In my previous essay, I used this basic accounting identity to show how the state can use property taxes to silently partner in the ownership of residential property.
Net rental value after maintenance and expenses = Rate of return on investment × Price
As described in the essay, property taxes can be seen as a change in the rate of return. So, something else in this equation has to change when property taxes change. The question is, when property taxes change the rate of return, does that cause a change in the rent or the price? A higher tax will either cause rents to rise to cover the tax or cause prices to decline if the owner can’t pass on the cost through higher rents.
The answer depends on what the rent is paying for. In 2014, Byron Lutz, an economist with the Federal Reserve, studied a change in property taxes in New Hampshire. He found that where building was not politically constrained, lower taxes led to more building. Where building was politically constrained, in urban areas with zoning restrictions, lower taxes led to higher prices rather than more building.
As I have suggested in earlier posts, it may add clarity to consider the role of landlord, tenant, and financier separately. Just as a physicist might separate the forces on an object between those operating horizontally and vertically, we can separate the forces acting on housing between those forces that act on landlords, tenants, or financiers. The fact that some tenants are also landlords or financiers of a given unit should not change that analysis.
Supply and demand for housing relates to tenancy. When building increased in New Hampshire after property taxes were reduced, we can infer that an increase in the quantity demanded was related to a decline in rents. Lower taxes meant lower rents, so tenants bought more shelter.
This was the case because in areas where supply is not constrained, the cost of housing is mostly a reflection of the cost of physically building a structure. In those places, price is relatively fixed by the cost of things like lumber and gypsum board. The property tax is like a tax on lumber and gypsum board, in that case. If landlords don’t need to share some of their rental income with the government, then they will use that income to build better houses to attract tenants. Supply will increase, reducing rents on existing units and increasing the quantity of housing that is consumed.
On the other hand, where supply is constrained by politics, Lutz found that no new building was triggered. Instead, lower property taxes led only to higher prices. That is because in those places the marginal value of a housing unit comes from the politically protected monopoly power the owner controls over a location. On the margin, the value of that unit is based on where it is, not what it is. And increasingly in major American cities, not only do property owners control their own locations, they also assert control over neighboring locations through zoning limitations and other political obstructions to new building.
Monopoly power means that the marginal price is not equal to the marginal cost. The value of living at that location remains the same regardless of the property tax rate. In other words, in those units, rents were the fixed factor, so a change in the rate of return caused a change in the price instead of a change in rent.
Property taxes might seem like a counterproductive solution to an urban housing shortage, then. As Lutz shows, raising property taxes has no effect on urban rents or housing consumption, while it would increase rents and reduce housing consumption in struggling areas where low rents are a key economic advantage.
This is true, but we should consider why property taxes don’t change rents or quantities in constrained urban centers. Rents in constrained urban markets are the product of a political cartel. Owners in those cities are collecting unearned profits from monopoly power by using local municipal bureaucracies to prevent new units from being built.
The fact that the renter does not pay the tax in those areas is a good thing. That means the monopolist owner is paying the tax. If politically maintained monopoly power is going to remain, claiming monopolist profits through taxes is an improvement. The fact that the tax doesn’t affect rents is a sign of efficiency. If rents must be elevated, better that they go to local public services than to the real estate cartel.
Ideally, those public revenues could be used to fund local infrastructure that would allow local populations to increase with fewer added stresses or congestion. Where home prices have become extremely high, there is a tremendous opportunity to fund public infrastructure with taxes on monopolist rents.
Photo credit: carebott / Getty Images.