Advanced Seminar Policy and Administration
Advanced Seminar Policy and Administration PPA 810
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7 Property Tax Capitalization and Public Policy Many types of public policy alter relative property tax burdens Assessment reform for example redistributes property tax burdens among the house holds within a jurisdiction State intergovernmental grants induce cities to spend more on public services but to some degree they also allow cities to cut their property tax ratesl Moreover some state aid programs are directed toward cities with low property tax bases and therefore allow those cities to cut their property taxes more than other cities With capitalization these changes in relative property taxes lead to changes in house values that is to capital gains and losses for current home owners These potential capital gains and losses reveal the importance of capitalization for an evaluation of policies that affect property taxes With out capitalization and hence without capital gains and losses these policies only affect future residents households are affected by the propertytax changes only if they stay in or move to the jurisdiction But with complete capitalization residents at the time the policy is implemented bear the full burden of any change in the future stream of property taxes on their houses in the form of a capital gain or loss regardless of whether they stay in the jurisdiction or move out of it In this chapter we consider various aspects of capitalization and public policy We begin by providing a detailed interpretation of our results and by exploring why capitalization is less than 100 and why it varies across 123 124 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY communities We then turn to speci c public policy issues We examine the problem capitalization poses for an assessor immediately after a revaluation and we measure the distribution of capital gains and losses caused by revalu ation We analyze the consequences of capitalization for economic ef ciency and the fairness of the property tax as measured by its horizontal and vertical equity Our discussion is limited to the case of owneroccupied housing we do not consider for example the implications of capitalization for the incidence of the property tax on rental housing or on commercial property 1 INTERPRETATION OF CAPITALIZATION ESTIMATES Our main result is that about 15 to 30 of the change in property taxes caused by communitywide revaluation is capitalized into house values As summarized in Table 71 the estimated degree of capitalization varies by community In Waltham for which we have the best data our estimate is 21 In Brockton with good data the estimate is 16 and in Barnstable with neighborhood controls only the estimate is 33 All of these estimates are signi cantly larger than zero and signi cantly smaller than 100 at a high level of con dence The remaining four communities do not have adequate control vari ables but by adding the average effect of controls in Waltham Brockton and Barnstable we obtain corrected estimates of the degree of capitaliza tion in these communities These estimates are 9 in Arlington 12 in Wellesley 46 in Brookline and 79 in Belmont 11 Why Is the Degree of Capitalization Less than 100 The rst question to ask in interpreting these results is why is the degree of capitalization less than 100 In our judgement the main reason appears to be that households do not expect prerevaluation tax differences to persist even before revaluation is announced We have no direct evidence to sup port this conclusion so far as we know no one has conducted a survey of homeowner expectations about revaluation Nevertheless the case histories of revaluation in Waltham and Brockton which were presented in Chapter 4 make it clear that revaluation was discussed and indeed debated vigorously for several years before it was actually implemented People in those communities knew that revaluation was likely to occur in the nottoo distant future Moreover in three of the seven communities including the two with the best data anticipated tax changes had a signi cant effect on house values in the period just before revaluation2 In Waltham we nd an L INTERPRETATION OF CAPITALIZATION ESTIMATES 125 anticipation effect in both the year before revaluation is announced and luring the period between announcement and enactment of revaluation We also find an anticipation effect in Belmont during the period between announcement and enactment and in Brockton in the year before an nouncement3 As explained in Chapter 3 the expectation that revaluation will occur in the near future can lead to a degree of capitalization well below 100 Using Equation 31 5 we show that if current tax differences are expected to persist for only 10 years the degree of capitalization for those tax differences will be only 26 This exercise suggests that the degree of capitalization may vary across communities because expectations about the likely persistence of tax differentials varies In communities with active assessors and a political climate that favors revaluation house buyers may expect revaluation to take place in just a few years whereas in communities with a history of in exible assessments and hostility to revaluation house buyers may expect revalua ion to be postponed inde nitely Let us assume for the moment that expectations are the only source of variation in tax capitalization rates On the basis of this assumption we can use Equation 3 1 5 to calculate what our estimated capitalization rates imply about house buyers expectations for the persistence of tax differen tials4 The results of this exercise for our seven sample communities are reported in Table 71 The range in the implied expected persistence of tax differentials is from 3 years in Arlington to 54 years in Belmont Belmont is an outlier however as the other six communities fall between 3 and 21 years The actual average time between an observed rst sale and revaluation was about 2 years in Bamstable and Brockton where we have no data before 1969 and between 3 and 5 years in the other ve communities Given this actual timing and the active debate over revaluation in most communities these expectations strike us as plausible but we cannot directly test the extent to which expectations are at work5 Several authors including Goodman 1983 have argued that if tax differences are not expected to persist then one should use a high discount rate in calculating the degree of tax capitalization This argument is formally correct but it changes the meaning of capitalization0ur approach focuses on the capitalization of current tax differences this alternative approach focuses on the capitalization of the expected future stream of taxes Without imperfect information or high search costs the statement that current taxes are not fully capitalized because they are not expected to persist is equivalent to the statement that the expected future stream of taxes is fully capitalized If one estimates the degree to which current taxes are capitalized but wants to calculate the degree to which the expected future stream is capitalized then 126 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY Table 7l Estimated Capitalization and Implied Expectations Estimated Implied Expected Degree of Persistence of Capitalization Tax Differences Community in percent in years With Complete Data 39 Waltham 21 8 Brockton 16 6 With Neighborhood Controls Only Bamstable 33 14 Without Housing and Neighborhood Controlsh Arlington 9 3 Belmont 79 54 Brookline 46 2 Wellesley 12 4 Calculated with the formula in footnote 4 I 397 Estimates of capitalization equal the nonlinear twostage least squares estimates in Table 61 corrected for the average effect of controls as observed in Waltham Brockton and Barnstable one should use a real discount rate adjusted in the manner described by Equation 34 for the expected persistence of tax differences6 Although this translation between the two meanings of capitalization is always possible all the research on capitalization including our study focuses on the capitalization of current tax differences which can be ob served instead of on the capitalization of differences in expected tax streams which cannot Nevertheless the important issue for some policy questions is whether the expected stream of taxes is fully capitalized not whether current taxes are fully capitalized We believe it is important therefore to keep in mind the distinction between these two meanings of capitalization Although the implied expectations in Table 71 are plausible they do not constitute a formal test of the hypothesis that expectations cause incom plete capitalization of current tax differences and they do not rule out the possibility that imperfect information and high search costs are also at work Indeed one would expect these other effects to appear in Massachusetts where effective property tax rates varied widely before revaluation largely because of assessment errors Within a community a tax difference cannot be fully capitalized unless house seekers know the town average tax rate as well as the rate on the houses for which they are bidding Assessment errors make it more dif cult to infer the townWide effective tax rate from the 1 INTERPRETATION OF CAPITALIZATION ESTIMATES 127 observed tax payments on the few houses that are for sale at a given time and make it more expensive for a house seeker to nd a comparable house with a lower tax rate By undercutting the quality of available information and raising search costs these errors could lead to incomplete property tax capi talization7 Some of our results in Chapter 6 support this conclusion In Waltham for example we nd that the rate of tax capitalization is signi cantly higher after revaluation than before revaluation which is con sistent with the hypothesis that all the publicity surrounding revaluation improved the quality of the information available to house seekers Infor mation appears to play a different role in Barnstable where the degree of capitalization is higher for a house s actual effective tax rate than for the town average effective tax rate Bamstable contains several villages with different tax rates so this result is consistent with the view that house seekers are aware of the rate in their village but have imperfect information about the average rate in the town as a whole 12 Why Does the Degree of Capitalization Vary Across Communities To further understand the sources of variation in the degree of capitalization across communities we examined the correlation between the degree of capitalization and various community characteristics Expectations are likely to be related to the prerevaluation tax situation Imperfect informa tion and high search costs are likely to be related to community characteris tics that affect the housing market We nd that the degree of capitalization is signi cantly related to a community s prerevaluation effective property tax rate population density percentage of old housing and median household income In particular the degree of capitalization is signi cantly higher in communities with a lower prerevaluation tax rate a lower population den sity more new housing and a lower median household income8 Our interpretation of these results is as follows A high property tax rate makes people more aware of property tax differences and increases the pressure for assessment reform9 All else equal therefore people in commu nities with high tax rates expect revaluation to occur sooner than people in communities with low tax rates In addition factors that add to the com plexity of the housing market make it more dif cult for house seekers to gather accurate information about the relative value of different houses If no two houses are alike for example a house buyer will have a hard time determining whether the tax payment on one house is higher or lower relative to its market value than the tax payment on another house Com munities with very high incomes have more types and styles of housing to 128 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY choose from A high population density which is associated with locations near urban centers signals that owneroccupied housing is located in a variety of different settings some next to commerical areas and some mixed with highrise apartments that are dif cult for house seekers to evaluate Finally a high concentration of new housing indicates a changing housing market in which it is di icult to collect accurate and uptodate informa tion House buyers may be uncertain for example about future building in a newer neighborhood and hence about future neighborhood quality In ad dition before revaluation new houses tend to be taxed at a higher e 39ective rate than old houses and builders may not be able to make a pro t at a price that fully capitalizes this relatively high tax rate Because of high search costs buyers may be willing to pay what builders asklo Thus high population density high median income and extensive new housing measure aspects of housing market complexity Most of our sample communities had prerevaluation effective tax rates near 28 however Bamstable and Belmont had tax rates about one percentage point lower and Brockton had a rate almost twice this high In addition the housing market appears to be relatively complex in Arlington Bamstable and Wellesley and relatively simple in Belmont and Brockton The sources of housing market complexity vary across communities how ever In Arlington the complexity is due to an extremely high population density Wellesley and Bamstable on the other hand have relatively low population densities but nevertheless have complex housing markets Bam stable because of its high percentage of new housing units and Wellesley because of its very high income The housing market is simple in Belmont because of a relatively old housing stock and in Brockton because 39of a relatively low household income According to our interpretation both a high prerevaluation tax rate and a complex housing market will be associated with a low degree of capitalization Thus Belmont has a high degree of capitalization because it has both a low prerevaluation tax rate and a simple housing market Arling ton and Wellesley have low capitalization because they have complex hous ing markets combined with an average prerevaluation tax rate Brookline and Waltham have average capitalization because they have average hous ingmarket complexity and average tax rates O setting forces are at work in Bamstable and Brockton Bamstable has a complex housing market which drives the degree of capitalization down but the lowest prerevaluation tax rate rate which keeps capitalization high Brockton has a simple housing market which keeps capitalization high and the highest prerevaluation tax rate which drives capitalization down In both cases the taxrate effect is somewhat stronger so the degree of capitalization is somewhat below aver age in Brockton and somewhat above average in Bamstable 1 INTERPRETATION OF CAPITALIZATION ESTIMATES 129 Overall we present evidence from a variety of sources to support the conclusion that household expectations about the persistence of tax differ ences imperfect information about relative tax rates and high housing search costs all in uence the degree of tax capitalization We discover that tax changes are anticipated in the period just before revaluation We observe that our estimates of capitalization have reasonable implications for house holds expectations about the persistence of tax differentials and indeed that these implied expectations are consistent with the actual timing of revalua tion in most communities We nd that the degree of capitalization is differ ent before and after revaluation in Waltham and Brockton and higher for the actual than for the townaverage effective tax rate in Bamstable and show how these differences could arise from changes in expectations or imperfect information Finally we discover that the degree of capitalization is corre lated with one likely source of household expectations the prerevaluation effective tax rate and with community characteristics that are likely to in uence the quality of information about relative tax rates and the magni tude of housing search costs Taken individually these results are not convincing The regressions to explain the degree of capitalization for example are based on only 7 observations But taken as a package we believe that this evidence provides strong support for the position that capitalization varies from one set of circumstances to another Unfortunately we cannot de nitively separate the role of expectations from the role of information and search costs This separation will prove to be important for the policy issues discussed in the rest of this chapter Our tentative conclusion based on all this evidence is that in our sample capitalization is far below 100 primarily because house holds do not expect current tax differences to persist but the precise degree of capitalization varies from one community to another because household expectations information quality and search costs all are in uenced by community characteristics 13 Modeling the Degree of Property Tax Capitalization Most of the empirical literature on property tax capitalization has attempted to estimate the degree of capitalization assumed to be the same under all circumstances We believe this assumption is inappropriate Even in our study which examines the capitalization of tax changes from a common source in relatively similar communities variation in household expecta tions information and search costs appears to in uence the degree to which current taxes are capitalized into house values We hope that the focus of future research will be to determine how the degree of capitalization varies from one set of circumstances to another by carefully modeling the sources 130 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY of variation or change in property taxes the formation of households expec tations and the role of housing market characteristics Proposition 13 in California for example provides an excellent con trast to the situation in Massachusetts Under the rules of this Proposition a house s assessed value equals its market values at the time of sale but then increases only 2 per year until the next sale12 This clear legal rule de nes households expectations Everyone knows that their effective property tax rate will decline over time so that current taxes will not be fully capitalized into house values The only variable factor is how long a household expects to stay in the house it wants to buy the longer the household expects to stay the longer the decline in effective tax rate will persist and the lower the degree to which current taxes will be capitalized With accurate assess ments at the point of sale imperfect information and high search costs should not matter buyers know that the property tax situation is the same for any house they buy As a result one should be able to estimate the degree of intrajurisdictional tax capitalization in California as a function of a house hold s expected mobility or of household characteristics associated with mobility The importance of circumstances also suggests that interjurisdic tional and intrajurisdictional differences in property taxes may be capital ized at different rates Taxes vary across jurisdictions because of systematic differences in tax bases and spending levels Because the sources of this variation are systematic households can obtain information about it more easily than about assessment errors It follows that imperfect information is not likely to have a large effect on the degree of interjurisdictional property tax capitalization Furthermore except under special circumstances such as an announced intention to change spending or the likelihood of extensive grth in industrial property in a community current taxes are the best forecast of future taxes in a community so expectations are unlikely to lower the degree to which current differences in taxes across communities are capitalized into house values The role of search costs could work the other way To be speci c certain types of housing may be clustered in one or two communities In this case households may be willing to buy housing in a hightax jurisdiction without a break in the market price because it would be costly for them to nd comparable housing in a lowtax jurisdiction Hence a high correlation between community and housing type could lead to a lower degree of capi talization for tax differences across communities than for tax differences within communities Further research is needed to determine which of these factors has the strongest impact on the degree of interjurisdictional property tax capitalization 3 CAPITALIZA I ION AND ECONOMIC EFFICIENCY 131 2 THE ASSESSOR S PROBLEM We now turn to questions of public policy The rst question is a very practical one how should an assessor determine assessed values in the period immediately after a revaluation In the following sections we examine the implications of tax capitalization for the equity and ef ciency of the property tax Given a large change in relative tax rates as with revaluation the assessor faces a dif cult shortrun problem His job is to estimate the market prices of all the houses in his community on the basis of a sample of houses that actually sold At the time of revaluation he has observed sales prices from the prerevaluation regime but must assess that is estimate sales prices for the postrevaluation regime To carry out this step he must know a house s pre and postrevaluation effective property tax rates and then use the analysis described earlier in this book as summarized by Equation 51 to calculate the real percentage change in the house s value An exact calculation is dif cult because it requires knowledge about the secondsale effective tax rate which depends on the secondsale house value that the assessor is trying to predict If revaluation is reasonably accu rate however the secondsale tax rate will be approximately the same for all houses in the community and it will drop out of the calculation and the assessor can use a much simpler approach which is described by Equation 59 This equation indicates that the real percentage increase in a house s value equals the di erence between the house s prerevaluation effective tax rate and the townwide average effective tax rate on singlefamily houses multiplied by the degree of capitalization and divided by the real interest ratequot Suppose for example that the real interest rate is 3 and that current taxes are capitalized at a rate of 20 Then if the prerevaluation effective tax rate is 2 percentage points above the average the real change in house value will be 020203 133 in other words the house in this example will experience a 13 real capital gain because of revaluation 3 CAPITALIZATION AND THE ECONOMIC EFFICIENCY OF THE PROPERTY TAX Many scholars including Oates 1972 have argued that the property tax iistorts the housing market As long as assessments are related to market Ialues the property tax alters the gross price ie the market price plus the ax a household must pay to buy a house The logic is analogous to the 39tandard case of a sales tax because households respond to the price of 132 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY housing including the property tax the property tax introduces a wedge between the price to which the households respond and the resource cost of housing Because of this tax wedge households consume less than the ef cient amount of housing The argument becomes more complicated in a secondbest world with taxes on other commodities Following the usual rule the tax rate on housing should be higher than the tax rate on other goods only to the extent that the price elasticity of demand for housing is lower in absolute value than the price elasticity of other goods 6 In fact however the property tax unlike most other taxes is levied against an asset instead of against an annual ow A t percent property tax applied to house value is equivalent to a t r percent tax applied to the annual value of housing services where r is the real discount rate With a real discount rate of 3 for example a 2 property tax rate is equivalent to a 67 tax on housing services It follows that property taxes are likely to be far higher than called for by any secondbest tax rule 7 31 The Ef ciency Consequences of Assessment Errors The existence of capitalization fundamentally alters these arguments be cause the market price of housing re ects the property tax Consider rst the case of assessment errors These errors lead to inef ciency if they alter hous ing consumption decisions at the margin Consider two houses that are identical except that because of an assessment error one of them has a higher tax payment If the market price of each house fully re ects the present value of its relative tax payment then they will be equally attractive to a household Even though one house has a higher tax payment in other words full capitalization insures that the asset price plus the present value of the tax payment is the same for both houses With full capitalization therefore assessment errors do not in uence housing consumption and therefore do not cause any inef ciency This argument applies to the capitalization of the expected stream of tax differences not to the capitalization of current tax differences If tax differences last only 10 years then the present value of the stream of tax differences equals only 26 of the present value of current tax differences strung out forever 9 In this case full capitalization of current tax differences would overcompensate people who buy houses with high tax rates and distort their housing choices Consider for example two identical house holds shopping for housing Suppose only one of these households buys a house with a favorable assessment error With full capitalization of this error this household will pay less than the other household for housing and prop erty taxes and will therefore consume more housing 3 CAPITALIZATION AND ECONOMIC EFFICIENCY 133 A similar distortion arises if poor information or high search costs leads to incomplete capitalization In this case a household that purchases a house with an unfavorable assessment error will pay more for housing and taxes than an otherwise identical household that purchases a house with a favorable assessment error Thus the first household will consume less hous mg With incomplete tax capitalization therefore the extent of ine i ciency in the housing market caused by assessment errors depends on the source of the incomplete capitalization If the source is the expectation that current tax differences will not persist then assessment errors cause no inefficiency If on the other hand the source is imperfect information or high search costs then assessment errors do distort housing consumption decisions to some degree On the basis of our conclusion that expectations are the principal source of incomplete capitalization we conclude that as sessment errors did not cause serious distortion of the housing market in Massachusetts 32 The Ef ciency Consequences of Interjurisdictional Tax Rate Differences Capitalization also alters the ef ciency consequences of interjurisdictional property tax rate differences20 To examine these consequences let us as sume for convenience that current tax rate differences are expected to persist for a long time21 The annual gross price of housing equals the annual market price of housing plus the annual property tax payment per unit of housing services Capitalization implies however that the market price of housing re ects the property tax payment With full capitalization a 1 increase in the present value of property tax payments per unit of housing leads to a 1 decrease in the market price per unit of housing so the gross price of housing is the same regardless of the property tax rate With no capitalization on the other hand the gross price varies with the property tax payment people with higher payments face higher gross prices and consume less housing This argument is incomplete however because it ignores the fact that only relative differences in tax rates are capitalized The conceptual frame work developed in Chapter 3 indicates that houses with aboveaverage tax rate increases due to revaluation will experience declines in value relative to the average house in the jurisdiction Applying the same logic to interjuris dictional tax differences leads to the conclusion that all else equal the higher the tax rate in a town the lower the average property value in the town This framework says nothing about the overall level of housing prices Strictly speaking therefore we have established that complete capitalization elimi nates the housingmarket inef ciency caused by variation in property taxes 134 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY but we have not established that complete capitalization eliminates inef ciency caused by the overall level of property taxes in a metropolitan area An analysis of the link between the level of property taxes and hous ingmarket inef ciency is provided by Yinger 1985 This analysis com bines two approaches to housingprice determination According to the standard model of urban structure the housing market expands outward in an urban area until its price equals the opportunity cost of taking the re quired resources out of some other activity say agriculture According to the standard assetpricing model however the price of a house also must equal the rental value of housing adjusted for property taxes or according to Equation 34 the beforetax annual rental value of housing divided by the sum of the discount rate and the effective property tax rate In combination these two approaches imply that in a community at the outer edge of the metropolitan area the opportunity cost of housing must equal the beforetax rental value of housing divided by the sum of the discount rate and the property tax rate Equivalently the beforetax rental value of housing must equal the opportunity cost of housing multiplied by the sum of the discount and tax rates Although this analysis applies to one reference jurisdiction at the outer edge of the urban area a competitive housing market insures that the beforetax rental value of housing will be the same in all other jurisdic tions In other words the beforetax rental value of housing throughout the urban area re ects the effective property tax rate in the reference jurisdic tion The higher this reference tax rate the higher the gross price of housing and the greater the distortion in the housing market In short full capitalization of the expected stream of tax differences eliminates all distortion from variation in the property tax rate across houses within a jurisdiction or across jurisdictions But it does not eliminate distor tion from the property tax altogether Even with full capitalization the property tax rate in the reference jurisdiction affects the beforetax price of housing services and therefore introduces a tax wedge into the housing market With lessthancomplete capitalization some additional distortion arises from variation in the property tax rate Differences in public service quality may also be capitalized Al though full capitalization eliminates distortion from variation in the prop erty tax it does not eliminate distortion from variation in public service quality With complete capitalization of public services the beforetax price of housing re ects service quality not just the resource cost of providing housing and the reference property tax rate Household decisions do not satisfy the relevant ef ciency conditions because the price of housing is too high in jurisdictions with relatively high service quality and too low in jurisdictions with relatively low service quality For a detailed discussion of this issue see Yinger 1985 4 CAPITALIZATION AND HORIZONTAL EQUITY 135 4 CAPITALIZATION AND THE HORIZONTAL EQUITY OF THE PROPERTY TAX Several authors including Hamilton 1976a have argued that capitaliza tion guarantees horizontal equity the equal treatment of people in the same circumstances for the property tax With full capitalization all vari ation in taxes is re ected in prices so nobody gains from purchasing a house with l0w taxes For a house with given structural and neighborhood charac teristics in other words everyone pays the same gross price Tax equity depends on the nal burden of a tax not on the tax actually paid to the g0vernment With capitalization the burden of the tax as measured by the gross price is the same for all house purchasers Note that the relevant concept here is the capitalization of expected tax streams not of current taxes horizontal equity is achieved if people are fully compensated in the form of lower house values for the present value of the property taxes they expect to pay22 41 The Horizontal Equity of Tax Rate Changes As Aaron 1975 and Feldstein 1976 make clear however this argument does not apply to changes in effective property tax rates According to F eld stein tax changes are a source of horizontal inequity because individuals make commitments based on the existing tax law Commitments in volving property may easily be reversed but the sale of assets will involve a capital loss Individuals who were equally well off before the tax change are not equally well off after the change p 95 96 Thus capitalization insures that all new buyers are on the same footing but it also insures that current owners bear the full burden of any unanticipated changes in future property taxes When assessment quality deteriorates for example or when past assessment errors are corrected some owners receive property tax cuts and others receive property tax increases As long as these tax changes were not anticipated each current owner experi ences a capital gain or loss equal to the present value of the change in her stream of property taxes This outcome violates the principle of horizontal equity With complete capitalization unanticipated property tax changes have the same impact on a homeowner regardless of whether she sells her house and thereby realizes the capital gain or loss on it or stays in her house and thereby pays the new property tax stream In other words capitalization eliminates the option of moving to avoid paying an unanticipated property increase and opens the option of moving to cash in on an unanticipated property tax cut The magnitude of the capital gains and losses and hence 136 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY the extent of the horizontal inequity depends on the degree to which current property tax differences are capitalized into house values The higher the degree of capitalization the greater the horizontal inequity from any unanti cipated property tax change In short complete property tax capitalization insures that once it has become established any set of effective property tax rates is horizontally equitable whereas any change in these rates is not Without capitalization variation in effective tax rates is a source of horizontal inequity whereas changes in effective tax rates are not because they do not lead to capital gains and losses 42 The Case for Assessment Reform The existence of capitalization therefore provides a strong argument for keeping assessments up to date To promote horizontal equity local asses sors should avoid the arbitrary changes in effective tax rates caused by assessment errors or by holding assessments constant while market values diverge Any such changes lead to capital gains and losses and therefore violate the principle of horizontal equity Furthermore a wellpublicized policy of regular revaluation will lead house buyers to expect that current tax differences will not persist This expectation will lower the extent to which current tax differences are capitalized into house values and therefore will lower the gains and losses associated with changes in tax rates brought on by assessment errors or market trends23 Aaron s and Feldstein s analyses also reveal however that capitaliza tion complicates the case for assessment reform Once assessment errors have been introduced into the system and home buyers have adjusted to them revaluation causes changes in effective tax rates which result in capital gains and losses for current owners and therefore violate the principle of horizontal equity A compensation scheme could eliminate this problem but as Feldstein points out such compensation would not be technically feasible for many important tax reforms and may always be politically impossible p 98 In the case of revaluation compensation would involve a payment to homeowners who received relative tax increases and hence capital losses and a windfall tax on homeowners who received relative tax decreases and hence capital gains Strictly speaking this compensation policy should recognize anticipation and the length of homeownership People who bought their house a long time ago may already have experienced capital gains or losses as their effective tax rate diverged from the average If so the capital losses or gains from revaluation simply offset the gains or losses from the introduction of assessment errors And if revaluation is anticipated then recent pur 4 CAPITALIZATION AND HORIZONTAL EQUITY 137 Chasers will not experience a capital gain or loss from revaluation regardless of the change intheir effective tax rate Needless to say these complexities make it unlikely than an acceptable compensation scheme could be devised Whenever large assessment errors exist therefore town policy makers must decide whether the bene ts of revaluation in the form of greater economic ef ciency greater longterm horizontal equity and per haps greater resident satisfaction with the property tax offset the shortterm horizontal inequity of the resulting capital gains and losses In our view the bene ts are likely to outweigh the costs particularly if revaluation is an ongoing process not a onetime correction If revaluation is carried out once but arbitrary assessment errors are then allowed to reappear the gains and losses from revaluation are followed by gains and losses that appear even more capricious If however revaluation is combined with an updated assessment system that prevents the reappearance of large assessment errors then economic ef ciency and horizontal equity will be well served in the long run Furthermore the belief that assessments will be updated holds down the degree to which current tax differences are capitalized into house values and therefore minimizes the capital gains and losses that arise from any assess ment errors that do occur either through inaccurate revaluation or through betweenrevaluation changes in market values These longterm gains clearly justify some horizontal inequity in the short run Feldstein also points out that the gains and losses from tax reform can be minimized by postponement that is by a pause between the announce ment and implementation of the reform25 Postponing implementation lowers the present value of the tax cuts or tax increases from revaluation and therefore lowers the associated capital gains and losses Moreover the pause between announcement and implementation allows people to prepare for the reform and eliminates the possibility that people will experience a large gain or loss immediately after purchasing a house As reported in Chapter 6 we nd evidence that this announcement effect is indeed at work in the case of revaluation in several of our sample communities house values change in anticipation of an announced but as yet unimplemented revaluation A lag between announcement and implementation is not necessary if revaluation takes place regularly but appears to be a common practice when revaluation has not occurred for many years precisely because a longpost poned revaluation causes painful losses for some taxpayers In Boston for example revaluation was resisted for many years despite the State Supreme Court ruling requiring it because assessment errors there were huge and some taxpayers would suffer severe losses from revaluation Indeed it was nine years between the major court decision and the rst major revaluation in Boston During this period the inevitability of revaluation became clear and taxpayers had plenty of time to prepare for it26 138 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY If imperfect information and high search costs lead to incomplete capitalization that is if the expected stream of future tax differences is incompletely capitalized then horizontal equity does not exist even for buyers unless the effective tax rate is the same for everyone Before assess ment reform people who stumble onto houses with low effective rates bear a smaller tax burden than people who stumble onto houses with high effective rates This unequal treatment of people in the same circumstance violates the principle of horizontalequity Incomplete capitalization of the stream of expected tax differences does lessen the unfairness of arbitrary changes in effective tax rates or of revaluation by lowering the capital gains and losses that such changes cause In other words compared to complete capitaliza tion of expected tax differences incomplete capitalization leads to more horizontal inequity from having assessment errors and to less horizontal inequity from introducing or correcting those errors This incomplete capi talization therefore strengthens the case for assessment reform Regardless of the degree of capitalization the only way to maintain horizontal equity after revaluation is to keep all effective tax rates in a jurisdiction the same through regular accurate assessment Taxpayers with relatively high effective tax rates have been known to sue assessors not just to correct their assessments but also to obtain com pensation for their relatively high tax payments in the past Our analysis sheds some light on these suits With complete capitalization people who buy houses with relatively high effective tax rates pay relatively low housing prices and are no worse off than other buyers Unless these people experience unanticipated tax rate increases after they buy their houses they have not been treated unfairly and in our judgement do not deserve compensation With incomplete capitalization of expected tax streams people who buy houses with relatively high tax rates are not fully compensated by lower housing prices and some compensation may be appropriate We conclude therefore that people who have paid relatively high effective property tax rates deserve compensation only to the extent that the capitalization of future tax streams is incomplete or to the extent that those relatively high rates re ect unanticipated tax increases that occurred after they bought their houses27 5 THE DISTRIBUTION OF GAINS AND LOSSES FROM REVALUATION IN WALTHAM In Massachusetts a long history of in exible assessment procedures pro duced wide disparities in effective tax rates within a community Because current effective tax rates are capitalized into house values to a signi cant 5 GAINS AND LOSSES FROM REVALUATION IN WALTHAM 139 degree this in exibility insured that the owners of houses with relatively rapid value growth would receive arbitrary capital gains and owners of houses with relatively slow value growth would receive arbitrary capital losses Moreover to the extent that incomplete capitalization of current taxes is caused by imperfect information and high search costs the variation in effective tax rates caused horizontal inequity among house buyers To prevent future arbitrary gains and losses and to insure horizontal equity for house buyers reform in the form of communitywide revaluations was needed Nevertheless revaluation often was resisted at least in part because of the capital gains and losses that it would impose on homeownersquot To shed light on this issue we now report on the distribution of gains and losses from revaluation in Waltham We do not face the assessor s dilemma in calculating these gains and losses because we are able to observe postrevaluation sales prices and tax rates As a result we can calculate capital gains and losses directly with Equation 51 The left side of this equation is the real change in house value due solely to revaluation Our results are summarized in Figure 71 The distribution of gains and losses in Waltham is remarkably compact The average house in the ACTUAL GAINS amp LOSSES FROM REVALUATION 26 Waltham 2 220 200 m m g m 5 140 E 120 g wa Z 80 60 I 0 W 0 quot771711 17 j I I I I I I I I I I l 1 1DO 90 BO70 60 5040 30 2010 O 10 20 50 40 50 60 70 BO 90 100 Percentage Change in House Value FIGURE 7l 140 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY sample experienced a 0 1 gain and the standard deviation of the gain is less than 10 percentage points29 Indeed 311 or 88 of the 353 houses in the sample experienced a change in house value between 10 and 10 and 94 of the houses experienced value changes between 20 and 20 One house for which revaluation lowered the effective tax rate by over 14 per centage points experienced a gain of almost 100 and another house for which revaluation raised the effective tax rate by over 6 percentage points experienced a loss greater than 40 But most houses experienced more modest gains or losses Overall therefore the capital gains and losses from revaluation in Massachusetts were not very dramatic and certainly did not offset even in the short run the advantages of assessment reform Only a handful of tax payers namely those with extremely high or extremely low effective tax rates before revaluation experienced changes in house values that either threat ened the equity in their homes or that gave them an unacceptable windfall Moreover some of the people with gains losses from revaluation previously experienced capital losses gains because of prerevaluation tax changes that is the gains and losses from revaluation to some degree offset previous losses and gains This point should not be pushed too far however because the link between previous losses and revaluation gains or previous gains and revaluation losses only exists for owners who experienced unanticipated effective tax rate changes before revaluation One might ask how the distribution of gains and losses changes as the degree of capitalization changes What if for example the degree of capitali zation in Waltham were as high as it appears to be in Belmont This situation could have arisen in Waltham if revaluation were imposed on the city with out warning so that at the time of revaluation the expected persistence of existing tax differences was 50 years instead of 8 years This type of hypothet ical question is answered in Figure 72 which plots the distribution of capital gains and losses for four capitalization rates 21 50 75 and 100 Even with complete capitalization of current tax differences the distribution of gains and losses is still tightly clustered around zero With 21 capitaliza tion 96 of the houses have value changes between 25 and 25 with 100 capitalization 73 of the value changes fall within this range and 86 fall between 50 and 50 Raising the capitalization rate pushes the ex treme cases much farther from zero however With 100 capitalization one house has a capital gain of 453 one has a loss of 2 12 and 45 of the houses have gains or losses that exceed 100 These calculations reveal the horizontal inequity that can arise from an unexpected revaluation imposed after a long history of inaccurate assess ments If revaluation is not expected that is if current tax differences are expected to persist the degree of capitalization is likely to be high so that 6 CAPITALIZATION AND VERTICAL EQUITY 141 HYPOTHETICAL GAINS FROM REVALUATION For Van39ous Capitalization Rates Number of Houses 0 39 i 7 r 2oo 175 150 125 1oo 75 5o 25 o 25 50 75 100 125 150 175 200 Percentage Change in House Value El 21 50 O 75 A 100 FIGURE 72 correcting large assessment errors causes large capital gains and losses at least for some taxpayers This situation and the associated inequity can be avoided however by moving gradually to the rst revaluation after a long period of inaccurate assessment and by maintaining accurate assessments after an initial revaluation Because it promotes ef ciency and longterm horizontal equity as sessment reform constitutes sound public policy Despite the attention they sometimes receive shortterm capital gains and losses should not be a barrier to implementing this reform 6 CAPITALIZATION AND THE VERTICAL EQUITY OF THE PROPERTY TAX Policy makers may also care about the relative treatment of different income classes of households that is about vertical equity In this section we exam ine the implications of tax capitalization for the vertical equity of the prop erty tax 142 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY Without accurate assessments effective property tax rates in a com munity may be systematically linked to income In fact one would expect effective tax rates to be lower for relatively expensive houses which are more likely to be purchased by highincome people The effective tax rate is pro portional to the assessed value divided by the market value With assess ments held constant changes in the effective tax rate are determined by changes in market value Market value often grows more rapidly for houses that begin with high values in addition market value will be particularly high if it has grown rapidly in recent years Over time therefore the effective property tax rate on highvalued property tends to fall below the rate on lowvalued property even if the two rates start out the same31 Although the effective tax rate may vary with house value capitaliza tion insures that the real burden of the property tax does not Everyone regardless of his or her income is willing to pay 1 to avoid 1 of property taxes If this willingness to pay shows up in house values that is if the capitalization of the expected tax stream is complete then the burden of the property tax is the same for all house buyers regardless of their income even if effective tax rates are systematically linked to income In other words full capitalization of the expected tax stream insures that property taxes impose the same burden per unit of housing regardless of income or of willingness to spend on housing From the perspective of new buyers therefore capitaliza tion enforces proportionality the burden of the property tax is a constant fraction of house value With capitalization the property tax cannot be either progressive or regressive with respect to house value This argument must be quali ed in two ways First the capital gains and losses associated with unanticipated changes in property tax rates may not be distributed proportionally Indeed if relative effective tax rates on relatively expensive houses systematically decline over time then the high income people who own those houses will systematically receive capital gains while the owners of relatively inexpensive houses will receive capital losses The only way to avoid this regressive outcome is to keep assessments equal to market values Second house values may not be proportional to income so it is possible to have a progressive or regressive outcome with respect to income even when one has a proportional outcome with respect to house value Most studies nd that spending on housing increases less then proportionally with income32 With full capitalization therefore the property tax will be regres sive with respect to income even from the perspective of new buyers This link to income is an important one most discussions of vertical equity focus on taxes as a fraction of income not of property value If imperfect information and high search costs cause incomplete capi 7 CONCLUSIONS 143 talization only a portion of expected future tax differences is offset by differences in housing prices If expensive houses face relatively low effective tax rates these lower taxes are not fully re ected in higher house values Some share of the regressivity or progressivity in the assessment system with respect to house value remains in nal tax burdens On the other hand this incomplete capitalization lowers the gains and losses that accompany unan ticipated changes in e ective tax rates and thereby lessens the vertical ineq uity that may be associated with such changes 7 CONCLUSIONS We nd strong evidence to support the hypothesis that differences in effec tive property tax rates are to some extent capitalized into the price of housing In the communities with the best data Waltham Brockton and Bamstable we find that the degree of tax capitalization is 21 16 and 33 respectively The degree of capitalization re ects households expectations about future tax changes In the Massachusetts case variation in effective tax rates is caused by assessment errors and because of much public debate about revaluation households know that these errors will eventually be corrected This type of expectation appears to be largely responsible for the incomplete capitalization of current tax differences The estimated rate in Waltham for example could be caused simply by the expectation that current tax differ ences will persist for only 8 years If household expectations are the only factor at work then the incomplete capitalization of current tax differences is equivalent to complete capitalization of the expected future tax stream To some extent however the rate of tax capitalization also appears to be af fected by imperfect information and high housing search costs The degree of capitalization can vary from one set of circumstances to another We study the capitalization of intrajurisdictional tax changes caused by revaluation Studies of other situations such as tax rate di 39erences caused by Proposition 13 in California or interjurisdictional tax rate differ ences are likely to nd different degrees of capitalization Furthermore the degree of capitalization appears to re ect characteristics of the local housing market that in uence the quality of information about tax differences and the magnitude of housing search costs Property tax capitalization has important implications for public policies such as assessment reform and intergovernmental aid that alter the relative property tax rates of owneroccupied houses in the presence of 144 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY capitalization all such policies impose capital gains and losses on current property owners Some of the policy implications of capitalization are very practical for example a knowledge of capitalization can help an assessor calculate accurate assessments in the period right after revaluation Other policy im plications are more abstract We show for example that complete capitali zation eliminates the housingmarket distortions associated with variation in property tax rates across communities but does not alter the housingmar ket distortion caused by the average property tax rate in a metropolitan area Even with complete capitalization the property tax causes underconsump tion of housing Capitalization greatly alters an analysis of the horizontal equity of the property tax 0n the one hand complete capitalization of the expected tax stream insures that the real burden of the property tax is the same for all house buyers in a metropolitan area regardless of the effective tax rate on the house they buy On the other hand complete capitalization also insures that any change in relative property tax rates will be accompanied by capital gains and losses for current owners which violates the principle of horizontal equity Ironically this lack of horizontal equity arises both for the arbitrary changes in effective tax rates that arise over time when assessments are not updated and for the changes in tax rates caused by revaluation which are designed to correct these assessment errors Despite the shortrun horizontal inequity of revaluation we believe that moving to regular accurate assessments is good public policy because it promotes horizontal equity in the long run by eliminating the arbitrary changes in effective property tax rates and accompanying capital gains and losses that arise as assessed values and market values diverge Incomplete capitalization as in Massachusetts strengthens the case for assessment re form because it lessens the shortterm horizontal inequity of revaluation indeed we show that the gains and losses from revaluation in Waltham are small Finally capitalization insures that the burden of the property tax on owneroccupied housing is proportional with respect to property value even if the effective tax rate declines as house value increases Even with complete capitalization of expected tax streams however the property tax on owner occupied housing remains regressive with respect to income because higherincome households tend to spend a smaller fraction of their income on housing Moreover capitalization insures that in exible assessments will lead to capital gains for homeowners whose house values grow relatively rapidly typically highincome people and to capital losses for homeowners whose house values grow relatively slowly This regressive distribution of gains and losses strengthens the case for assessment reform NOTES 145 NOTES For a review of the literature on the behavioral effects of state grants see Rubinfeld 1985 2 Smith 1970 also found that anticipated tax changes from revaluation are capitalized in the period after revaluation has been announced but before it is implemented 3 These announcement effects are small in magnitude This nding suggests either that property tax changes were anticipated and capitalized well before revaluation was announced or that anticipation has a small effect on house values With no way to choose between these opposite conclusions we do not place much weight on the magnitude of the anticipation coef cients Equation 315 gives the degree of capitalization as a function of the expected persistence of tax differentials so all it takes is a little algebra to solve for the implied expected persistence of tax differentials as a function of the estimated degree of capitalization The answer is that N39 the expected persistence of tax differentials equals ln1 8nl r where In stands for a natural logarithm is the estimated degree of capitalization and r is the real interest rate which in our case is 3 This formula is used to calculate the entries in Table 7 l 5 Differences in the expected persistence of tax differences also could explain why Smith 1 970 obtains a higher estimate of capitalization than we do in most of our communities The revaluation he studies was required by a state law and may not have been actively debated at the city level so that until shortly before the law was passed house buyers may have expected tax differentials to persist for a long time Using the formula in Footnote 4 and Smith s estimate that capitalization is 44 with a 3 discount rate we nd that the implied expected persistence of tax differentials in his case is 20 years 6 Although this point has been recognized at an intuitive level to our knowledge it has never been stated precisely According to Equation 315 the coef cient of the tax difference variable is 13 the degree of capitalization based on imperfect information and high search costs multiplied by the ratio r r where r is the real discount rate with an in nite horizon that is equivalent to the real discount rate r with horizon de ned by the persistence of tax differences The degree of capitalization for current tax differences is i r r whereas the degree of capitali zation for the expected stream of tax differences is simply 13 The capitalization ratio which many studies estimate is the coef cient of the tax difference variable divided by r which reduces to i39 r To nd r r therefore one must multiply the estimated tax coef cient by r whereas to obtain 5 alone one must multiply it by r 7 This argument is also made by lhlanf39eldt and Jackson 1982 They make the concep tual argument that systematic assessment errors are easier to identify and less likely to be corrected and are therefore more likely to be capitalized than random assessment errors Their results suggest the opposite the degree of capitalization is larger although less signi cant for random assessment errors As explained in Chapter 2 however their methodology is seriously flawed Furthermore as pointed out in a comment by Gerking and Dickie 1985 their de ni tion of random assessment error is quite narrow namely the portion of assessment error that is not correlated with house valuequot These conclusions come from a regression of the degree of capitalization on commu nity characteristics The coefficient tstatistic is l 58 40 for the prerevaluation effective tax rate 007 36 for population density 0025 509 for percentage old housing and 003 385 for median income The rsquared for this regression is 095 None of these explanatory variables is statistically signi cant in a bivariate regression to explain the degree of capitalization quot The simple correlation between the pre revaluation effective tax rate and city popula 146 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY tion is about 09 Moreover by substituting for the effective tax rate in the regression in footnote 8 we nd that population has a signi cant e ect on the degree of capitalization An alternative interpretation of this result therefore is that it takes house seekers longer to gather comparative tax information in larger communities than in smaller ones 0 This explanation is not the same as the supplyside explanation offered by Edel and Solar 1974 Note 1976 and Hamilton 1976b In their argument builders respond to situations in which taxes are low and hence prices are high by building more housing thereby driving down the price and eliminating capitalization Because of assessment practices in Massachusetts however new housing was taxed at a relatively high rate which when capital ized resulted in a lower price for new housing than for existing housing This lower price cannot induce a supply response Noto tested and rejected this alternative hypothesis by interacting her tax rate variable with the rate of growth in community population See the discussion of her study in Chapter 2 In our sample the simple correlation between the percentage of old housing and the rate of change in community population between 1970 and 1980 is about 08 but the percentage change in population unlike the percentage of old housing is not signi cantly related to the degree of capitalization In fact the housing stock in Belmont is very homogeneous and housing seekers may be able to inspect several similar houses In this case random assessment errors are revealed in comparisons of the tax payments of these houses and bids on housing do re ect relative tax rates These observations come from one of the authors who lived in Belmont for ten years and had a strong professional and personal interest in the prices of the three types of colonial houses that comprise most of the housing stock in the town 391 To be precise assessed value increases at 2 or at the same rate as house value whichever is smaller Given the rapid recent appreciation in house values in California how ever we doubt that anyone expects assessments to increase by less than 2 It should also be pointed out that for owners at the time the proposition passed assessed values were rolled back to 1975 levels For some evidence on the intrajun39sdictional variation in e ective tax rates caused by Proposition 13 see Wiseman 1986 Two studies discussed in Chapter 2 Gabriel 198 1 and Rosen 1982 examine interjurisdictional tax differences caused by Proposition 13 Because these intetjurisdictional di 39erences are likely to be longlived it may seem surprising that these studies obtain estimates of capitalization that are similar to ours namely 36 and 22 However general uncertainty about the effects of the Proposition on taxes and services may have kept capitalization low in the year immediately after it passed 3 The expected grth rate is slower for tax payments than for house values so the real discount rate is higher for tax payments than for house values This case is analogous to Equation 315 therefore in which the degree to which current taxes are capitalized re ects the relatively high discount rate for taxes Strictly speaking one should also consider households beliefs about the expectations of people to whom they are likely to sell their house the expecta tions of those future buyers also may have a small effect on current house values quot This argument applies to the sample of houses that sold before revaluation To predict the postrevaluation value of houses that did not sell before revaluation the assessor also must have an accurate estimate of their value in the prerevaluation regime To obtain such an estimate he must account for their pre revaluation relative effective tax rate Note also that with a guess about the expected persistence of tax differences an assessor can read from right to le in Table 7 1 or use Equation 315 to obtain a rough estimate ofthe degree of tax capitalization 395 In principle the same logic can help an assessor account for interjurisdictional tax capitalization Suppose the assessor knows that the town s effective tax rate is going to change relative to other towns This relative change will cause a real change in the value of all houses in the town This problem is much more difficult to solve however because the assessor must know what is going to happen to the tax rates in other towns and he cannot use the shortcut in NOTES 147 the text because the secondsale tax rate may not be equal to the areawide average Actually the average rate is not quite right See Yinger I985 This problem can be solved if the assessor knows how much money the property tax must raise but the algebra is very complicated and is not presented here Note that this interjurisdictional problem does not raise a fairness issue A change in the town s average tax rate will have the same percentage impact on all houses in the town and will therefore have the same impact on the effective tax rate of every house in the town even if the assessor does not account for it This problem also disappears in the long run as the assessor observes house sales after the relative tax change 5 For a discusion of this rule see Atkinson and Stiglitz 1981 397 The price elasticity of demand for housing appears to be about 05 For a recent review of the literature see Mayo 198 1 This elasticity is not close enough to zero to justify an extremely high second best tax rate on housing quot The text asks whether assessment errors distort housing choices made at the time of purchase One could also ask whether these errors distort decisions to upgrade or renovate housing Aaron 1975 argues that they do There exists no mechanism to capitalize property taxes into the price of these housing changes so Aaron argues that households with higher effective tax rates will undertake less rehabilitation This argument does not apply in Massachu setts however because assessors ignore minor rehabilitation and value all major additions or renovations at some fraction of their cost regardless of the household s effective property tax rate In other words the marginal property tax rate which in uences decisions to upgrade does not vary across households despite assessment errors that exist before upgrading 9 Strictly speaking a distortion can arise if expectations about the persistence of tax differences differ from the actual persistence of tax differences Because the implied expecta tions are close to correct in most of the communities we study we believe that this type of distortion is inconsequential 2 Two technical points First we limit our analysis to existing housing and do not consider the consequences of capitalization for the efficiency of housing construction By raising the price of land in lowtax towns capitalization might cause an inefficient shift away from land and toward capital in the construction of housing in those towns Second Hamilton 1983 provides an alternative approach to the analysis of capitalization and the efficiency of the property tax He argues that if the price of housing re ects both the bene ts of public services and the property tax then the property tax must be serving as a price for public services By drawing an analogy to the operation of a price in a private market Hamilton concludes that the property tax does not distort the housing market However his argument is based on the incorrect assumption which was discussed in Chapter 2 that 1 of public spending yields 1 of bene ts In fact the demand curve for public spending like the demand curve for anything else is downward sloping not horizontal as this assumption implies and varies from one household to another Moreover even with this assumption Hamilton only shows that the average bene t equals the average cost not as ef ciency requires that the marginal bene t equals the mar ginal cost 239 The discussion could be extended to consider tax di erences that were not expected to persist As in the case of assessment errors this extension shifts the focus from the capitaliza tion of current tax differences to the capitalization of the expected stream of tax differences 2 As in the ef ciency discussion in Section 3 the difference between expectations and realizations might matter A wide divergence between the expected and actual persistence of tax differences which does not appear to exist in Massachusetts could lead to some horizontal inequity in the long run even with complete capitalization of expected tax streams 23 Announcing the switch from a policy of xed assessments to a policy of regular revaluation will by itself cause capital gains and losses as will any event that changes house holds expectations about the persistence of tax differences The inequity of these one time 148 7 PROPERTY TAX CAPITALIZATION AND PUBLIC POLICY gains and losses is more than offset however by equity gains from minimizing capital gains and losses in the future 3 Aaron 1975 states the same tradeo for assessors but he assumes that the capitali zation of current tax differences is likely to be complete in many cases and therefore in our judgement overstates the disadvantages of assessment reform 25 Zodrow 1980 points out that postponement may not be a good policy if it extends the time period in which large ef ciency losses occur As explained in Section 3 however assessment errors do not cause ine iciency as long as the expected stream of tax differences is fully capitalized which appears to be approximately true in Massachusetts Thus the e iciency losses from postponing revaluation are likely to be very small 2quot For some of the history of revaluation in Boston see Paul I975 and Avault et al 1979 27 One important application of these arguments is to the socalled Tregor payments made by the City of Boston For many years commercial property in Boston paid a higher effective rate than residential property Several owners of commercial property sued the city for compensation and won The City was required to pay tens of millions of dollars to these property owners In our judgement this compensation was not appropriate Although we have no direct evidence on the point we believe that the capitalization mechanism is likely to work very well for commerical property people who buy such property have good information and full knowledge of the implications of different property tax payments Thus people who buy business property with a relatively high effective tax rate are compensated in the form of a lower market price for that property The real burden of the property tax in other words is no higher on them than on the owners of business property with a low effective rate Thus it is not fair to compensate the owners of hightax property again in the form of a payment from the City Some compensation would be called for if relative taxes on commercial property increased after these people bought it and if this increase were not anticipated by them This does not appear to have been the case commercial property was overassessed for many years prior to the Tregor suits We also cannot prove that the capitalization of expected tax streams was complete But even if it was only 50 the awards to these property owners should have been cut in half So far as we know the existence of capitalization was not considered by the courts in these cases as a result we believe that equitable treatment of taxpayers was not achieved We must add a footnote to this footnote The incidence of the property tax on commercial property unlike on owuer oc cupied houses might be affected by backward shifting to factors of production or forward shifting to consumers We believe that such shifting is not important in evaluating the Tregor payments For more on the Tregor payments and their impact on Boston s nances see Bradbury and Yinger 1984 For a discussion of revaluation and classi cation in Boston see Avault et al 1979 1 The high rates on commercial property in Boston caused a similar transition prob lem Moving to the same effective tax rate for all kinds of property not only eliminates unfair treatment within a property type it also eliminates the relatively high tax rate on commercial property As a result the tax rate on residential property would go up With full capitalization this rate increase would lead to a capital loss for the average homeowner This outcome was not politically acceptable in Boston and was a key obstacle to assessment reform This obstacle was eliminated by allowing property tax classi cation which involves different nominal tax rates and hence different effective tax rates even with accurate assessment for different types of property The combination of revaluation and tax classi cation allowed Boston to eliminate variation in effective tax rates within classes of property but to retain the relatively high effective rate on commercial property See Avault et al 1979 29 These capital gains and losses are primarily caused of course by the changes in relative effective property tax rates that occur because of revaluation The mean and standard NOTES 1 49 deviation of the distribution of these tax rate changes are zero and 145 percentage points respectively 3 In principle a compensation scheme for these people could be devised along with a windfall tax on people with capital gains As pointed out earlier however such a scheme would be complicated and probably not politically feasible 3 A negative link between effective tax rate and house value has been found by several studies See for example Chun and Linneman I985 32 For a recent review of this literature see Mayo 1981