Capitalization of Residential Property Taxes: An Empirical Study

Abstract

THE assumption that taxes are capitalized plays a central role in public finance theory. It would seem that the taxation of residential property offers a good opportunity to test this assumption empirically. One need simply investigate whether or not, after holding constant housing and land characteristics, a house with higher taxes sells for a lower price. Indeed there have been many attempts in the literature to estimate the extent to which -residential property taxes are capitalized.' Many of these studies have focused on differences in tax rates existing in neighbouring communities, and have attempted to determine whether in such a setting property values are inversely related to tax rates. The major difficulty with this approach, in which tax rates in different communities are compared, is that government expenditures may also differ from one location to another and may also be capitalized in property values. It is therefore necessary to hypothesize that property values depend on both taxes and expenditures, in which case the relationship comes close to being an identity, with average property values related to average tax rates and average levels of government expenditures.2 It is not surprising that tax rates are found in these cases to be negatively, and government expenditures positively, related to property values. However, it is not clear (two-stage least squares notwithstanding) how much of these effects can be attributed to capitalization and how much is due to the tautological nature of the problem. In this paper we focus on individual residential property values in one municipality only, and thus avoid the major problem discussed above since the level of general government services is the same for all property owners.3'4 Further, restriction to one locale does not imply that effective tax rates will be the same on all houses even though the mill rate is, of course, the same. As is the case in most cities there are wide variations in the ratio of assessed value to market value for residential properties, (even within homogeneous housing categories) thus resulting in differences in taxes paid for basically identical housing units.5' 6 Consequently, we hypothesize a relationship of the form