Thursday, February 24, 2005

Property taxes, interest rates and starve the (local) beast

Most local governments and school districts heavily rely on property taxes to fund a significant portion of their annual budgets. These taxes are directly borne by the owners of land and buildings and the incidence of the taxation is primarily upon the users of land and buildings. (Incidence of taxation means who actually pays the tax, not who is signing the check. For example, part of my rent for my apartment is used to pay local property taxes despite my landlord writing the check.) Governing bodies are faced with the conflict of wanting growing revenues to provide more services and the resistance of property owners from paying higher taxes. It is a natural and good conflict. Now there are a couple of ways of increasing revenue. First is just raise the millage rate, secondly see property values increase, and thirdly, decrease any exemptions or deductions. The first and third are politically extremely dangerous unless there is a wide communal appreciation that the new services are vastly more preferred than saving money. So most governing bodies rely on seeing property values increase.

Now there are a couple of different ways that property values will increase. The first and most preferred is by seeing an actual improvement upon the land. For instance a plot of land that is empty will have a higher value to tax against if someone builds a steel mill on it. Jobs are created, products are created, income streams are created, and everyone is happy as the profit of the new improvement more than covers the increase in taxation. Governments will sometimes intervene and provide subsidies and tax abatements to reap the local benefits of new construction. The Tax Increment Financing incentive is a very common tool in Pennsylvania that seeks to accomplish this very objective. Some new tax revenue is dedicated to infrastructure improvements in order to increase the taxable base of a community. Sometimes it works well, sometimes it fails.

But the more common way for property values to increase is through a general rise in the market to bring up prices of previously improved properties. General market price increases can come through a couple of different angles. The most preferred is that a region is doing something so well that it is an extremely attractive region. It will be attracting new people into the region, retaining a lot of its current residents, and creating a lot of high paying regional exporting jobs to fuel an import replacement cycle of wealth creation. Silicon Valley and the Boston 128 Belt during the late 90s are two good examples of this type of property price pressures as everyone wants a piece of the action, thus bidding the prices of property upwards. However, not everywhere is Boston or Silicon Valley or Lower Manhatten etc. The next option is that some community has greatly improved its school district or restricted new construction or otherwise created a localized semi-monopoly/non-moveable asset that externalizes value that can be captured by property owners.

There are two more common drivers of property price increases. First is basic inflation, as in a boring economy with homogenous price and wage increases, the nominal cost of housing will increase as everyone has nominally more money. This is boring. However there is a second driver that can be politically interesting. Inthe past couple of years as interest rates decrease, the ability of a given level of cash expenditure per month to finance a larger mortage has increased. (The opposite will also be true) Since everyone at the same cash expenditure constraint level can finance the same (larger) mortage, the price of a house increases. Assuming instanteneously property assessments that are accurate, the same millage rate will lead to greatly increased revenue to the taxing body. However this pisses property owners off as they are writing the same size mortage check but are looking at writing larger property tax checks while living in the same house.

The second case is one of the things that I strongly suspect is happening in the Pittsburgh region as the current round of property tax assessments** show valuation increases of 20% for the county as a whole, with significant variations between communities. Signicant increases in tax bills without significant improvements in either the real property or public services are never popular or a good thing for a politician to not do something about. Dan Onorato, the County Executive, has decided to do a couple of things:

Cap assessment increases to 4% or less than the general inflation rate.
Expand the homestead deduction to shield $15,000 to $30,000 in value from school and local taxation.
Eliminate any windfall revenue flows to a taxing body

The second action of doing something against this outrage is purely a sop to the Blue Haired Brigade, so no big deal, politics as normal. However the first and third steps would create, if enacted, a very strong structural and political incentive to deprive local taxing bodies of any ability to maintain a constant level of real income at a given, constant millage rate. If property assessments are not allowed to increase at the inflation rate, much less at the market rate, the take of the real local domestic product will over time decrease. The same logic that applies to the debate over wage v. price indexing for Social Security applies here. Secondly, if a taxing body is not able to collect any windfall tax increases due to general market conditions, the only way to increases revenues for other needed services is through millage increases. This is politically dangerous and provides a very strong incentive to underspend, to undermaintain infrastructure and not to make investments into the future. I am curious as to why these restrictions are desired by Onorato, who is not a soulmate of Grover Norquist, but instead a typical SW PA Democrat.

** Yes, I know, the assessments have a good chance of being systemically high, but let's take this for argument that there is a significant interest rate driven general price increase due to the reallocation of cash flow within refinanced and recently financed mortages.

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