DYNAMIC PROPERTY TAXES AND RACIAL GENTRIFICATION.

• Author: Hayashi, Andrew T.

INTRODUCTION

Although housing prices can fluctuate dramatically from year to year, real property taxes generally do not. This is because property owners are taxed on their property's assessed value, and assessed values typically do not move in lockstep with the property's fair market value. Instead, in many jurisdictions, a property's assessed value is a function of both the property's current value and its value in prior years. As a result, two properties worth the same amount today may be taxed at different rates depending on the evolution of the properties' values over time. Property taxes that depend on the history of a property's values are dynamic property taxes.

For example, many jurisdictions limit the rate at which a property's assessed value can increase over a period of years (a "cap"). For example, consider a home in New York City valued at $800,000 in 2020, increasing in value to $860,000 in 2021. The property's assessed value in 2021 will only be $848,000 because its assessed value cannot increase by more than 6% in any one year. (1) In other jurisdictions, properties are reappraised only every few years, and any increase in a property's value between appraisals is added to the property's assessed value in increments (a "phase-in"). Consider a home in Maryland valued at $860,000 in 2021, valued at $800,000 when it was last assessed in 2018. (2) The property's assessed value will be $820,000 in 2021, $840,000 in 2022, and $860,000 in 2023.

Caps and phase-ins reduce the assessment ratio (assessed value as a share of market value) for a rapidly appreciating property. Because taxes are based on assessed values, caps and phase-ins therefore reduce the effective tax rate (ETR) for such a property. (3) The result is that rapidly appreciating homes have lower ETRs compared to properties with stable values, declining values, or only modest growth rates.

I have written elsewhere about the advantages and disadvantages of caps, arguing that they either do not achieve their objectives or do so at too great a cost. (4) In this Essay, I focus on the beneficiaries of caps and phase-ins and how the evolution of a neighborhood's racial composition interacts with dynamic property taxes to affect the property tax incidence. Home prices reflect (among other things) racial preferences for neighbors, which typically manifests as a valuation penalty in predominantly minority neighborhoods. (5) Since property taxes are based on home prices, racial preferences influence property taxes. When home prices are stable, ETRs should be roughly constant across neighborhoods, including both those that are predominantly white and those that are composed mostly of racial minorities. But when home prices are changing, ETRs under a dynamic property tax will vary across neighborhoods. When these changes result from the interaction of racial preferences and the re-sorting of households across neighborhoods--such as in the case of gentrification--dynamic property taxes have racially disparate impacts. (6)

These impacts are nuanced and contingent on empirical facts about the incidence of dynamic property taxes and the process of neighborhood change. In Part II, I describe conditions under which dynamic property taxes result in higher ETRs for black homeowners than white homeowners during a period of gentrification. This result may partially explain evidence that black homeowners face higher ETRs than similarly situated white homeowners, a fact that has been attributed to the overvaluation of black-owned properties. (7) If dynamic property taxes--not overvaluation--are why black homeowners have higher property taxes than white homeowners, then the remedy lies in the elimination of assessment caps and phase-ins rather than more accurate valuation methodologies.

Seeing the relationship between dynamic property taxes and gentrification also reveals a problem. By lowering the ETR for rapidly appreciating homes, dynamic property taxes subsidize investments and processes that lead to rapid appreciation. The displacement of minority residents by white residents in a neighborhood is one such process, so dynamic property taxes subsidize gentrification and the racial preferences that are associated with it.

1. KEY FEATURES OF DYNAMIC PROPERTY TAXES

   Evaluating the effects of dynamic property taxes requires specifying a baseline against which to measure those effects. Current-value taxation serves as an intuitive and justifiable baseline that has both efficient and equitable properties. (8) Property values reflect local amenities and public goods--such as schools and public parks--and the expected provision of those goods in the future. A tax based on current property values captures the benefits of these public goods to the extent they are capitalized in home prices and, in this respect, operates as an efficient user fee. If home prices are correlated with homeowner wealth, then taxing homeowners based on home values is also reasonably equitable and allocates the local tax burden according to homeowners' ability to bear the costs of government. Against this baseline, dynamic property taxes lower ETRs on appreciating properties, taxing them less than properties with more stable values. But determining who actually benefits from dynamic property taxes depends on key design features of the tax.

   1. Caps and Phase-Ins

      The first key feature of a dynamic property tax is whether it employs caps or phase-ins. Assessment caps lower ETRs on properties that appreciate at a rate higher than the annual cap. For example, New York City's caps prevent assessments from increasing more than 6% annually or 20% over five years. (9) The five-year cap corresponds to an annualized rate of price growth of a little over 3.7%. (10) The cap confers no benefit for properties that appreciate at a rate below the cap. By contrast, phase-ins benefit all appreciating properties because any increase in market value between assessment years is added to the assessed value incrementally.

      A second difference between caps and phase-ins is how they affect ETRs in a period of price stability or decline after a run-up in housing prices. In the case of caps, the appreciation accrued during the run-up may require a long period of subsequent price stability before assessed values converge to fair market values. In the case of phase-ins, by contrast, all of the gain that accrues during a housing price run-up is fully reflected in assessment ratios by the second assessment period after the boom ends.

      Summarizing the differences, caps tend to benefit the fastest appreciating neighborhoods for a relatively long time. In contrast, phase-ins benefit all appreciating neighborhoods, but the benefits tend to be shorter-lived.

   2. Transferability

      A second important design feature of dynamic property taxes is how they treat the transfer of property. In some jurisdictions, such as California, assessed values are reset to fair market values when properties are sold. (11) Since this means that the current owner may have a much lower ETR for the property than a potential buyer, this discourages efficient property transfers and can create "lock-in." (12) Lock-in entrenches outdated patterns of property ownership, meaning that neighborhood demographics are more likely to be influenced by anachronistic homeownership preferences than in another jurisdiction where taxes do not create a wedge between buyer and seller valuations. For example, lock-in might inhibit neighborhood integration that would otherwise occur because of changing racial preferences.

      In other jurisdictions, such as New York City, assessed values are unaffected by property transfers, and the buyer of a property inherits the seller's assessment. (13) Notionally, this means that the buyer of the property subject to a cap or phase-in derives a benefit from owning a property with a lower assessment ratio. Of course, sellers whose property has a favorable assessment ratio should, in theory, be able to charge a higher price in an amount equal to the present value of the property tax benefit. In jurisdictions like New York City, identifying the true beneficiaries of dynamic property taxes is not as simple as looking at the owners of properties with low assessment ratios. If those owners paid a premium to the seller for the tax benefit, then the economic beneficiary of the cap or phase-in may be long gone. And property taxes are generally--if only partially--capitalized in home values and sales prices. (14) In fact, there is evidence that buyers dramatically overpay for short-term property tax benefits, so that property tax benefits are overcapitalized. (15)

2. DYNAMICS OF NEIGHBORHOOD CHANGE

   In this Part, I explore the theoretical racial effects of dynamic property taxes under gentrification. To understand these effects, we must first understand the racial impacts of property taxes in a static environment because it is current or expected changes in that environment that drive changes in property values. Many people judge neighborhood "quality" based, in part, on the racial composition of the neighborhood. They do this either because they have direct preferences about their neighbors' race or because they use race as a proxy for other characteristics of the neighborhood. (16) Home prices should reflect the preferences of those who have the greatest ability to act on these preferences, and there is evidence that this is likely to be white homeowners. (17)

   The value of a home depends partly on factors unique to the home itself, such as the features of the structure and size of the lot. But a home's value also depends on factors particular to the neighborhood. Local amenities such as parks, good public schools, and low crime rates will generally increase homes' value in the area. The production of these amenities depends on the allocation of public resources but also on neighborhood residents' behavior. A parent considering whether to buy a...