The Property Tax Bound

Abstract

In most states, the property tax departs markedly from the ideal of a low-rate, broad-based tax that treats various types of real property uniformly. Recently, many states have responded to rapidly rising residential property values with new constraints such as assessment caps. This paper will review property tax performance and analyze several arguments relating to alleged deficiencies of the property tax. The analysis suggests that the property tax has performed well by most measures and that it ranks high in terms of both stability and revenue elasticity. The restrictions and constraints imposed on the property tax are likely the result of the pursuit of political objectives by decision makers and not the result of structural problems with the tax itself.

Full text

The Property Tax Bound
695
National Tax Journal
Vol. LIX, No. 3
September 2006
Abstract - In most states, the property tax departs markedly from
the ideal of a low–rate, broad–based tax that treats various types
of real property uniformly. Recently, many states have responded
to rapidly rising residential property values with new constraints
such as assessment caps. This paper will review property tax per-
formance and analyze several arguments relating to alleged defi -
ciencies of the property tax. The analysis suggests that the property
tax has performed well by most measures and that it ranks high in
terms of both stability and revenue elasticity. The restrictions and
constraints imposed on the property tax are likely the result of the
pursuit of political objectives by decision makers and not the result
of structural problems with the tax itself.
INTRODUCTION
The property tax in the United States has not withered away
as many observers predicted and some hoped. In fact, it
has remained a remarkably resilient component of state and
local revenue systems. However, rather than a board–based,
low–rate tax that treats all types of real property uniformly,
the tax in most states is characterized by a bewildering
array of constraints and preferences including classifi ed bases,
rate limits, revenue limits and caps, assessment exemptions,
freezes and caps, circuit breakers, and special incentives for
business.1 Recently, steps have been taken in many states to
reduce the impact of rising residential property values on
homeowners.
It has been argued that the property tax is a poor revenue
source that is revenue inelastic (fails to keep pace with the
economy) and regressive. These alleged defects are often
cited as reasons justifying the use of the constraints that are
placed on the tax. In this paper, the analysis indicates that the
property tax, rather than being a poor performing tax, ranks
high in terms of both stability and revenue elasticity and that
the regressivity concerns are likely ill–founded. The paper
suggests that the restrictions and constraints imposed on the
property tax are likely the result of the pursuit of political
objectives by decision makers and not the result of structural
problems with the tax itself.
The paper begins with a review of the role of the property
tax in state and local revenue systems in the U. S., including
the increased importance of residential property in the tax
The Property Tax Bound
J. Fred Giertz
Department of
Economics and Institute
of Government and
Public Affairs,
University of Illinois at
Urbana–Champaign,
Urbana, Illinois 61801
1
See Anderson (2006) for a detailed discussion of limitation measures.

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696
base. Then, the stability and responsive-
ness of the property tax within the state
and local tax system are analyzed using
an effi cient portfolio approach borrowed
from finance. Next, incidence issues
related to the property tax are briefly
summarized. The paper concludes with
a discussion of alternative explanations
for the existence of constraints on the
property tax.
PROPERTY TAX RELIANCE:
A REVIEW
The property tax in the U. S. has been a
growing and consistent source of revenues
for local governments since the late 1980s.
Figure 1 presents the combined state and
local tax collections in the U. S. for the
four most important tax sources in most
states: the property tax, the individual
income tax, the general sales tax, and the
corporate income tax.2 The revenues for
each tax are normalized by setting 1988
levels at 100. The results combine the
impacts of economic growth as well as
rate and base changes. Note that through
2005 property tax revenues have kept
pace with the individual income tax and
outpaced both the corporate income
and sales taxes, but without the cyclical
variations of the other taxes, most notably
the corporate income tax. Annual percent-
age changes in property tax revenues
are more stable as measured by their
standard deviation than any other taxes.
Only selective excise taxes such as the
motor fuels and alcoholic beverage taxes
are more stable, but they have lower
growth rates.
2
The property tax is almost exclusively a local government tax while the corporate income tax and to a lesser
extent the individual income tax are predominately state-level taxes. The general sales tax is used by both
state and local governments with the states playing a more important role.
Figure 1. Growth in Selected State and Local Taxes: 1988–2005 (1980=100)

The Property Tax Bound
697
For this same period, Figure 2 shows
that the property tax is still the single larg-
est source of state and local tax revenues,
accounting for nearly one–third of all tax
revenues. There was, in fact, a signifi cant
increase in property tax reliance after 2000.
The increased reliance on the property tax
was the result of a reduction in individual
and corporate income tax revenues after
the stock market decline in 2000 and the
recession in 2001 and increases in property
tax revenues that were used to compen-
sate for reductions in state aid to local
governments.
There has also been a significant
increase in the residential component of
the property tax base. This is illustrated
using Illinois data in Figures 3 and 4,
which show the increase in the residential
component of the property tax assess-
ment base. The use of Illinois data allows
the analysis to focus on the tax base of
assessed value rather than tax revenues.
These fi gures show a long–term increase
in the residential share of the property
tax base in Illinois. This is the result of
a steady increase in residential property
values accompanied by a reduction in the
importance of manufacturing in the state
that is real–property–intensive compared
with other types of business activities.
ATTRIBUTES OF THE PROPERTY TAX
Revenue Elasticity and Stability
For many years the property tax was
considered an inferior revenue source
because it failed to keep pace with a grow-
ing economy compared to the income and
sales taxes that were assumed to track
economic activity better.3 To analyze this
Figure 2. State and Local Tax Reliance: 1988–2005 (Tax as percentage of total state and local taxes)
3
A Google search of “property tax” and “inelastic” yields thousands of results, often from local jurisdictions
bemoaning their reliance on property tax revenues.

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698
Figure 3. Residential Assessed Value as Percentage of Total Assessed Value (Illinois)
Figure 4. Assessment Shares by Class of Property (Illinois)

The Property Tax Bound
699
assertion more directly, the four major
state and local taxes are treated as if they
are assets that comprise an overall state
and local tax portfolio. Each tax base has
a historic annual average growth rate as
well as a measure of stability. Correlations
among the growth rates of the various tax
instruments are also important. These
inputs are then used to construct an “effi -
cient frontier” detailing various growth
and stability combinations that can be
achieved by the judicious combinations
of the various taxes.
This approach is borrowed directly
from asset allocation theory in fi nance
developed by Nobel Prize winner Harry
Markowitz where an efficient frontier
comprising various risk–return combi-
nations is derived using combinations of
various assets. Each asset has a historic
risk and return associated with it as well
as return correlations with other assets.
These inputs are used to construct an
effi cient frontier illustrated in Figure 5.
Movement along the frontier is achieved
by combining assets with differing
risk–return characteristics. The low–risk,
low–return options in the lower left
would presumably be comprised largely
of money equivalents and fi xed income
instruments, while points farther to the
right would have larger allocations of
more risky, but higher return, assets such
as equity. Note that the effi cient frontier
does not dictate the optimal risk–return
combination. This is ultimately deter-
mined by the risk–return preferences of
the investor as illustrated by the tangency
of the investor’s indifference curve with
the effi cient frontier.
Applying this approach to analyze the
mix of taxes is instructive, but something
of a stretch. Several caveats should be
noted. First, the mix of state and local taxes
Figure 5. Portfolio Analysis: A Review

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700
is not decided by one entity. Instead, it is
the outcome of decisions made by the state
government and a number (often large)
of local jurisdictions. State revenues are
spent, for the most part, without regard
to the areas where they are raised, while
property taxes usually remain in the local
jurisdiction where they are levied. Fur-
ther, taxes used by governments, unlike
investments made by small investors, are
not scalable because risk–return charac-
teristics may change with the intensity
of use. For example, even if a state was
attracted to the risk–return characteristics
of a minor tax such as the cigarette tax, the
state would not be able to use it to replace
a major tax such as the individual income
tax. Finally, while investors are primarily
interested only in the risk–return attri-
butes of assets, politicians are concerned
with aspects of taxes that go well beyond
the growth–stability characteristics. For
example, equity concerns such as the
degree of progressivity of the system are
ignored in this analysis as are regional
redistribution issues.
Using the portfolio approach, an opti-
mal growth–stability frontier is con-
structed for the state of Illinois. Tax base
data for the individual income tax, the
corporate income tax, the sales tax, and
the property tax are available for a 25–year
period from 1980 to 2004. The focus here
is on the tax base (adjusted as much as
possible for legal changes in the base),
not tax revenues, which are the result
of both rate and base changes. Table 1
presents the basic ingredients that are
used in deriving the optimal frontier. In
this period, the property tax base was a
truly superior “asset” in the sense that it
had the highest growth rate and the low-
est standard deviation in growth rates.4
Further, the tax had another really valu-
able characteristic in that the property tax
growth rates were negatively correlated
with the growth rates of the other tax
bases. This provides important diversifi -
cation advantages. The other three taxes
had positive growth rate correlations with
each other.
When these characteristics are put into a
mean–variance estimator, the effi cient tax
mix frontier emerges as shown in Figure
6. The curve shows the various combina-
tions of growth and stability that could be
achieved by the effi cient mix of various
taxes. The actual mix of the four taxes
for ten different points on the frontier is
detailed in Table 2. Note that the property
tax comprises a signifi cant portion (more
than 50 percent) of every portfolio mix on
the frontier. Parenthetically, the corporate
income tax is a truly inferior tax “asset”
in that it does not make its way into any
effi cient tax mix. The reason for this is that
the corporate income tax had the lowest
rate of growth along with the highest
TABLE 1
CHARACTERISTICS OF TAX BASES: 1980–2004 (ILLINOIS)
Corporate Individual Income Sales Property
Annual Change
Variance
Standard Deviation
Correlation Coeffi cients
Corporate
Individual Income
Sales
Property
4.3%
0.023
0.151
1.00
0.62
0.52
–0.42
5.2%
0.002
0.049
1.00
0.65
–0.52
4.5%
0.001
0.030
1.00
–0.57
6.3%
0.001
0.030
1.00
4
It should be noted that part of the property tax base’s stability may come from institutional, not economic,
factors resulting from lags in the assessment process in dynamic property markets.

The Property Tax Bound
701
variation in growth rates of the four taxes,
while also being highly correlated with the
growth rates for the individual income tax
and sales tax.
It is important not to make too much
of this analysis. The widely heard warn-
ing in the investment arena that “past
performance is no guarantee of future
returns” applies here as well. There is
no assurance that the next 25 years will
be like the last period. In particular, real
estate markets may be quite different in
the future compared to the past. In addi-
tion, Illinois may not be exactly like other
states.5 Nevertheless, the analysis soundly
refutes the assertion that the property tax
is an anemic tax instrument characterized
by slow growth.
Regressivity
Another long–standing and widely held
belief about the property tax is that it is
highly regressive.6 This assertion is the
hallmark of many tax study reports that
urge reduced reliance on the property
tax with replacement revenues coming
from more progressive sources such as
the individual income tax.7 The tax is
often assumed to be borne by users of
residential property, either directly for
owner–occupants or indirectly through
Figure 6. Optimal Tax Instrument Frontier (Illinois)
5
Similar although not identical results are achieved when national state and local tax receipts data are used to
derive an effi cient frontier.
6
As with the revenue inelasticity issue, a Google search of “property tax” and “regressive” yields over 100,000
results. Numerous tax study reports from the U. S. and Canada feature this assertion about the regressivity
of the property tax. The regressivity belief is also documented in Youngman (2002).
7
The opposition to the property tax on grounds of its regressivity may be a variation of the theme raised by
Slemrod (2006) where survey results suggest that many taxpayers support the replacement of the individual
income tax with less progressive taxes such as a national sales tax or value added tax because they mistakenly
view the income tax as regressive.

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702
TABLE 2
COMPOSITION OF OPTIMAL TAX INSTRUMENT FRONTIER (ILLINOIS)
48
910
Corporate
Individual
Sales
Property
SD
Return
567123
0.0%
7.6%
41.3%
51.1%
0.014
0.055
0.0%
19.0%
17.7%
63.3%
0.015
0.058
0.0%
24.3%
6.9%
68.9%
0.017
0.059
0.0%
25.4%
0.0%
74.6%
0.019
0.060
0.0%
19.3%
0.0%
80.7%
0.021
0.061
0.0%
14.6%
0.0%
85.4%
0.023
0.061
0.0%
10.6%
0.0%
89.4%
0.024
0.062
0.0%
6.8%
0.0%
93.2%
0.026
0.062
0.0%
3.3%
0.0%
96.7%
0.028
0.063
0.0%
0.0%
0.0%
100.0%
0.030
0.063

The Property Tax Bound
703
higher rents for renters. Since lower–
income residents pay a larger share of
their income in housing costs compared
to those with higher income, the tax is
considered regressive.
In contrast, a recent article by Zodrow
(2006) provides a valuable summary of
current thinking by economists about the
incidence of the tax—an issue that is still
not fully resolved among tax experts.8
Zodrow characterizes two current views
of the incidence of the property tax.9 The
“benefi t tax” view treats the property tax
as a kind of user charge for local public
services with little redistributive impact.
Under this view, the property tax is a user
charge where local public services are
allocated effi ciently in a Tiebout world
based on willingness to pay with no redis-
tributive consequences where regressivity
and progressivity measures are not really
appropriately applied.
The alternative “capital tax view” is a
derivative of the Harberger (1962) gen-
eral equilibrium analysis first applied
to the corporate income tax. Under this
view, the property tax is treated as a tax
on the use of capital that redistributes
investments ineffi ciently between high
and low tax jurisdictions based upon tax
considerations with the burden falling
on owners of capital in all jurisdictions
through lower rates of return. Because
capital ownership is highly progressive,
the property tax under this view is pro-
gressive. Zodrow (2006, 15) summarizes
the impact of this view on incidence in
the following way: “Because the primary
effect of nationwide use of the property
tax is a reduction in after–tax returns to
capital owners, it is a highly progressive
tax. Nevertheless, from the perspective of
a single taxing jurisdiction, the local tax is
not borne by capital owners as a whole but
rather by local residents and is a roughly
proportional tax.”
POSITIVE EXPLANATIONS OF
PROPERTY TAX CONSTRAINTS AND
PREFERENCES
Rather than being a wounded, defective
tax instrument, the property tax unbound
appears to be a productive tax with a
number of positive attributes, not the
least of which is that it provides “fi scal
empowerment” to local governments. For
local governments to be effective in a fed-
eral system, they must have independent
sources of revenue. The property tax base
is one of the few taxes that is not either
preempted by higher levels of govern-
ment or severely hampered by the mobil-
ity of the tax base. If this is the case, why
then is the property tax so constrained? It
will be suggested here that the restrictions
and constraints imposed on the property
tax are likely the result of political factors
in the decision–making process, not struc-
tural problems with the tax itself.
A number of possible explanations
will be considered here. Many of the
explanations are speculative in nature
and no single explanation provides a full
understanding of the phenomenon.10 First,
it should be noted that few participants in
the tax decision–making process place the
same importance on economic effi ciency
as do economists. Decision makers are
often willing to sacrifice efficiency to
achieve equity goals or redistributive
outcomes that further pragmatic politi-
cal objectives. In addition, there may be
fundamental misunderstandings among
politicians and taxpayers about the basic
structural characteristics of the tax similar
to those found by Slemrod (2006) relating
to the income tax.
8
The debate about the regressivity of the property tax is also summarized by Youngman (2002).
9
Zodrow’s approach, in a sense, is an updated and expanded version of the “old view–new view” analysis
explained in Aaron (1975).
10 For an earlier analysis of this issue, see Giertz and McGuire (1991).

NATIONAL TAX JOURNAL
704
It is possible that the property tax is
constrained not because it is a bad tax, but
because it is such a powerful and produc-
tive tax instrument. Buchanan (1975) sug-
gests that taxes may be purposely bound
by making them ineffi cient in an effort
to control the size of government. One
example of the “starve the beast” explana-
tion emerged in the debate about taxation
of sales over the Internet. Some of the
opposition to requiring out–of–state ven-
dors to collect sales taxes was not based on
tax policy considerations. Instead, it was
simply a means to reduce the size of state
and local governments by making it more
diffi cult for them to collect the sales tax.
A more sophisticated version of this
argument suggests that there may be a
systemic inability of elected local govern-
ments to exercise effective control over
the size of their operations. It might be
expected that the decisions made by demo-
cratically elected offi cials would represent
the median citizen’s preferences.
11
In
regard to the “problem” of rapidly rising
assessment levels, local governments have
it within their power to reduce tax rates to
offset the assessment increases without the
needs for caps, freezes, and the like. Why
are additional controls necessary?
Many local governments operate in a
kind of information vacuum where most
voters know little about the jurisdiction’s
activities and have little incentive to
spend the time and effort to acquire more
information. The elected offi cials are the
ones who have the greatest interest in the
activities of their particular government.
They may behave in at least a limited way
as budget–maximizers in the Niskanen
(1971) mode. In such situations, it may be
more effi cient for relatively disengaged
citizens to impose broad, continuing
restrictions on taxing capacity rather than
attempting to monitor local government
actions on an ongoing basis.
However, such restrictions are usually
not imposed at the local jurisdiction level
where the tax and spending decisions
are made, but at the state level. In most
states, local jurisdictions must operate
according to general rules determined at
the state level. State–imposed restrictions
on local discretion can be of two types.
They may be imposed to impart fi scal
discipline that is lacking at the local level
through broad, general rules. Alterna-
tively, they may be a means by which state
politicians grant special favors to various
interest groups, receiving the political
credit while the local jurisdictions bear
the costs.
In summary, while there is an incom-
plete understanding of the positive
reasons for the existence of property tax
constraints, the argument that the intrinsic
defi ciencies in the property tax give rise
to the restrictions is dubious.
REFERENCES
Aaron, Henry.
Who Pays the Property Tax: A New View. Was h -
ington, D.C.: Brookings Institution, 1975.
Anderson, Nathan.
“Property Tax Limitations: An Interpreta-
tive Review.” National Tax Journal 59 No. 3
(September, 2006): 685–94.
Buchanan, James M.
The Limits of Liberty: Between Anarchy and
Leviathan. Chicago: University of Chicago
Press, 1975.
Giertz, J. Fred, and Therese J. McGuire.
”State Aid and State–Imposed Controls and
Local Fiscal Outcomes.” In Proceedings of
the Eighty–Third Annual Conference on Taxa-
tion, 62–7. Washington, D.C.: National Tax
Association, 1991.
Harberger, Arnold C.
“The Incidence of the Corporation Income
Tax.” Journal of Political Economy 70 No. 3
(June, 1962): 215–40.
11 The “fl y–paper” effect is another example of this seeming lack of responsiveness of local governments to
constituent preferences.

The Property Tax Bound
705
Niskanen, William A.
Bureaucracy and Representative Government.
Chicago: Aldine, 1971.
Slemrod, Joel B.
“The Role of Misconceptions in Support for
Regressive Tax Reform.” National Tax Journal
59 No. 1 (March, 2006): 57–75.
Youngman, Joan M.
“Enlarging the Property Tax Debate—
Regressivity and Fairness.” State Tax Notes
26 No. 1 (October 7, 2002): 45–52.
Zodrow, George.
“Who Pays the Property Tax?” Land Lines 18
No. 2 (April, 2006): 14–9.