The Theory of Property Tax
LECTURER: JACK WU
Outline
 Topic I: What Are Property Taxes?
 Topic II: Property Tax Incidence
 Topic III: Property Tax Capitalization
 Topic IV: Property Tax Competition and Provision of
Local Public Goods
Topic III. Property Tax Capitalization
3
 The Property tax capitalization occurs when
the present value (PV) of future tax liabilities is
incorporated into real estate values.
R t
R t
V


2
1  r (1  r )
R t

(1  r ) n
Testable Hypothesis


Oates (1969, JPE) was the first to formulate and test the
hypothesis of property tax capitalization as an implication of
Tiebout’s (1956, JPE) model of efficient housing markets with
inter-jurisdictional mobility.
The large volume of empirical literature that followed Oates
largely documents that property values are impacted by future
tax liabilities, but fails to reach a consensus regarding the
“extent” of tax capitalization.
The Extent of Property Tax Capitalization
 Full capitalization: property tax fully reduces the




property rate
Partial capitalization: property tax partially reduces
the property value
Overcapitalization: property tax increases the
property value
Zero capitalization: no relationship
Overcapitalization suggests the current tax rate is
smaller the optimal rate.
Mixed Empirical Results
6
 No Significant Capitalization Effects:
 Wales and Wines (1974, REST)
0%
 Chinloy (1978, CJE)
0%
 Gronberg (1979, SEJ)
0%
7
 Varying Degrees of Partial Tax
Capitalization






Oates (1969, JPE)
King (1973, Book)
Edel and Sclar (1974, JPE)
Gustely (1976, SEJ)
King (1977, JPE)
Rosen and Fullerton (1977, JPE)
61%
18%
20%
34%
36%
58%
8







Dusansky et al. (1981, JUE)
22%
Gabriel (1981, NTAP)
36%
Richardson and Thalheimer (1981, SEJ) 15%
Ihlanfeldt and Jackson (1982, SEJ)
66%
Lea (1982, PFQ)
26%
Rosen (1982)
Goodman (1983) Intra-jurisdiction 65%
Inter-jurisdiction 25%
22%
9
 Full- or Over-Capitalization:
 Oates (1973, JPE)
90%
 Church (1974, NTJ)
 Reinhard (1981, JPE)
Aggregate: 107%
Micro data: 120%
> 100%
Empirical Models of Property Tax Capitalization
 Amenity models
 Capitalization models
 A Modified Capitalization models
Amenity Models
(Oates 1969, JPE)
11
 The level of property tax rates is treated as one
among several attributes (amenities/disamenities)
affecting home values.
k
Pi  1    j Zij  tt i
j 2
where Pi ≡ the value of the i-th property
Zjs ≡ structural and locational characteristics
(including measures of public services in the area)
ti ≡ the annual rate of property taxation.
ˆ ≡ the estimated coefficient of the property tax
t
rate
Capitalization Models
(Mill and Hamilton, 1994)
12
 Capitalization Models
— property values are viewed as the capitalized value
of future housing services net of costs.

Capitalization

R
R
V 

t
r
t 1 (1  r )
P
13
S
r  g    m t
where S ≡ the value of housing services
r ≡ the real discount rate
g ≡ the expected real rate of marketwide
appreciation
 ≡ the depreciation rate of property with age
m ≡ the rate of maintenance costs
t ≡ the property tax rate

The Capitalization Model
14
Property values are viewed as the capitalized value
of future housing services net of costs.

The Estimating Equation: Non-linear
Regression Model
Si
Pi 
r  tt i
where r = r – g +  + m
r  the net of property tax user cost of housing
Si  the value of housing service provided by the
i-th property
Measure of the degree of capitalization: ˆt
 Testing Hypothesis
Full Capitalization
 H 0 : ˆt  1  0

 H1 : ˆt  1  0
Zero Capitalization
 H 0 : ˆt  0

 H1 : ˆt  0
15
 The Estimating Equation:
16
The equation identified above cannot be directly
estimated, because S and r are not directly
observable.
Pi 
S (Zij )
r  tt i
where
S(Zij) ≡ the hedonic function for housing
services
r  the specified net user cost of housing
The Modified Capitalization Model
(Palmon and Smith 1998, JUE)
17
 The modified capitalization model avoids using fixed
estimates of net user costs conjectured from rates of
return found outside the housing market. The
identification is accomplished by estimating the
values of housing services from rental data.
Ri
 ri  tt i
Pi
Note: Utilizing the rent-to-price ratio as the dependent
variable provides a means to estimate both t and r
directly from the housing market, thereby eliminating
the need to conjecture the net user cost from other
markets.

Estimating the Rental Values
ln Ri ,k  1,k   2,k SFi ,k   3,k SFi ,2k   4,k Agei ,k
  5,k CBDi ,k   6,k Bathi ,k  ei , k
where i ≡ the i-th property, n
k ≡ the k-th MUD (municipal utility district), K =
45
R ≡ Annual rent
SF ≡ Square feet of living area
Age ≡ Home age in year
CBD ≡ Distance from the central business district
Bath ≡ Number of bathrooms
18

Estimating the Rent-to-Price Equation
 Rˆ 
    1   2 SFi   3 Agei   4CBDi  tt i   i
 P i

Testing Hypothesis
Full Capitalization
 H 0 : ˆt  1  0

 H1 : ˆt  1  0
Zero Capitalization
 H 0 : ˆt  0

 H1 : ˆt  0
19

Table: Estimated Coefficients
The estimate of the
capitalization
coefficient is
0.9166.
20
Palmon & Smith (1998) Table 1, p. 311.
21


H0: ˆt – 1 = 0 cannot be rejected at any acceptable level of
confidence.
H0: ˆ = 0 can be rejected at the 5% confidence level.
t
Evidence from Taipei
 Partial capitalization
 Partial capitalization for low value houses and
overcapitalization for high value houses
 The current property tax rate for high value houses is
smaller than the optimal rate.