts are not tidy, reform-minded affairs. When a property tax revolt occurs, passions run high and there is considerable anger at the politicians who have failed to address the problems, or have created new problems with their laws. We do not expect the solutions brought on by taxpayer revolts to be tidy or precise. The changes brought on by Proposition 13 so transformed the revenue and finance system of California that a wholesale return to an ad valorem system is virtually impossible. California residents will

The future of the property tax

145

be living with the distortions and inequities of Proposition 13 for some time. The lesson for politicians and policymakers everywhere is to avoid the conditions that lead to property tax revolts: Limit the reliance on the property tax and avoid rapid changes in the fraction of individual income spent on it.

NOTES

Chapter 1 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

For a fascinating account of the Chicago tax strike, see Bieto (1989). Ibid., (1989), p. 6. This summary discussion draws on Oakland (1979). See Citrin (1979). Fischel (1989). See Adams (1984), p. 323. Davis (1983). Ladd and Wilson (1982). This discussion draws on two papers: Sheffrin (1991) and Smith (1991). See Giles and Ridge (1993). Amador Valley Joint Union High School District v. State Board of Equalization, 22 Cal. 3d 208, 583 P. 2d 1281, 149 Cal. Rptr 239 (1978). 12. This inflation rate is based on our estimates of disparity ratios for Los Angeles County in Chapter 4. 13. Post (1979), p. 385. Chapter 2 1. Advisory Commission on Intergovernmental Relations (hereafter ACIR) (1992), v2, table 60, p. 118. 2. Ibid., table 67, p. 130. 3. Ibid., tables 93 and 94, pp. 178-81. 4. U.S. Bureau of the Census (1982), table 13. 5. ACIR (1992), v2, table 65, pp. 126-28. 6. Ibid. 7. Ibid., table 60, p. 118. 8. Ibid., table 102, pp. 196-97.

146

Notes to pages 17-32 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

147

Ibid., table 60, p. 118. Ibid. Ibid. ACIR (1989), v2, table 23, p. 36. ACIR (1992), v2, table 65, p. 126-28. Ibid. Ibid. ACIR (1989), table 24, p. 37. Ibid. ACIR, 1992, v2, table 65, pp. 126-28. Bahl and Linn (1992) and Beaumont (1989). The OECD Federal countries are Australia, Austria, Canada, Germany, Switzerland, and the United States. The OECD Unitary countries are Belgium, Denmark, Finland, France, Great Britain, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, and Turkey. 20. ACIR (1992) v2, table 1, pp. 20-21. 21. Ibid. 22. See the discussion in Chapter 1. 23. Dillinger(1988)p. 3. 24. International Association of Assessing Officers (hereafter IAAO) (1992), section 7. 25. Ibid., sections 3, 4, and 7. 26. Bowman, Hoffer, and Pratt (1990). 27. IAAO (1992), section 3. 28. Ibid., section 4. 29. Ibid. 30. Ibid. 31. Ibid. 32. Ibid., section 9. 33. Ibid., section 2. 34. ACIR (1992) vl, table 44, pp. 143-52. 35. Ibid., table 43, p. 140. 36. Ibid., table 42, pp. 133-39. 37. Ibid. 38. Ibid., table 41, pp. 126-32. 39. Ibid., table 43, p. 140. 40. IAAO (1992), section 16. 41. Ibid., section 19. 42. Bahl and Linn (1992), chapter 4, and McCluskey (1991). 43. Ibid. 44. McCluskey (1991). 45. Bahl and Linn (1992), chapter 4, and McCluskey (1991). 46. Ibid. 47. Ibid. 48. Ibid. 49. McCluskey (1991).

Notes to pages 32-55 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61.

148

Preston and Ichniowski (1991). Schwadron, Richter, and Citrin (1984), p. 6. Adams (1984), chapter 10. ACIR (1992) vl, table 7, p. 18. IAAO (1992), section 16. Ibid. Preston and Ichniowski (1991). Ibid. ACIR (1991). Kleine and Cummings (1993). IAAO (1991), sections 14 and 18. Ibid., section 14.

Chapter 3 1. A classic text on renewal theory that contains all the key results we use is Cox (1962). Another useful book that illustrates applications of renewal theory is Bartholomew (1982). Sheffrin and Thurow (1977) use renewal theory to help understand increases in productivity through learning by doing. 2. In our work, we actually use continuous functions. The probability of a house selling in year three is approximated by/(3) times the interval of a year. 3. The expression for the renewal density is called a convolution. Given a density function, analytical solutions for the renewal density can sometimes be derived using Laplace transforms or can be derived numerically. For the density that we will use, there is an exact analytical expression. 4. Technically this is known as the backward age distribution. 5. See, for example, the study by Quigley (1987). 6. The factor of proportionality is the reciprocal of the mean of the probability-density function. The age distribution is itself a probability distribution and thus integrates to 1. 7. We use the coefficient on the mortgage term from the regression in column 2 of table 1 in Quigley's paper. This is near the midpoint of his various estimates. In this specification, the mortgage effects shift the hazard function proportionally. This is also our assumption. 8. The Department of Finance in California provides estimates of new construction for each county. For single-family residences, the data is in units and can be used directly. For commercial property, they report only the dollar value of construction. We deflated these numbers using the average assessed value for commercial property with that base year after adjusting for the 2% per year increase allowable under Proposition 13. 9. Specifically, data were available for 1980, and data on new construction allowed us to estimate the number of units in 1975. Chapter 4 1. For a legal discussion of change in ownership rules, see Steele (1991). For an overview of changes in property tax administration following the passage of Proposition 13, see Welch (1991).

Notes to pages 56-108

149

2. Since the largest number of sales were from 1975 base years, those disparity ratios were the most accurate. We always anchored our exponential curve with the 1975 values. 3. This method was suggested to us by Loren Leavitt, who is the assistant assessor of Santa Clara County. A bias could arise if recently built properties had higher market values than older properties. 4. This is calculated by finding the average inflation rate that would produce the 1975 disparity ratio after 16 years and then adding 2% per year for the allowable increase under Proposition 13. 5. As Chapter 6 explains, the statewide model draws heavily on data from the nine counties. Thus, this estimate is not totally independent of the one made from the nine-county data. 6. This point is starting to be recognized. See Report of the Senate Commission (1991), p. 36.

Chapter 6 1. 2. 3. 4. 5. 6. 7.

Bradbury (1988), p. 37. Ibid. Massachusetts Taxpayers Foundation (1993), supplementary tables, p. 10. Bradbury (1988), p. 37. Massachusetts Taxpayers Foundation (1993), supplementary tables, p. 10. Citrin (1984), p. 47. Massachusetts Taxpayers Foundation (1993), supplementary tables, p. 10.

8. Ibid. 9. Ibid. 10. Ibid. 11. Ibid. 12. Ibid. 13. Ibid. 14. 15. 16. 17.

California California California California

State Department of Finance (1991), table 37, p. A-46. State Controller, various years. Assembly Office of Research (1989) and (1992). State Controller, various years.

18. 19. 20. 21. 22. 23. 24.

Ibid. Ibid. Ibid. Ibid. Ibid. Ibid. Ibid.

25. 26. 27. 28.

Merrill Lynch Pierce Fenner & Smith Inc. (1979), p. 3. Senate Committee on Local Government (1987), p. 27. California Senate Office of Research (1992). Legislative Analyst's Office (1993).

Notes to pages 137-43

150

Chapter 8 1. For a recent comparison of taxation across states, see National Conference of Legislatures (1992), pp. 435-50. 2. The burden actually falls on the owner of the land at the time the tax is levied. Subsequent owners will pay a lower price for the land because of the tax payments. 3. See Oates and Schwab (1992). 4. See Bogart and Bradford (1990), pp. 59-82. There is one caveat to these recommendations with regard to farmland. Lower property taxes on farmland may be a useful tool for preventing conversion to urban uses. 5. For homeowner properties, the reported land-to-value ratios are significantly lower. Sonoma, San Bernardino, and Los Angeles counties have land value percentages of 38, 33, and 44 respectively. These may also be biased upward if improvements are measured at construction costs. 6. This estimate is based on the assumption that 15% of all commercial and industrial property falls within the two most recent base years; that one-third of the property in these base years is new construction; that the ratio of land to assessed value is approximately 40% statewide for commercial and industrial property; that the 1% rate prevails; and that total market value for commercial and industrial property is $649 billion.

REFERENCES

Aaron, Henry J. (1975). Who Pays the Property Tax? Washington, DC: Brookings Institution. Adams, James Ring (1984). Secrets of the Tax Revolt. New York: Harcourt, Brace, Jovanovich. Advisory Commission on Intergovernmental Relations (1989). Significant Features of Fiscal Federalism, vol. 2. Washington, DC: Government Printing Office. (1991). Changing Public Attitudes on Governments and Taxes. Washington, DC: Government Printing Office. (1992). Significant Features of Fiscal Federalism, vols. 1 and 2. Washington, DC: Government Printing Office. Amundsen, Erik (1985). "Moving Costs and the Microeconomics of Intra-Urban Mobility," Regional Science and Urban Economics 15, pp. 573-83. Bahl, Roy W, and Johannes F. Linn (1992). Urban Public Finance in Developing Countries. New York: Oxford University Press. Bartholomew, D. J. (1982). Stochastic Models for Social Processes, 3rd ed. New York: Wiley. Beaumont, Marion S. (1989). "The Worldwide Status of Property Taxation," Western Tax Review, double issue: 7, no. 2 (Summer 1989)/8, no. 1 (Winter 1990), 54-99. Bieto, David T. (1989). Taxpayers in Revolt. Chapel Hill: The University of North Carolina Press. Bogart, William T, and David F. Bradford (1990). "Incidence and Allocation Effects of the Property Tax and a Proposal for Reform," Research in Urban Economics 8, pp. 59-82. Bowman, John H., George E. Hoffer, and Michael D. Pratt (1990). "Current Trends in State and Local Intangibles Taxation," National Tax Journal (December), pp. 439-50. Bradbury, Katherine L. (1988). "Shifting Property Tax Burdens in Massachusetts," New England Economic Review (September/October), pp. 36-48. Break, George F. (1991). "Proposition 13's Tenth Birthday: Occasion for Celebration or Lament?" in Frederich D. Stocker (ed.), Proposition 13: A Ten-Year Retrospective, Cambridge, MA: Lincoln Institute. California Assembly Office of Research (November 1989 and March 1992). Survey. Sacramento.

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California Debt Advisory Commission (various years). Debt Line. Sacramento. California Senate Office of Research (1992). An Overview of the Budget Solution for 1992-93. Sacramento. California State Controller (various years). Annual Reports of Financial Transactions. Sacramento. California State Department of Finance (1991). Economic Report of the Governor. Sacramento. Citrin, Jack (1979). "Do People Want Something For Nothing? Public Opinion on Taxes and Government Spending," National Tax Journal 31 (June supplement), 113-29. (1984). "Introduction: The Legacy of Proposition 13," in T. Schwadron (ed.), California and The American Tax Revolt. Berkeley and Los Angeles: University of California Press. Cox, D. R. (1962). Renewal Theory. New York: Wiley. Davis, Sherry Tvedt (1983). "A Brief History of Proposition 21/2," in Lawrence E. Susskind (ed.) and Jane Fountain Serio (co-ed.), Proposition 2V2: Its Impact on Massachusetts, pp. 3-9. Cambridge, MA.: Oelgeschlager, Gunn & Hain. Dillinger, William (1988). Urban Property Taxation in Developing Countries. Policy, Planning and Research Working Paper Series. Washington, DC: World Bank. Englund, Peter (1985). "Taxation of Capital Gains on Owner-Occupied Homes: Accrual Versus Realization," European Economic Review 27, pp. 311-34. (1986). "Transactions Costs, Capital-Gains Taxes, and Housing Demand," Journal of Urban Economics 20, pp. 274-90. Fischel, William (1989). "Did Serrano Cause Proposition 13?" National Tax Journal (December), pp. 465-74. Giles, Christopher, and Michael Ridge (1993). "Right This Time? An Analysis of the First Year's Council Tax Figures," Commentary No. 37 (April). London: Institute tor Fiscal Studies. Hanushek, Eric, and John Quigley (1979). "The Dynamics of the Housing Market: A Stock Adjustment Model of Housing Consumption," Journal of Urban Economics 6, pp. 90-111. Harmon Oskar, and Michael Potepan (1988). "Housing Adjustment Costs: Their Impact on Mobility and Housing Demand Elasticities," AREUEA Journal 16, pp. 459-75. Henderson, J. V., and Y M. Ioannides (1989). "Dynamic Aspects of Consumer Decisions in Housing Markets." Journal of Urban Economics 26, pp. 212-30. International Association of Assessing Officers (1992). Assessment Administration Practices in the U. S. and Canada. Chicago. Jensen, Jens P. (1935). "Property Tax Limitations," Tax Policy 2, (February) pp. 2-9. Kleine, Robert and Laurie Cummings (1993). "Legislature Votes to Eliminate All Property Taxes for School Operations," State Tax Notes (July 26), pp. 187-88. Ladd, Helen F, and Julie Boatright Wilson (1982). "Why Voters Support Tax Limitations: Evidence from Massachusetts' Proposition 2V2," National Tax Journal 35 (June), pp. 121-148. Legislative Analyst's Office (1993). Focus: Budget 1993: 2, pp. 1-2. Sacramento. Massachusetts Taxpayers Foundation (1993). Local Government Revenue: The Big Squeeze. Boston.

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McCluskey, William J. (1991). Comparative Property Tax Systems. Brookfield, VT: Avebury. Merrill Lynch Pierce Fenner & Smith Inc. (1979). California's Tax Allocation Bonds: Victims of Proposition 13. New York: Merrill Lynch. National Conference of State Legislatures (1992). "State and Local Tax Levels: Fiscal Year 1992" in State Tax Notes (March 30), pp. 435-50. Oakland, William. (1979). "Proposition 13 - Genesis and Consequences," National Tax Journal 32 (June supplement), pp. 387-409. Oates, Wallace, and Robert Schwab (1992). "The Impact of Urban Land Taxation: The Pittsburgh Experience." Cambridge, MA: Lincoln Institute. O'Sullivan, Arthur, Terri Sexton, and Steven Sheffrin (forthcoming). "Property Taxes, Mobility, and Home Ownership." Journal of Urban Economics. Post, Alan (1979). "Effects of Proposition 13 on the State of California," National Tax Journal 32, (June supplement), pp. 381-85. Preston, Anne E., and Casey Ichniowski (1991). "A National Perspective on the Nature and Effects of the Local Property Tax Revolt, 1976-1986," National Tax Journal (June), pp. 123-45. Quigley, John (1987). "Interest Rate Variations, Mortgage Prepayments, and Household Mobility," Review of Economics and Statistics 69, no. 4, pp. 636-43. Quigley, John, and Daniel Weinberg (1977). "The Determinants of Intra-Urban Household Mobility: A Review and Synthesis," International Regional Science Review 2, pp. 41-46. Report of the Senate Commission on Property Tax Equity and Revenue to the California State Senate (1991). Sacramento. Schwadron, Terry, Paul Richter, and Jack Citrin (1984). California and the American Tax Revolt: Proposition 13 Five Years Later. Berkeley and Los Angeles: University of California Press. Senate Committee on Local Government (1987). Property Tax Allocation Summary Report from the Interim Hearing of the Senate Local Government Committee. Sacramento. Sheffrin, Steven M. (1991). "The Anatomy of a Failure: The Poll Tax in the United Kingdom." U. C. Davis Working Paper in Macroeconomics #73. Sheffrin, Steven M., and Lester Thurow (1977). "Estimating the Costs and Benefits of On-the-Job-Training," Economie Appliquee 30, no. 3, pp. 507-19. Smith, Peter (1991). "Lessons from the British Poll Tax Disaster," National Tax Journal 44 (December), pp. 421-36. Steele, Thomas H. (1991). "Proposition 13's 'Change in Ownership': When May Property Be Reassessed Under Article XIIIA of the California Constitution?" Memorandum, September 1, Morrison & Forester, San Francisco. U.S. Bureau of the Census (1982). Census of Governments: Historical Statistics, table 13. Washington, DC: U. S. Government Printing Office. Wassmer, Robert W. (1993). "Property Taxation, Property Base and Property Value: An Empirical Test of the 'New View,'" National Tax Journal 46, pp. 135-60. Weinberg, Daniel (1979). "The Determinants of Intra-Urban Mobility," Regional Science and Urban Economics 9, pp. 219-46.

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Weinberg, Daniel, J. Friedman, and K. Mayo (1981). "Intra-Urban Residential Mobility: The Role of Transactions Costs, Market Imperfections, and Household Disequilibrium," Journal of Urban Economics 9, pp. 332-48. Welch, Ronald B. (1991). "Property Tax Administrative Changes Resulting From Proposition 13," in Frederick D. Stocker (ed.), Proposition 13: A Ten-Year Retrospective, pp. 113-33. Cambridge, MA: Lincoln Institute.

INDEX

Aaron, Henry, 71 Acquisition-value property tax, 11-12, 22, 134 alternatives to, 86-88, 127-32 assessed value under, 55-70, 141 and business mobility, 93 efficiency loss of, 84-88 and Equal Protection Clause, 7-10, 144 home ownership bias under, 88-90 and household mobility, 49-53, 79-85, 9192, 138, 139 low-income homeowners under, 73-77, 92, 138, 140 operation of, 6-7 reform options for, 140-45 revenue projections for, 123 senior citizen homeowners under, 77-79, 92, 138, 140 turnover rate under, 11, 12, 39-54, 121 vs. market-value taxes, 109-15 young households under, 92-93 See also Proposition 13 Ad valorem property tax, 6, 21, 71, 72, 139, 141 Advisory Commission on Intergovernmental Affairs, 33, 34 Age distribution of property, 43, 44, 45-47, 48, 53-54 Agricultural land, 29 Alabama, 17, 25, 33, 36 Alameda County, 60, 61, 63, 67, 73-75, 78, 110 Alaska, 25, 27, 32, 36 Allegheny Pittsburgh v. Webster County, West Virginia, 7-8, 9, 10 Amador Valley v. State Board of Equalization, 1 American Institute of Real Estate Appraisers, 22 Amundsen, Erik, 79 Annual-value-based tax system, 30 Arizona, 22, 25, 27, 32, 33, 34

Arkansas, 25, 34, 36, 37 Assessed value, 22, 26, 30 in acquisition-value system, 55-70, 141 legal inequities in, 38 in market-value system, 55 unintended inequities in, 35, 37 use-value, 29 See also Disparity ratio; Reassessment Australia, 31, 141 Backward age distribution, 148n Bahl, Roy W., 19 Barbados, 31 Base-year distribution of property, 12, 42, 44, 46, 53-54, 58, 64 for modified properties, 62-63 Beaumont, Marion S., 19 Benefit-assessment districts, 105 Blackmun, Justice Harry A., 8-9 Block grants, 99, 101 Brazil, 29 Break, George E, 93 Britain Council Tax in, 5 poll tax in, 4-5, 20, 136-37 rates tax system, 30 Butte County, California, 58, 60, 61 California, 27, 33, 34, 36, 38, 95 assessed value in, 22 budget troubles in, 107-09 city revenue in, 103-04 county revenue in, 102, 103 financing tools in, 105-07 property tax growth in, 137 property tax revenue in, 17, 98 return to market-value system, 109-15, 116-17 revenue transfers to local government, 98-102 school district finances in, 104, 139

155

Index California (continued) special district revenues in, 104-05 tax rate in, 23, 24, 25, 62, 86, 90, 137 See also Acquisition value property tax; Proposition 13 California Department of Finance, 122-23, 148n California Franchise Tax Board, 73 Capital gains, 21, 50, 79, 140 Capital improvements, 71-72 Capitalization process, 90-92 Capital-value tax system, 29-30 Cenzer, Bob, xii Chicago, tax revolt in, 1,2 Chile, 29 Circuit-breaker programs, 27-28, 32 Cities, California funding reductions, 108 under Proposition 13, 104 Citrin, Jack, 96 Classified tax system, 22, 30 Colombia, 31 Colorado, 22, 25, 32, 33, 36 Colusa County, California, 117, 119 Commercial/industrial property tax, 12-13 land and structures, 143 and mobility, 93 for modified vs. unmodified property, 67, 68 and new construction, 37, 142-43 for new vs. existing firms, 141-42 rate, 69 rentals, 142 Community facilities districts (CFDs), 105-06 Comparable-sales approach, to market value estimates, 22-23 Connecticut, 22, 25, 36 Construction, new, 37, 53-54, 142-43 Convolution, 148n Costa Rica, 29 Council Tax, in Britain, 5 Counties, California funding reductions, 108 under Proposition 13, 102, 103, 116 Cumulative-distribution function, of property sales, 42, 43 Decay rate, household, 82, 83, 84, 85, 86, 88 Deferred tax, 29, 87, 88, 122, 129-31, 134, 139, 140-41 Delaware, 22, 25, 36 Denmark, 31 Developing countries infrequent reevaluations in, 31-32 property tax revenue in, 20

156 Disparity ratio, 12, 13, 48, 56, 58-70 median, 57 District of Columbia, 25, 27, 36 Educational finance, and property tax, 3 Englund, Peter, 79 Equal Protection Clause and acquisition-value taxation, 7-10, 144 and school finance, 104 Exempt property, 21-22, 31, 33 Exponential density, 45 Fischel, William, 3 Florida, 10, 22, 25, 34, 36, 144 Franchise Tax Board of California, 13 Friedman, J., 79 Gann limit, 106 Georgia, 21, 25, 36 Gift tax, 21 Government inefficiency, as motive for tax revolts, 3, 4 Government-owned property exemption, 21 Great Depression, tax revolts during, 1-2, 95, 137 Greece, 20 Gross domestic product (GDP), 19, 20 Gross national product (GNP), 16 Hanushek, Eric, 79 Harmon, Oskar, 79 Hawaii, 25, 36 Hazard function, of property sales, 42-43, 45, 50,52 Headlee Amendment, 33 Henderson, J. V., 79 Home ownership decision, 88-90 Homestead exemptions/credits, 26-27', 32 Horizontal equity, 35, 37, 38, 138, 141 Household decay rate, 82, 83, 84, 85, 86, 88 Household mobility, 49-50, 73, 79-84, 91-92 Idaho, 25, 32, 36 Illinois, 25, 33, 36 Income-capitalization approach, to market value estimates, 22, 23 India, 20, 30, 31 Indiana, 25, 32, 33, 36, 95 Indonesia, 29, 30 Inflation rate and mobility costs, 49-50 for property, 39, 40, 59, 139, 140, 141 Intergenerational transmission of property, 141, 143 International Association of Assessing Officers, 33

157

Index Ioannides, Y. M , 79 Iowa, 24, 25, 36 Ireland, 20, 30 Italy, 30 Jamaica, 31 Jensen, Jens P., 95 Kansas, 25, 32, 33, 36 Kentucky, 25 Kenya, 20, 31 Kern County, California, 58, 60, 61, 115 Korea, 31 Land agricultural, 29 commercial, 143 Land-value tax system, 30-31 Leavitt, Loren, 149n Leontief, Wassily, xi-xii Linn, Johannes F, 19 Local government loss of autonomy, 139-40 pre-Proposition 13, 6 property tax revenue of, 2, 15, 17-19, 94 tax limitation impact on, 94-119 Lock-in effect, 49-51, 79, 138 Los Angeles County, 58-59, 60, 61, 62, 6 3 64, 66, 67, 74, 75, 78, 110, 115, 128-31, 134, 143 Louisiana, 17, 22, 24, 25, 32, 34, 36 Low-income homeowners, and tax reform, 73-77, 92, 138, 140 McCluskey, William J., 19 Macy's Inc., 8 Maine, 17, 22, 25, 36 Malaysia, 30, 31 Marin County, California, 115 Market value, 22-23, 37 See also Disparity ratio Market-value system, 55, 56, 122 and home ownership, 88-89 and household mobility, 73, 84-85 and low-income households, 73-77 and revenue gains, 139 revenue projections for, 124-27 and revenue ratios, 109-17 and senior households, 77-79 Maryland, 25, 27, 33, 36, 37 Massachusetts, 36, 37 Proposition 2 Vi in, 1, 3-4, 13, 32, 72, 95-97, 116, 136 tax rate in, 22, 23, 24 Mayo, K., 79

Mello-Roos Community Facilities Act of 1982, 105-06 Mexico, 20, 31 Michigan, 24, 25, 32, 33, 34, 36, 95 Millage rates, 23 Minnesota, 25, 28, 32, 33-34, 36 Mississippi, 25, 36 Missouri, 25, 33, 36 Mixed exponential, 45 Mixed tax system, 31 Mobility business, 93 household, 49-50, 73, 79-84, 91-92, 138, 139 Modified properties commercial/industrial, 66 residential, 56, 62-63 Montana, 24, 25, 27, 28, 33, 35, 36, 37 Mortgage interest rates, and lock-in effect, 50 Multifamily property, 66, 142 Nebraska, 25, 33, 36 Netherlands, 31 Nevada, 25, 32, 36, 37 New Hampshire, 16-17, 25, 36 New Jersey, 22, 24, 25, 27, 32, 34, 36, 143 New Mexico, 25, 36, 95 New York, 22, 25, 27, 36 New Zealand, 31 Nigeria, 30, 31 Nonhomeowner property, 64, 139, 142 Nordlinger, Stephanie, 8, 9-10 Nordlinger v. Hahn, 7, 8-10, 12, 59 North Carolina, 25, 27, 36 North Dakota, 24, 25, 36 Northern Ireland, 31-32 Ohio, 25, 32, 36, 95 Oklahoma, 25, 27, 32, 35, 36, 37, 95 Orange County, California, 115 Oregon, 24, 25, 32, 35, 36 Organization for Economic Cooperation and Development (OECD) countries capital-value systems in, 29-30 property tax revenue of, 19-20 O'Sullivan, Arthur, 86 Owner-occupied single-family residential (OSFR), split roll, 128, 132, 133, 134, 135 Park and Playground Act of 1909, 105 Pennsylvania, 25, 36 Perez, Steve, xii Personal property exemptions, 21-22 tangible/intangible, 21

Index Philippines, 20, 29 Pittsburgh (Pennsylvania), 143 Placer County, California, 58, 59 Poll tax, in Britain, 4-5, 20, 136-37 Portugal, 29 Potepan, Michael, 79 Probability-density function, of property sales, 42, 43, 44 Progressive rates, 31 Property tax ad valorem, 6, 21, 71-72, 86-87 and educational finance, 3 future of, 136-45 inequities in, 15-16, 34-38 legal vs. economic incidence of, 71 as local government revenue source, 2, 15, 17-19 preservation of, 15 pre-tax revolt, 2-3, 4 relief programs, 24, 26-29 revenue growth of, 16-17 structure of, 20-32 unpopularity of, 11, 34 See also Acquisition-value property tax; Market-value system; Proposition 13; Tax reform/revolts Proposition 2 Vi, 1, 3-4, 13, 32, 72, 95-97, 116, 136 Proposition 4, 105 Proposition 13, 1, 16,48 base year distribution of properties, 12, 4 1 42, 58-64 and capitalization process, 90-92 commercial/industrial property under, 67, 68, 69, 93 consequences of, 6-7, 137-40 constitutionality of, xi, 7-10, 108 homeowner vs. nonhomeowner residential property under, 64-66 inequities of, 137-38, 141, 144-45 influence on tax limitation movement, 32, 136 local government impact of, 97-109, 116, 139-40 modified properties under, 56, 62-63, 67, 68 origins of, 2-3 and property value increase, 39 provisions of, 5-6 residential vs. commercial property under, 12-13, 67, 69-70 and statewide property tax, 139 winners and losers from, 13, 73-79, 92 See also Acquisition-value property tax

158 Quigley, John, 50, 52, 79 Real estate tax, 21 Reassessment and base year distribution, 41-42 cycles of, 37 infrequent, 31-32, 37 and intergenerational transmission, 141, 144 Renewal density, of property sales, 43, 44 Renewable theory, and acquisition-value taxation, 11-12,40,41,42-49 Rental property, 66, 89-90, 142 Replacement-cost approach, to market-value estimates, 22, 23 Revenue-neutral tax rate, 126-27, 134, 138 Revenue projections, 123-35, 273 for acquisition-value system, 123 for deferred market-value tax, 129-31 for market-value system, 124-27 for split-roll system, 127-28 for transfer tax, 128-29 Revenue ratio, 49, 107, 117-19 Reynolds, Jeff, xii Rhode Island, 25, 27, 36 Riverside County, California, 115 Sacramento County, California, 60, 61 Sales tax, 108 San Bernardino County, California, 59, 60, 62, 66, 74, 75, 78, 109-10, 115, 117, 118, 128-31, 134, 143 San Francisco County, California, 115 San Mateo County, California, 60, 61, 74, 75, 78 Santa Barbara County, California, 115 Santa Clara method, 57 School districts, California construction finance, 106 equalization, 139 and property tax revenue, 18, 101, 108 under Proposition 13, 104, 139 Second homes, 66 Senior citizen homeowners, and tax reform, 77, 79, 92, 138, 140 Serrano, John, 104 Serrano v. Priest, 104 Sexton, Terri, 86 Sheffrin, Steven, 86 Singapore, 30, 31 Single-family residential (SFR), split roll, 125-28, 132, 133, 134, 135 Site-value tax system, 30-31 Sliding scale approach, to tax relief, 28

Index Sonoma County, California, 60, 61, 63, 143 South Africa, 31 South Carolina, 25, 34, 36 South Dakota, 24, 25, 36 Spain, 20 Special districts, California funding reductions, 108 property tax revenue of, 19, 101 under Proposition 13, 104-05, 116 Spilberg, Phil, xii Split-property roll, 28 Split-roll system, 122, 127-28, 132, 133-34, 135 Spot value, 31 Stevens, Justice John Paul, 10 Sudbury decision, 95-96 Supreme Court, California on acquisition-value taxation, 7-10, 144 on school finance, 3, 104 Supreme Court, U.S., on acquisition-value taxation, 7-10 Survivor function, of property sales, 42, 43, 44, 45, 47, 50-53 Swenson, Jenny, xii Taiwan, 31 Tax assessment. See Assessed value Tax base, 21-23, 30, 35 Tax deferral programs, 29 Tax-increment financing, 107 Tax rates, 23-24, 25, 62, 66, 67, 69-70, 86 caps on, 32, 33, 72 Tax reform/revolts deferred tax, 87-88, 122, 129-31, 134, 140-41 and limitation measures, 32-34, 121, 136 local government impact of, 94-119 options for, 140-45 origins of, 1-5, 136-37 and revenue projections, 121-35

159 split-roll system, 28, 122, 127-28, 132, 133-34, 135 transfer tax, 86-87, 98, 122, 129-30, 134, 138-39, 140 See also Acquisition-value property tax; Proposition 13 Tennessee, 22, 25, 36 Texas, 25, 33, 36 Thailand, 31 Thatcher, Margaret, 4 Thomas, Justice Clarence, 10 Threshold approach, to tax relief, 28 Tisch Amendment, 33 Townships, property tax revenue of, 18-19 Transfer tax, 21, 86-87, 98, 122, 129-30, 134, 138-39, 140 Turkey, 31 Turnover rate, 11, 12, 39-54, 121, 139 Use-value assessment, 29 Utah, 25, 32, 36 Vacation property, 66 Vermont, 17, 25, 36 Vertical equity, 34-35, 38, 138 Virginia, 25, 34, 36 Washington, 25, 32, 36, 95 Wassmer, Robert W., 71 Weinberg, Daniel L., 79 West Virginia, 25, 33, 36, 37, 95 Williamson Act, 110 Wilson, Pete, 107 Wisconsin, 25, 32, 34, 36 Worcester, Ellen, xii Wyoming, 21, 25, 33, 35, 36 Young households, 92-93 Zimbabwe, 29