The Money Commando

Unintended side effects – California’s Prop 13

TheMoneyCommando

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:

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:

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).

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 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?