The Case for Property Tax Reform
Detroit and Beverly Hills; Also: California Exodus?
On Tuesday, Bloomberg published an excellent piece investigating whether property taxes, as implemented in America, are racist. It follows the story of a woman who buys a home in Detroit in 2005, misses property tax payments after losing her job in 2011, has the property seized as a result, and now currently rents it:
Owning a home gave her three children the kind of stability she’d never known herself, and the house became home base for her family and friends. Her best friend helped scrub soot off the foyer’s marble tile. Her sister hung curtains in the living room. “For me, it’s not just a piece of property,” Scott says. “It’s where life has existed.”
Then, in 2011, she lost her job during the Great Recession and missed her annual tax payment, for $3,120.
Her house, which she’d bought in 2005 for $63,800, was auctioned off by the county and snapped up by an investment company for less than $5,000. Scott lost every cent she’d put into it.
The article is worth reading in its entirety. It shows how assessors systematically inflate the assessed value of low-value houses, and thus overcharge low-income homeowners. It finds that the woman had already been overcharged in past years by an amount greater than the taxes owed when her property was seized. The piece is heavily based on this excellent paper by Christopher Berry of the University of Chicago, showing similar patterns across the country.
The Bloomberg article tells a story of inflated assessments, which while illegal, are somehow only part of the story. The woman profiled in the story was paying $3,120 per year on a house she originally purchased for $63,800, an annual tax rate of nearly 5%! Even if her assessments had been correct the entire time she owned it, that would be extraordinarily high. And in fact her assessments were not correct - the article states that the home sold at auction for $4,630 in 2013, meaning her effective tax rate at the time was actually 67%!
Five percent sounds like a small enough number, but as a wealth tax, is outrageously high and punitive. When Elizabeth Warren proposed a 2% annual wealth tax on assets over $50 million the other day, commentators came out of the woodwork to point out how high that really is. In many regions, a 5% property tax would be enough to wipe out all of the rental income from a property, and then some.
In my home state of Washington, the state constitution mandates a maximum property tax rate of 1%. This study shows that most states have an average tax rate near or below 1%, though some states, like Texas and New Jersey, are closer to 2%.
Property taxes are set through a complex web of rules and tax districts. In California, we have Prop 13, which also mandates a 1% tax rate but also mostly freezes taxes at the time a property last changed hands. Here is a random $4.1 million home in Beverly Hills which Zillow tells us had a property tax bill of $4,130 in 2020, for an effective tax rate of 0.1%. This house has almost the same annual tax as the house in Detroit, but a much different effective tax rate.
This example is definitely on the low end but probably not exceptional: Trulia estimates the average effective property tax rate in Beverly Hills is 0.53%. Since Prop 13 sets the standard tax rate at 1%, there must be a lot of homes like this one with very low effective tax rates to pull the average all the way down to 0.53%.
So, what is going on in America that a $4,000 house in Detroit and a $4 million house in Beverly Hills can have the approximately the same annual property tax bill? And how is this legal?
In America, local municipalities are responsible for providing many of our basic services - police, fire, water, sewer, parks, roads, schools. Local governments (cities and counties) receive some funding from the federal and state government, but mostly they have to raise money on their own.
Traditionally, local governments in the US rely on property taxes for funding. One big advantage is that property taxes are not volatile, which is important when you rely on them to pay salaries. Also, in theory, property taxes should be at least somewhat fair and progressive - people with expensive houses will pay more.
One possible explanation for the gap in tax rates is that the cost to provide basic services is about the same per capita, no matter how rich or how poor the municipality. Generally, that means that less wealthy cities and counties should need a higher tax rate to provide basic services. This is even more pronounced in a city like Detroit which has to pay health benefits for employees from when it was a larger city, and has to provide services such as fire coverage even in areas with abandoned buildings.
Detroit’s population collapsed from 1.8 million in 1950 to 700,000 in 2010; aggregate property values fell from $45 billion to $10 billion, adjusted for inflation. Detroit had a median household income of $30,894 in 2019, less than half of the US median household income of $68,703. (The median household income in Beverly Hills is $106,936.)
Detroit today has a very high official property tax rate of 7% (although in practice it is less for most homeowners), a personal income tax rate of 2.4% (most cities have none), and revenue from its casinos. By contrast, Beverly Hills has an official property tax rate of 1% (in practice much less), and no casinos or city personal income tax.
There is an additional explanation, the one implied in Christopher Berry’s paper, which is that wealthy households have much more political power. They vote for ballot measures like Prop 13 that limit their taxes, and they place pressure on assessors to lower their assessments. As a result, wealthy households end up paying a much lower effective tax rate.
One can imagine a tax regime where real estate is taxed in the same way as any other business, where the income produced from the business is partially taxed at a standard rate, and partially taxed at a rate determined by the owner’s income tax bracket. This way, rich people would pay more, and everyone else would pay less.
Owner-occupied real estate works in almost exactly the opposite way. Imputed rental income is completely tax-exempt, which is great for wealthy homeowners in high tax brackets, but does much less for other homeowners. Then you have property tax, which is a separate wealth tax on real estate, but the rates paid by wealthy homeowners are very low, and the rates paid by everyone else are very high. In theory, property tax is a wealth tax, but in practice, it looks suspiciously like a poll tax - where everyone pays the same amount regardless of means.
America as a whole is not particularly reliant on property taxes; all property taxes, business and residential, account for only 12% of all taxes collected in this country. It would seem like the simplest thing in the world to reform property taxes to be more progressive. We could enact a rule that exempted the first $150,000 of property value from property tax, and set a maximum tax rate, and limit exemptions to senior citizens and veterans. Any loss in tax revenue from reform would be small and easily made up from other sources.
Our current system seems to run counter to our national goals. High property taxes lower the value of a property, so high property taxes on low income housing destroy the wealth of low income households and discourage the construction of low income housing.
The fix is simple. So why haven’t we done it?
The main obstacle, in my view, is the idea of local control. It is not the federal government that imposes property taxes - in fact they do the opposite, and grant major tax exemptions on property - but local governments who need a steady source of income. If this country was to move to a progressive tax system to fund local government, it would have to be through federal funding to states and cities. The federal government is the only entity that can redistribute money efficiently, and the only entity that can borrow cheaply to pay the bills in difficult times.
It is not clear how much support there would be for major reform of that nature. Once the federal government is funding state and local governments, they will naturally want to exert control over how the money is spent. (This week’s Covid relief bill, which provided $350 billion to cities and states, is perhaps evidence in the opposite direction.) One can imagine a lot of local interests being uncomfortable with the idea of ceding control to Washington, DC.
Still, the status quo seems much worse. The system where local governments make their own spending and taxation and regulatory decisions sounds great in theory - they can be more responsive to their constituents! - but seems to be at the root of most of the issues around housing today.
Local governments inevitably discover that the best way to be responsive to their constituents is by pursuing beggar-thy-neighbor policies to lower their own taxes and raise their own property values while pushing their problems to other cities and states. We see this everywhere in local government - in zoning laws that prohibit new housing, property tax regimes that favor the rich, and one-way bus tickets for the homeless.
Anyone who watches sports knows that coaches will often come up with strategic innovations that will help their team win, but threaten to destroy the game from the inside; for example, stalling and refusing to play once they have the lead. It is up to the rulemakers to preserve the game and counteract this by imposing rules such as the 24-second clock. Perhaps the only way to stop this particular race to the bottom is for the federal government to step in and play referee.
Here is a story that was picked up by the AP last weekend, stating that there was no exodus from California in 2020, as previously feared [Source]:
Most moves during 2020 happened within the state, the California Policy Lab said Thursday.
Departures from the state were consistent with historical patterns, but the biggest statewide change was that fewer people moved into California, the group said in a statement.
The lab’s researchers used a dataset of quarterly credit bureau information called the University of California Consumer Credit Panel to analyze where people from each California county moved after the coronavirus pandemic struck a year ago.
“While a mass exodus from California clearly didn’t happen in 2020, the pandemic did change some historical patterns, for example, fewer people moved into the state to replace those who left,” author Natalie Holmes said.
Setting aside the suspect methodology - presumably people don’t report moves to their credit card company as promptly as they used to, now that everything is online - this is a fairly believable and mundane finding. Even if demand to live in California plummets, we shouldn’t expect the number of residents to change much at all!
Here’s why. Generally, landlords and homeowners want to keep their properties occupied. It is fairly expensive to carry a property and leave it unused, earning zero rent.
That means that in practice, if there is a reduction in demand to live in a given city, the population will stay constant, while rents decline. Landlords will slash rents to keep a building occupied, as it is preferable to earning nothing.
This is a bit of an oversimplification, of course, particularly in the short term. There are other considerations at play - for example, leasing out a property is a long term commitment, particularly in a city with rent control, so it can be beneficial to keep a property empty for a bit while seeking the ideal tenant.
Also, high rents encourage people to cohabitate, increasing the number of residents per unit slightly during a boom and decreasing the population slightly during a bust.
Still, all things being equal, one expects population to track housing supply fairly steadily through booms and busts, while housing prices fluctuate significantly to balance supply and demand. When demand falls, landlords cut rents to get people to stay or attract replacement residents, and when demand rises, landlords raise rents to force people to consider moving to make way for wealthier residents.
You can see this if you chart San Francisco population against San Francisco housing prices:
The population of San Francisco has been almost unchanged for 35 years - in fact it is not much higher today than it was in 1950. The big difference is housing prices; the Case-Shiller index attempts to map the price of similar houses over time. Housing prices in San Francisco have gone up over 6x since 1987, adjusted for inflation! You can clearly see the booms and busts. (This would have been more accurate with a good rental index, but this is what is easily available.)
People have a mental model that lower demand means lower quantity consumed, which is usually true - if people drive less, they consume less gas. However, that’s not how housing works: once you build housing, it’s there permanently, and you have to try to fill it in good times and in bad.
There is also the effect of anecdotal evidence. Particularly in superstar cities, people move in after graduating from college, to be around other young people and to gain work experience not easily obtained anywhere else. As Joan Didion wrote in her famous essay about 1950s New York, “It is often said that New York is a city for only the very rich or the very poor...but at least for those of us who came here from somewhere else, [New York] is a city for only the very young.”
As young professionals get married and get older, they face diminishing returns from additional work experience and the youthful social scene, so they leave for cheaper locales and are replaced by a new generation of graduates. As they see their peers leave, they sometimes attribute this to the perceived decline of the city, rather than a natural cycle that has gone on for decades.
Here is the same chart for Atlanta, a city that has actually built housing:
The 60% increase in population in only 30 years is a fairly big gain for a large city, but has been fairly steady throughout. (Note that the apparent dip in population in 2010 is apparently a statistical anomaly in the census data related to the census that year, rather than an actual decline.)
To be clear, you would expect to see a significant decline in population in economically distressed areas such as the Detroit example we saw previously - but at that point, you start to have abandoned buildings, and real estate prices are very low.
This implies that any shift to remote work would show up mostly in rents, not in a reduction in the number of people living in cities. Landlords will lower prices until enough companies and workers are willing to stay to keep buildings full.