Tax Hike Idea Ignores 'Capitalization'

SEPT. 22, 2010


San Francisco Chronicle Columnist Debra Saunders has proposed raising the annual rate of property tax increase allowed under Proposition 13 from 2 percent to 2.5 percent to solve the state budget crisis (see “What I Would Do If I Were Governor,” SFGate, Sept. 21, 2010). As she wrote, “If I were governor, I’d fight tax increases. But if they must happen, I would push for increases that everyone absorbs. No more chasing rich taxpayers out of state because they’re an easy-to-target minority.”

In general, I find Debra Saunders to be a responsible voice in the newspaper media and agree with most of her proposals to reform California, with the exception of relaxing Prop 13. Saunders’ proposal to bump up the annual inflation tax rate of Prop 13 has been met with positive comments by many so-called conservative commenters at the Chronicle Web site.  An example is a commenter named Calfuture who writes:

“Nice job. I’m amazed to have not seen comments from the Union blasting the idea of bringing benefits more in line with the other 90 percent who work for the public sector.  As a conservative, I TOTALLY, agree with Prop 13 perspective – the idea was noble, but capping increases at 2 percent when community services (notably education costs) have gone up around 6 percent has created a huge hole over 30 year compounding.  Why can’t 2 percent be 3 percent? No one loses their home, but the depth of the hole is positively affected! “

This writer is suspicious of the notion that many conservative online newspaper commenters in San Francisco are favorable to raising the property tax inflation rate from 2 percent to 3 percent. But then again, maybe they know something that they are not letting everybody else in on (read below).

Nevertheless, Debra Saunders and those who favor her idea to raise the property tax inflation rate allowed under Prop 13 are missing one big thing. That one big thing is called tax capitalization — a sophisticated term that means that in a depressed economy if you raise property taxes the real estate market will adjust property values downward accordingly. Stated differently, tax capitalization means the real estate market may compensate for higher taxes with lower property values and vice versa (the market may ignore slightly higher property taxes in a market bubble).

For example, let’s say you have a $300,000 assessed value on your home and you pay a property base tax of 1 percent, plus a 2 percent inflation increase annually, or $3,000 taxes in year 1 ($300,000 x 1.0% = $3,000).

In Year 2 the tax rises 2 percent to $3,060 ($3,000 x 1.02 = $3,060).

If you raise the annual tax inflation rate from 2 percent to, say, 3 percent, the property tax will rise to $3,090 ($3,000 x 1.03 – $3,090).

But the market may adjust downward the property value by $3,000 for the extra tax load of 1 percent ($300,000 x .01 = minus $3,000). The resulting property value after the market adjusts for a higher tax load is $297,000 ($300,000 minus $3,000).

So now you can end up imposing an additional annual tax increase of 1 percent on a $297,000 home, or $2,970, plus 3 percent annual increase, equating to $3,059, or $1 less than if you left the annual tax increase at 2 percent ($297,000 x 1% = $2,970 x 1.03 = $3,059).

Conversely, if I wanted to increase taxes I might lower the tax inflation rate from 2 percent to 1.5 percent. This is counterintuitive to most people but is how the market works.

Mathematical innumeracy and market ignorance abounds among journalists and the public. Which makes me suspect the online commenters were not conservatives or were conservatives who pretended that higher tax rates led to greater tax revenues.

Raising the property tax inflation rate allowed under Prop 13 would most definitely not be something I would do if I were governor and I needed to raise taxes.  But on second thought if I were governor and I had a bill placed before me for signature that raised the property tax inflation rate, maybe I would sign it because it would result in a slight decrease in net taxes and nobody would know the difference, especially the newspaper media.

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