This is part 3 of a series on unintended consequences of government policies.
In Part 1 of this series we looked at the mortgage interest tax deduction.
In Part 2 of this series we looked at student loans.
One of the main reasons I have such a strong libertarian bent is because I’ve seen so many unintended side-effects from various government programs. It’s almost impossible to create a policy, tax break, or government program that doesn’t affect the behavior of the free market.
That isn’t to say that these policies/programs are necessarily bad or harmful. In fact, I agree with the stated goals of many of them. Unfortunately, as we’ll see, these policies/programs always have unintended side effects that sometimes cause problems that are bigger than the problem that are designed to solve.
California’s Prop 13
The stated goals
California Proposition 13 was passed in 1978 as part of a general anti-tax movement. The primary goal of the proposition was to prevent people from being forced to sell their houses due to skyrocketing housing prices (and the corresponding property taxes). The proponents of the proposition publicized stories of retired men and women who were living on a fixed pension and/or Social Security and were unable to pay the rapidly escalating property taxes on their home.
(A quick aside – California is one of the few states that allows propositions to be proposed by the public. Basically, anybody can pull together an idea for a proposition, get enough signatures to support it, put it on the ballot for the public to vote on. I’m not sure if this is a good idea or not – I tend to believe that it’s best to allow experts to do their jobs. Unfortunately, in the case of making laws, the experts are politicians, who often make decisions based on politics rather than furthering the common good.)
People being forced out of their homes due to rising property taxes was a real problem that was caused by the intersection of two things:
- High inflation in the 1970’s that lead to corresponding increases in property values. Inflation in the 70’s averaged around 7% a year.
- The fact that many pension programs did not have annual adjustments for inflation.
Since property taxes are based on property values, higher property values meant higher property taxes. And if property taxes are going up and your income is fixed it suddenly becomes very difficult to afford to live in your house. I’d probably revolt too.
(Another quick aside – the lack of inflation protection in pensions is STILL an issue today. My mom’s Arizona state pension does not have any inflation adjustment. My mother-in-law’s California state pension has a fixed 2% annual adjustment, regardless of the actual inflation rate. This has looked pretty good in the last few years as inflation has been close to 0%, but when inflation rises to 3%+ it’s going to be a problem.)
Prop 13 was designed to limit property taxes.
Explanation of program
Prop 13 works by doing 2 main things:
- It limits property taxes to 1% of the property’s assessed value and
- It limits annual increases in the assessed value of the property to no more than 2% per year. In fact, the way this works is that your property taxes are the LESSER of either:
- A compounded 2% annual increase per year since you purchased the property, or
- The fair market value of the property less a few minor adjustments
For virtually every California homeowner who has owned his/her house for more than a few years, the 2% annual increase is less than the fair market value of the property.
The Prop 13 limitation applies as long the homeowner owns the house. However, once the house is sold the assessed value resets.
Here’s an example. Let’s say I purchased a house in Santa Barbara in 1990 for $200k. In 2017 the house is worth a cool $1M. This means that over the last 27 years my house has appreciated at an average of 5.27%/year. Let’s calculate what the tax would be with and without Prop 13 (assuming a 1% tax rate).
- Without Prop 13: 1% of $1M = $10,000 annual property taxes
- With Prop 13: First we must calculate the “Assessed Value”. That would be $250k * 27 years of 2% annual increases. This puts the “Assessed Value” at $426,721.60. The property tax is then 1% of $426,721 = $4,267 annual property taxes.
In this situation, Prop 13 results in a ~58% reduction in taxes paid. Clearly, Prop 13 is doing what it was designed to do.
Let’s make this more concrete by looking at real data I found on Zillow.com:
Property 1
You can see that from 2000-2002 the Tax Assessment (aka the assessed value) increased by 2% per year – this is Prop 13 at work. Then in 2003 the Tax Assessment jumped from $330,634 to $695,000. My guess is that the property was sold, causing a reset in the Tax Assessment. It looks like the house was sold again in 2005 and the Tax Assessment jumped to $931,000. The value then increased by the max of 2% in 2006 and a mere .8% in 2007. This implies that the fair market value was less than the Prop 13 assessed value, which increases by 2% every year.
The Assessed Value then dropped from $957,000 in 2007 to $751,000 in 2012 as housing prices dropped. In 2017 the Assessed Value was $792,182, which is substantially less than the value in when it was purchased in 2005.
Property 2
Here’s another property. This one had 2% increases in 2001 and 2002, then was sold in 2003. The Tax Assessment then jumped 594%. The new owner would be paying almost 7x as much in property taxes as the previous owner did just 1 year before!
Unintended side effects
Prop 13 discourages people from moving to pursue better job opportunities
The problem is that your assessed value is reset when the house is sold. So, in the example I used above, if you bought the house at $250k in 1990, you’d be paying $4,267 in property taxes in 2017. Let’s say you have a neighbor who owns an identical house (same layout, same lot size, etc.). Your neighbor also bought his house in 1990 for $250k and his house is also worth $1M today, so he also pays $4,267 in property taxes per year.
That makes sense – you essentially have the same house and you bought at the same time for the same amount of money.
For the sake of argument let’s say that you and your neighbor decide to swap houses. Let’s ignore the transactional costs and just say that it’s an even exchange. You now own a $1M house that’s identical to the $1M house you previously owned.
Unfortunately for both you and your neighbor, selling your house resets the assessed value of the house to the current fair value (in almost all cases this is the amount of money the house sold for). The assessed value of both houses has risen to the current $1M value.
You now both pay $10k in property taxes instead of $4,267. Your property taxes have now more than doubled even though you own an identical piece of property.
What if, instead of swapping houses, your decide to continue living in your house but your neighbor sells his house? Well, you’re still paying $4,267 in property taxes and your new neighbor is now paying $10,000 in property taxes.
This seems to be a fundamentally unfair outcome – you would expect that two people living in identical houses with the same value should be paying the same taxes.
Here’s the problem: let’s say you’re in the same situation as above (bought a house in Santa Barbara in 1990 for $250k and it’s now worth $1M). You’ve recently been offered your dream job in San Diego. The pay is the same but the job is exactly what you want to do.
You find a house in San Diego that’s identical to your current house for $1M.
You’re now faced with a dilemma. If you move you’ll pay almost $6,000/year in additional property taxes, with the difference growing at 2%/year.
In effect, Prop 13 acts as a substantial disincentive to move. On one hand this can be a good thing – long-term residents lead to stronger communities. On the other hand, it causes a drag on the economy. A mobile and fluid economy should make it easy for people to move to pursue better job opportunities, start new businesses, etc.
And there isn’t just economic harm. What if you want to move closer to your children or grandchildren? The tax increase might be large enough to prevent you from making a move.
The longer you’ve lived in your home the less property taxes you’re paying, which means that the longer you’ve lived somewhere the stronger the disincentive to move.
As an economist would say, Prop 13 introduces friction into the economy.
Prop 13 increases the price of housing
Rational people looking to purchase a product will evaluate 2 types of costs:
- The up-front costs (commissions, fees, down payment, etc.)
- The ongoing costs (maintenance, taxes, insurance, mortgage payments)
The total cost of home ownership is the up-front costs plus all future ongoing costs discounted to the present value.
Prop 13 has the effect of reducing ongoing costs. If ongoing costs are reduced then a given home is more affordable than it might have otherwise been. That is, if the future costs of owning a house are $100,000 instead of $200,000 then logically you’d be willing to pay more money for the house with lower future costs. This drives the price of housing up.
I guess it can be argued as to whether or not an increase in the price of housing is a positive or negative effect. If you’re a homeowner then an increase is probably a good thing, but if you’re looking to purchase a house then the price increases are a negative.
It think that overall higher housing prices are a net negative. Owning your home really isn’t a source of wealth, and I like the idea of housing being affordable enough that anybody who wants to put down roots in a community and buy a house should be able to do so.
Whether you think higher values are a good thing or a bad thing, it’s clear that Prop 13 affects property values.
Prop 13 hurts local communities, schools, and infrastructure
The primary goal of Prop 13 was to limit taxes. In this goal it has clearly succeeded. What have been the effects of lower tax collection?
Property taxes are used to fund local and state governments. Property taxes fund schools, pay public sector employees, maintain parks and roads, and provide other services.
Let’s take a look at California schools. Have they, in fact, been hurt by Prop 13? Are schools receiving lower funding due to Prop 13? To find out, let’s look at how much California spent per capita on education before and after Prop 13.
Thankfully, this research has already been done by the National Center for Education Studies. From page 98 we see this table:
The category we are interested in is the percentage change from 1969-70 to 1995-96. This includes a period from a few years before Prop 13 was put into effect until about 20 years afterwards. This is enough time to give us a rough idea of whether or not Prop 13 has had an effect on educational spending in California.
I’ve used my world-class art skills to highlight the California numbers (in yellow) and the US average (in light green). You can see that the US average increase over this time was 653% and California’s increase was 489%. The US average increase was about 50% higher than the increase in California. This is interesting, but even more interesting is the fact that California had the lowest increase in the entire country during that time period.
This decrease might make sense if California had previously had especially high funding and the funding levels just reverted to the average during the time period in question. But that’s not the case.
California doesn’t have the absolutely lowest level of per capita spending on education, but most of the states with lower per capita spending are from areas with significantly lower cost of living (Arkansas and Alabama, for example). If you compare California with other similarly high cost of living states (like Connecticut, New York, and New Jersey) you’ll see that California’s spending is significantly below those other states.
We can’t say for sure that this decrease in spending was due to Prop 13, but it doesn’t take much of a leap of faith to come to the conclusion that Prop 13 has had an effect.
Possible fixes
Prop 13 is largely considered untouchable in California. Any move to repeal Prop 13 would result in a revolt by current homeowners. It’s clear that Prop 13 will be a fixture in California politics for at least the foreseeable future. However, that doesn’t mean Prop 13 can’t be tweaked to improve it.
Fix 1 – Change the maximum annual increase
The easiest fix would be to change the rate of annual increases. Moving it from 2% to 3.22% would be a rational fix for a number of reasons. Why 3.22%? Well, the long-term average rate of inflation in the US has been 3.22%. I can’t see any possible justification for saying that property taxes should somehow be afforded a special treatment that other taxes (income, capital gains, Social Security, etc.) don’t receive. All of those taxes increase as your income or capital gain increase.
Similarly, we could change the way Prop 13 works so that annual increases in the assessed value are tied directly to inflation. If inflation was 1% in a year then property taxes would increase by 1%. If inflation was 5% then property taxes would increase by 5%. And since Social Security benefits are also tied to inflation, this would prevent Social Security beneficiaries from getting priced out of their homes.
Either way would allow the tax base to grow more quickly and level out the sometimes huge differences in property taxes paid by neighbors for nearly identical houses.
This fix also has the advantage of phasing in slowly. There would be no immediate large jump in property taxes dues. The difference in taxes paid would be inconsequential for the first 5-10 years, allowing the market plenty of time to adjust.
Fix 2 – Make the property tax progressive
The property tax is a flat tax. If your house has 2x the assessed value of your neighbor’s house then you pay 2x the property taxes.
By contrast, our income tax system is progressive. If your income doubles you’ll pay more than 2x the income taxes as your last dollar of income is taxed at a higher rate than your first dollar of income.
Would it make sense to change property taxes to also be progressive?
The problem here lies in the ability to pay. When you receive income you have cash that you can use to pay income taxes. That is not the case when pay property taxes. By living in the home you’re not receiving income that could be used to pay the property taxes. Of course, you could argue that what you do have is the money saved from not paying rent, but I think that’s a bit tougher of an argument.
I like the idea of improving the property tax system in some way, and I generally think that progressive taxes are a good idea. It’s possible that making the property tax moderate progressive in some way (1% on properties up to $1M, 1.1% on properties from $1M to $5M, 1.25% on all properties above $1.25M) might make sense.
Conclusion
I’m not a fan of Prop 13. When you buy a new house you’re paying higher taxes so that your neighbor (who has owned their home for 40 years) can pay much lower taxes. Not only is this fundamentally unfair, but it punishes the young and first time homebuyers. It hurts the economy and keeps families apart.
If Prop 13 was repealed we could likely reduce the current property tax rate from 1% to something much lower and still collect the same amount of taxes. Long time homeowners would pay more in taxes and recent homeowners would pay less. Unfortunately, as with any change, there will be winner and losers, and the potential losers will always fight and lobby much harder than the potential winners.
As always, government interference distorts markets. The problem is that the effects of interference sometimes aren’t realized until later.
What are your thoughts on Prop 13? If you’re a California resident do you benefit from Prop 13? If you live outside California would you like to see your state adopt a similar system? Does Prop 13 seem fair or unfair? Have I missed something in my analysis?
My understanding is there are 6 counties in CA that allow people over a certain age (55, I believe) to transfer their property tax base if they move. When my mom was considering moving here, she also looked at Ventura County because she would have been able to transfer her (extremely low) property tax base to a house purchased there. Should this be allowed? Should it be extended to the entire state? Should there be no age limit?
What a coincidence – I feel like I was JUST discussing this very topic with my wife a few days ago.
I think the value of this exemption depends on whether or not you like the fundamental idea of Prop 13, which is to lock in low property taxes for existing home owners. The value in allowing seniors to transfer their tax base is that you enable people to move around. Unfortunately, since the exemption only applies to people near retirement it probably doesn’t to much to encourage a more fluid economy (by not preventing people from moving to pursue new job opportunities).
On the whole, I think this exemption is a bad idea. It provides an even BIGGER tax break for seniors at the expense of the young.
I bought a home in CA recently, and am paying over $18,000 a year in property taxes. I just found out that a friend owns a similar home, and pays $2500 a year in property taxes, and has paid this ridiculously low tax for decades. Obviously people like me are subsidizing people like my friend, although we are all at the same socio-economic level. This is grossly unfair. My children just bought a house, and they too will be paying exorbitant taxes (now not even federally deductible!) while older, wealthier people, often with much lower family expenses, will pay pennies. How can we let this injustice go on? And I assume these tax-favored properties will be passed on by some legal finagle to the children at the same ridiculously low tax, while others have to pay soaring taxes, and public services are starved. What can we do to restore fair taxation? Is there any group already formed that is working on this?
Well, the political reality is that we’ll probably NEVER be able to repeal Prop 13. There are just too many people who benefit from it.
My thinking is that perhaps what we can do is modify Prop 13 so that instead of property taxes only increasing at a max of 2%/year they can increase at inflation (measured by CPI). Or, if that’s too difficult for people to understand, change the yearly increase to 3% or 3.5% instead of 2%. That would, over time, help the assessed value catch up to the actual value.
Not only government interference, the accumulation of the giant-tech private sector in California is driving exponentially high the cost of living in certain cities like San Francisco, LA etc. wouldn’t you say?
I’m not sure exactly what you’re saying by “…the accumulation of the giant-tech private sector is driving exponentially high…”
Certainly it’s the case that as the economy strengthens in an area the housing prices increase as well. However, I don’t see any sign of exponential growth in the cost of living. And, in fact, the information I’ve seen in the last few months shows that the higher end of the rental market in the Bay Area has actually been weakening this year.
Even if the cost of living is increasing proportionally to the strength of the economy, I’m not sure that’s necessarily a bad thing. It’s just standard supply and demand. The only potential negative is long-time residents being priced out of a market, but then again, that’s more or less exactly what Prop 13 was designed to prevent.
A big oversight of Prop. 13 when it was passed was to have commercial and rental properties assessed by a greater amount than residential properties. Owners of commercial properties do not sell property as frequently as residential homeowners and, therefore, the value stays the same. Owners of commercial properties have made out like bandits the past 40 years which has caused a huge inequity in California. Politicians are reluctant to address this inequity due to opposition of voters who own substantial commercial properties. Everyone realizes the unfairness of this measure and how difficult it will be to modify. I believe it has been the ruination of California.
Great points. I’ve yet to hear a compelling argument for why commercial properties should be covered by Prop 13.
I’m a bit more torn by the rental property argument. If rental properties aren’t covered by Prop 13 then rents will necessarily rise faster than they’ve been rising. Given that renters tend to be lower income than home owners, this seems like a regressive tax.
Hmm … to me it made more sense to keep Prop 13 for commercial lots, than rentals.
See http://www.latimes.com/opinion/op-ed/la-oe-friedersdorf-prop-13-20180604-story.html
I guess I’m making the assumption rents have to come down if no one can afford them. How does keeping a rental vacant help?
Keeping a rental vacant doesn’t help anybody. The owner of the property isn’t making any money on it, and reducing the number of rentals (supply) the price of rent must necessarily go up.
Ok, so I guess you’ve changed your mind, and are no longer torn by the rental property argument?
I was questioning my assumption, trying to figure out why you were torn.
Oh, maybe I misunderstood your comment. I was responding to the last sentence in your comment: “How does keeping a rental vacant help?”. My response – it doesn’t help.
I haven’t changed my mind about Prop 13 for rental properties vs. commercial properties. Let me first say that I don’t think that Prop 13 should apply to either of them, as they are both profit making enterprises and the original intent of Prop 13 was to prevent people from being priced out of their homes due to higher property taxes caused by rising housing prices.
However, I think that if Prop 13 were to be applied to either rental properties or commercial properties I think that rental properties more closely align with Prop 13’s intent. After all, many rental homes were at some point in the past used as primary residences. In fact, it’s not uncommon for somebody to buy a house, live in it for some amount of time, then buy a new house and rent out the old one. In that case I can understand the argument that it’s all housing and should be treated the same way.
The other argument, which I alluded to in my response to you, is that extending Prop 13 to rental properties helps keep rents lower. If property taxes increase by 20% in a year then the landlord will be forced to pass that on to the tenants. Without Prop 13 it would be very, very difficult to defend rent control. After all, how could you defend only allowing rent to increase by 5% a year if property taxes are going up by 10% per year?
Commercial buildings aren’t housing. They are used by businesses to generate profit. As such, it doesn’t seem as logical to extend Prop 13 to commercial buildings. A rise in commercial property prices doesn’t price anybody out of their home.
But again, to be clear – I personally believe that Prop 13 is a bad idea, and if it MUST exist, it should only extend to a primary residence, not to rentals or commercial/business properties.
You missed the most ironic bad effect of Prop 13: It has greatly increased the power of the State.
1. Most obviously, it gutted the funding and independence of local communities. They became dependent on Sacramento for funding and are now powerless to resist state regulation and control, especially in regard to schools, hospitals, public safety, and zoning regulation. (See here, for example). The outsized power and graft of public employee unions in the state is a secondary effect.
2. Prop 13 is an extremely powerful disincentive to make any significant improvements/upgrades to properties (especially older and/or marginal ones) as doing so results in a reassessment. While the resulting rundown of large swaths of our towns and cities and the explosion in un-permitted gray-market construction are bad in their own right, the larger effect is, again, the empowerment of government. Cities are increasingly forced to resort to “redevelopment” (aka liberal use of eminent domain) because neighborhoods and commercial/industrial districts are no longer developing naturally and are on a non-stop slide toward blight and non-productivity.
Your second point is pretty timely – we just got hit with a “supplemental tax assessment” for some improvements we recently made on our property. Although I think it’s reasonable to pay higher taxes if/when an improvement increases the value of the property, it’s obviously true that an owner is disincentived to make improvements as they result in reassessment. From a property owner perspective, the longer you’ve owned a property and had its taxes suppressed under Prop 13, the better. Once you’ve owned a property for a decade or so the cost of a reassessment can be prohibitive.
Your and other comments explain why the apartment building I just moved into has very few upgrades — this 5 unit building was bought for $320,000 in 2001; they are avoiding reassessment. Redfin estimates the mortgage on this 5,500 square foot property is about $1,900–*with* taxes impounded. We are getting a very good rate at $1,800 for a 2 bedroom. Meanwhile, we had to move out of the building next door when it was sold (the beneficent owner died, so the heirs cashed out)–after staying there for 15 years; we also benefitted from low rent (it was $1,175 in 2019), but the taxes had to also have been extremely low. Thank God for non-greedy owners! The new owners, however, extensively remodeled and basically tripled the rent. On moving into our current unit, we had to do a moderate amount of cleaning and prep — although there are new tile floors and nice windows. But it makes sense. And we are definitely not complaining! 🙏🙏🙏
Thanks for the comment.
The funny thing is that Prop 19 was passed a few years ago and it REMOVES the ability of heirs to inherit their parents’ property tax basis for investment properties (they can still inherit the property tax basis for the primary residence if the kid(s) move into it once the parents pass away).
So, theoretically, the disincentive to make improvements (and trigger a reassessment for property tax purposes) should be removed. When an investment property is inherited from a parent the property tax basis will be brought up to the current value, after which it will then be subject to yearly Prop 13 limitations.
You’ll be seeing a lot more situations like you saw – a property that’s been held for a long time will have very few improvements made during the life of the original owners, and as soon as it’s inherited the kids will want to make a bunch of improvements right away to increase the amount they can charge in rent.