In the previous essay of this series, I used this basic accounting identity to think about how rent, price, and rate of return to investors are related.
Net Rental Value after maintenance and expenses = Rate of return on investment × Price
Property taxes are commonly used in the United States to fund local public services, and since they are imposed as a percentage of assessed price, we can think of property taxes as part of the rate of return on investment.
For instance, the rate of return (after costs and depreciation) that a wealthy homeowner would expect in a market with no taxes could be about four percent. If that market has a property tax rate of two percent, then the homeowner would require a rate of return of six percent. They would retain four percent as a return on their investment, and they would send a tax payment to the local government for the two percent property tax assessment. The taxing jurisdiction is like a silent business partner that contributes nothing, but claims their portion of the income.
As a percentage of real estate values, property taxes, in the aggregate, peaked at about 1.7 percent in 1971. They have fallen steadily since then. By 2017, property taxes amounted to about 0.7 percent of real estate value. In terms of rental value, property taxes peaked at 22 percent and by 2017 they were below 12 percent of the aggregate rental value of residential real estate. Property taxes can be thought of in this way—as an approximation of a sales tax. And, as it goes, it is a pretty hefty sales tax.
Because the property tax is administered as a wealth tax, it has a couple of useful features.
First, some of the tax falls on the value of the land itself. This feature was popularized by the 19th century celebrity economist Henry George. Land cannot be created and is simply a natural endowment, protected legally by the state.
A good case can be made that, practically and morally, gains from the value of land (distinguished from structures and improvements) should flow to the state rather than to the owner. Since land is a natural endowment, its production cannot be affected by taxation, so the portion of property taxes that apply to the value of the land are efficient. Farmers may decide to keep fewer cows if the state taxes milk, but the quantity of land is fixed regardless of how it is taxed.
Property taxes have another useful feature, which is apparent when giving proper attention to rental value, as in the simple equation above. Generally, over time, home prices should rise proportionately with rental value. However, prices do fluctuate for various reasons.
In cities where housing supply is politically restricted, buyers may expect rents to rise in the future, which would lead them to pay more for homes relative to today’s rents. The yields on other investments can fluctuate. If bonds are fetching lower real yields, for instance, investors may prefer housing as an investment, pushing down the rate of return on homes. Or, if irrational exuberance overtakes the country, housing speculators may push up the prices of homes relative to rents.
It doesn’t really matter what causes the rise in prices. In every case, mathematically, all of those scenarios mean that the rate of return on housing is lower. If the price-to-rent ratio rises for any reason, the rent-to-price ratio declines.
If property taxes are based on property values, that means that the government stake, as “silent partner,” will naturally shift counter-cyclically. When homeowners earned four percent returns and property taxes were based on two percent of market value, the state was a one third owner [two percent divided by (four percent + two percent = six percent)]. But if owners only require a two percent return, then the state becomes a half owner [two percent divided by (two percent + two percent = four percent)]. The state’s stake naturally rises and falls in inverse proportion to the market value of property.
Now, one of the themes of this series of posts is that rental value is the key measure regarding housing affordability. This effect of property taxes mostly has to do with changing prices, unrelated to rents. Yet, there is still a benefit to having less volatile market prices. There is also some benefit to claiming capital gains for the state when those gains come from speculation on local land-use restrictions.
If there is concern that the net effects of government policies, in total, favor housing and lead to market volatility, a return to higher levels of property taxation can be a useful tool for countering it. As I’ll discuss in the next post, higher property taxes can be a corrective tax on monopoly power.
Photo credit: Toa Heftiba/Unsplash.