The Effect of Property Reassessments on Fiscal Transparency and Government Growth: Evidence from Virginia

An important concern to the efficiency of public finance systems is that voters suffer from various “fiscal illusions” that can politicians can exploit to expand the public sector. This paper contributes evidence of this effect on a public finance system through the revenue elasticity hypothesis, which is a form of fiscal illusion in which voters confuse tax rates with tax burdens in the approval of public spending. The applied empirical setting is Virginia cities and counties from 2001 to 2011, where the timing of mass property reappraisals is exogenous but known to local policymakers in setting the annual budget.

I. Introduction

The conventional view of real property tax that is taught in most American public finance textbooks states that, unlike the case with taxes on flows of exchanges, the valuation of the taxable property stock (i.e., property assessment) is irrelevant to the revenue it produces. Barring special legislation that seeks to link property values to property tax revenues, the primary purpose of property assessment is simply to maintain a distribution of the tax burden that is proportional to the share of property assets across taxpayers. The nominal property tax rate, as Netzer (1964, 207) explains, “is essentially a residual, derived by determining the level of expenditures, subtracting state aid and other non-property tax revenues from budget outlays, and comparing the remainder with assessed values. . . . Assessed values are no more ‘actual’ as determinants of property tax yield than are a number of other factors.” Of course, this process is often confusing to the public, perhaps because the more frequent exposure to tax rates on market exchanges (e.g., sales or income taxes) results in an emphasis on monitoring rates as a signal for public revenue growth. There has been mounting empirical evidence (e.g., Mikesell 1978, 1980; Bloom and Ladd 1982; Ladd 1991; Ross and Yan 2013; Brien 2014; Ihlanfeldt and Willardsen 2014) against this residual view of property reassessment as a budget-neutral process, and researchers are finding instead a propensity for property tax revenues to grow with these events.

This paper is intended to extend the literature on property reassessment and property revenue into a broader test of the effect of fiscal illusion on public-sector growth. Fiscal illusion posits an asymmetry between citizens and their government representatives that results in the growth of government. The theory states that public-sector agents will seek out instruments that cause taxpayers to underestimate the cost of government and increase budgets beyond what would have been approved if this cost were fully perceived. There are numerous hypotheses within this theory over the specific mechanisms for raising funds and distributing them. On the expenditure side, public choice theory generally predicts that politicians will favor visible spending programs for which they can take credit, but scholars have pointed out that this hypothesis is less likely to be true if the expenditure draws visibility to the revenue side (e.g., Turnbull 1998). There are several hypothesized mechanisms in fiscal illusion theory by which fiscal resources could be raised, including the use of public debt and the complexity of the tax system, among others. The administration of the property tax in local public budgeting is particularly well suited for testing the revenue elasticity hypothesis of fiscal illusion. This hypothesis posits a mechanism in which taxpayers confuse tax rates for tax bills, and as a result, growth in the tax base is more apt to become new spending rather than a reduction in the tax rate.

As Oates (1975, 141) explains:

What the proposition under study seems to imply is that people will not object to increases in public expenditure if they can be funded with no increase in tax rates (that is, from increments to revenues resulting solely from growth in income), but they will not support an expanded public budget if it requires a rise in tax rates. This suggests what people care about is not their tax bill, but rather their tax rate. Viewed this way, the hypothesis simply is not consistent with our conventional description of rational behavior; it implies that consumer-taxpayers are subject to a kind of “fiscal illusion.” (original emphasis)

One of the empirical challenges of the revenue elasticity hypothesis is that it usually results in legislative transaction costs that are difficult for researchers to observe; hence, the lack of rate changes in response to base growth might be rational adherence to voter preferences rather than indulgence in the voters’ misperceptions of government cost (Wagner 1976). Although state policymakers may incur separate deliberation costs for expenditures and appropriate tax rates, the residual rule in local government has no such distinct legislative costs because the rates are automatically calculated on the basis of the adopted budget, which rules out these transaction costs as a competing explanation for rate persistence.

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