Review Articles: The History of Property Tax Capitalization in Real Estate

By Sirmans, G. Stacy; Gatzlaff, Dean H. et al. | Journal of Real Estate Literature, September 1, 2008 | Go to article overview

Review Articles: The History of Property Tax Capitalization in Real Estate


Sirmans, G. Stacy, Gatzlaff, Dean H., Macpherson, David A., Journal of Real Estate Literature


Abstract

This study examines the capitalization of property taxes in real property. Capitalization theory would suggest that property values depend on the level of public services and taxes within a community. Differences in taxes relative to public services should be reflected in property values. Studies on property tax capitalization have essentially tested the Tiebout hypothesis that allocative efficiency in the delivery of public services is achieved through a system of local governments. Some conclusions from the literature are: (a) the degree of capitalization depends on the elasticity of supply of housing. An increase in demand with inelastic supply will raise the price of housing whereas, with a perfectly elastic supply, a change in demand will not change price, (b) tax capitalization can "lock-in" homeowners and make it more difficult to move, (c) most studies measuring property tax capitalization have used two-stage least squares, and (d) the most typical empirical result has been partial capitalization.

There has been significant debate over the extent to which property taxes are capitalized into property values. Property tax capitalization occurs when a change in taxes or public services causes a change in house price. Thus capitalization theory suggests that property values depend on the level of public services and taxes within a community. As Brasington (2001) points out, with differences in population and with mobile capital, a change in house price will cause utility to be different across communities and people will move between communities until equalization is restored.

Hamilton (1976) points out some features of property taxes that may affect their capitalization in house prices. First, taxes are levied on a large fraction of the capital stock in the United States, suggesting that the tax might depress the return on capital (leaving the value of capital assets unchanged). Second, rates of taxation vary across locations and these variations should be capitalized into property values. He argues that both the difference in taxes and the difference in benefits are important and that the difference in taxes relative to public service benefits should be reflected in property values. He also argues that the market will adjust to these capitalization effects in that, if assets prices are changed by tax and benefit capitalization, these price changes would affect supply and this change in supply would generate second-round price changes.

Richardson and Thalheimer (1981) pose the question of property tax capitalization very simply: assuming two residential properties are the same in all aspects, including public services received, but are subject to different property tax rates, to what extent is the market value of the house with the higher tax rate reduced relative to its counterpart? This issue is a special case of Tiebout that says that housing values will vary directly with receipt of different levels of local government services and inversely with the cost of those services.

As Reinhard (1981) discusses, studies examining the capitalization of property taxes in property values have essentially tested the Tiebout (1956) hypothesis that allocative efficiency in the provision of public services can be achieved through a system of local governments.

The Theory of Property Tax Capitalization

The capitalization of property taxes depends on the elasticity of the supply of housing. If the supply curve of housing is perfectly inelastic or upward sloping, any increase in the demand for housing in a given community will raise the price of housing. An increase in public services or a decrease in taxes will increase demand and raise prices. Decreased demand in other communities will lower house prices in those communities. At some point equal utility will be established across communities.

On the other hand, if the housing stock is perfectly elastic (Henderson, 1985), taxes and services will not be capitalized in house prices since a change in demand for housing causes no change in house prices.

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