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4. Binary Intervention: Taxation > 4. The Incidence and Effects of Taxation Part II...

B. Property Taxation

A property tax is a tax levied on the value of property and hence on accumulated capital. There are many problems peculiar to property taxation. In the first place, the tax depends on an assessment of the value of property, and the rate of tax is applied to this assessed value. But since an actual sale of property has usually not taken place, there is no way for assessments to be made accurately. Since all assessments are arbitrary, the road is open for favoritism, collusion, and bribery in making them.

Another weakness of current property taxation is that it taxes doubly both “real” and “intangible” property. The property tax adds “real” and “intangible” property assessments together; thus, the bondholders’ equity in property is added to the amount of the debtors’ liability. Property under debt is therefore doubly taxed as against other property. If A and B each own a piece of property worth $10,000, but C also holds a bond worth $6,000 on B's property, the latter is assessed at a total of $16,000 and taxed accordingly.35 Thus, the use of the credit system is penalized, and the rate of interest paid to creditors must be raised to allow for the extra penalty.

One peculiarity of the property tax is that it attaches to the property itself rather than to the person who owns it. As a result, the tax is shifted on the market in a special way known as tax capitalization. Suppose, for example, that the social time-preference rate, or pure rate of interest, is 5 percent. Five percent is earned on all investments in equilibrium, and the rate tends to 5 percent as equilibrium is reached. Suppose a property tax is levied on one particular property or set of properties, e.g., on a house worth $10,000. Before this tax was imposed, the owner earned $500 annually on the property. An annual tax of 1 percent is now levied, forcing the owner to pay $100 per year to the government. What will happen now? As it stands, the owner will earn $400 per year on his investment. The net return on the investment will now be 4 percent. Clearly, no one will continue to invest at 4 percent in this property when he can earn 5 percent elsewhere. What will happen? The owner will not be able to shift his tax forward by raising the rental value of the property. The property's earnings are determined by its discounted marginal value productivity, and the tax on the property does not increase its merits or earning power. In fact, the reverse occurs: the tax lowers the capital value of the property to enable owners to earn a 5-percent return. The market drive toward uniformity of interest return pushes the capital value of the property down to enable a return on investment. The capital value of the property will fall to $8,333, so that future returns will be 5 percent.36

In the long run, this process of reducing capital value is imputed backward, falling mainly on the owners of ground land. Suppose a property tax is levied on a capital good or a set of capital goods. Income to a capital good is resolvable into wages, interest, profit, and rental to ground land. A lower capital value of capital goods would shift resources elsewhere; workers, confronted with lower wages in producing this particular good, would shift to a better-paying job; capitalists would invest in a more remunerative field; and so forth. As a result, workers and entrepreneurs would largely be able to slough off the burden of the property tax, the former suffering to the extent that their original DMVP was higher here than in the next-highest-paying occupations. Consumers would, of course, suffer from a coerced misallocation of resources. The man bearing the major burden, then, is the owner of ground land; therefore, the process of tax capitalization applies most fully to a property tax upon ground land. The incidence falls on the owner of the “original” ground land, i.e., the owner at the time the tax is first imposed. For not only does the landlord pay the annual tax (a tax he cannot shift) so long as he is the owner, but he also suffers a loss in capital value. If Mr. Smith is the owner of the above property, not only does he pay $83 per year in taxes, but the capital value of his property also falls from $10,000 to $8,333. Smith openly absorbs the loss when he sells the property.

What, however, of the succeeding owners? They buy the property at $8,333 and earn a steady 5-percent interest, although they continue to pay $83 a year to the government. The expectation of the tax payment attached to the property, therefore, has been capitalized by the market and taken into account in arriving at its capital value. As a result, the future owners are able to shift the entire incidence of the property tax to the original owner; they do not really “pay” the tax in the sense that they bear its burden.

Tax capitalization is an instance of a process by which the market adjusts to burdens placed upon it. Those whom the government wanted to pay the burden can avoid doing so because of the market's resilience in adjusting to new impositions. The original owners of ground land, however, are especially burdened by a property tax.

Some writers argue that, where tax capitalization has taken place, it would be unjust for the government to lower or remove the tax because such an action would grant a “free gift” to the current owners of property, who will receive a counterbalancing increase in its capital value. This is a curious argument. It rests on a fallacious identification of the removal of a burden with a subsidy. The former, however, is a move toward free-market conditions, whereas the latter is a move away from such conditions. Furthermore, the property tax, while not burdening future owners, depresses the capital value of the property below what it would be on the free market, and therefore discourages the employment of resources in this property. Removal of the property tax would reallocate resources to the advantage of the consumers.

Tax capitalization and its incidence on owners of ground land occur only where the property tax is partial rather than universal—on some pieces of property rather than all. A truly general property tax will reduce the rate of income earned from all investments and thereby reduce the rate of interest instead of the capital value. In that case, the interest return of both the original owner and later owners is reduced equally, and there is no extra burden on the original owner.

A general, uniform property tax on all property values, then, will, like an income tax, reduce the interest return throughout the economy. This will penalize saving, thereby reducing capital investment below what it would have been and depressing real wage rates further below their free-market level.37

Finally, a property tax necessarily distorts the allocation of resources in production. It penalizes those lines of production in which capital equipment per sales dollar is large and causes resources to shift from these to less “capitalistic” fields. Thus, investment in higher-order productive processes is discouraged, and the standard of living lowered. Individuals will invest less in housing, which bears a relatively heavy property tax burden, and shift instead to less durable consumers’ goods, thus distorting production and injuring consumer satisfaction. In practice, the property tax tends to be uneven from one line and location to another. Of course, geographic differences in property taxation, in impelling resources to escape heavy tax rates,38 will distort the location of production by driving it from those areas that would maximize consumer satisfaction.

  • 35. See Groves, Financing Government, p. 64.
  • 36. The final capital value is not $8,000, since the property tax is levied at 1 percent of the final value. The tax does not remain at 1 percent of the original capital value of $10,000. The capital value will fall to $8,333. Property tax payment will be $83, net annual return will be $417, and an annual rate of return of 5 percent on the capital of $8,333.
        The algebraic formula for arriving at this result is as follows: If C is the capital value to be determined, i is the rate of interest, and R the annual rent from the property, then, when no tax enters into the picture:
    iC = R
    When a property tax is levied, then the net return is the rent minus the annual tax liability, T, or:
         iC = RT
    In this property tax, we postulate a fixed rate on the value of the property, so that:
         iC = RtC,
    where t equals the tax rate on the value of the property.
    C = R/i + t; the new capital value equals the annual rent divided by the interest rate plus the tax rate. Consequently, the capital value is driven down below its original sum, the higher are (a) the interest rate and (b) the tax rate.
  • 37. On tax-capitalization, see Seligman, Shifting and Incidence of Taxation, pp. 181–85, 261–64. See also Due, Government Financing, pp. 382–86.
  • 38. This distortion of location would result from all other forms of taxes as well. Thus, a higher income-tax rate in region A than in region B would induce workers to shift from A to B, in order to equalize net wage rates after taxes. The location of production is distorted as compared with the free market.